Summary
Recently, with changes in the regulatory environment, DeFi protocols have offered much higher interest rates than traditional financial wealth management scenarios, thanks to the enthusiasm of on-chain traders for crypto assets. This has had a positive impact on two groups of users. First, for some traders, after most blue-chip crypto assets have broken historical highs, it is a good choice to appropriately reduce leverage and look for low-alpha risk wealth management scenarios. At the same time, as we enter a rate-cutting cycle on a macro level, for most non-crypto professionals, allocating idle assets to DeFi can also yield higher returns. Therefore, I hope to start a new series of articles to help everyone quickly get started with DeFi, and, by combining real trading data from DeFi whales, analyze the returns and risks of different strategies. I hope for your support. In this first installment, I want to start with the currently popular interest rate arbitrage strategy and analyze its opportunities and risks by looking at the fund allocation of AAVE whales.
What is Interest Rate Arbitrage in the DeFi World?
First, for those unfamiliar with finance, let me introduce what interest rate arbitrage is. Interest rate arbitrage, also known as carry trade, is a financial arbitrage strategy whose core is to profit from the interest rate differences between different markets, currencies, or debt instruments. Simply put, this business follows a path: borrow at low interest, invest at high interest, and earn the spread. In other words, arbitrageurs borrow low-cost funds and invest in higher-yielding assets to earn the difference in interest rates.
To give an example of the most favored strategy by hedge funds in traditional financial markets: the USD-JPY carry trade. We know that under Japan's YCC policy, bond yields have been extremely low, with real interest rates even in negative territory. Meanwhile, the US dollar remains in a high-interest environment, creating an interest rate differential between the two financing markets. Hedge funds use US Treasuries, a high-yielding asset, as collateral to borrow yen from various financing channels, then either buy high-dividend assets from Japan's five major trading companies or convert back to USD to purchase other high-return assets (PS: one of Warren Buffett's favorite strategies). The advantage of this strategy is that it increases capital leverage efficiency. This arbitrage path alone can reach a scale sufficient to impact global risk asset prices, which is why every rate hike by the Bank of Japan after abandoning YCC in the past year has greatly affected risk asset prices.
In the DeFi world, there are two main categories of core innovation. The first is decentralized exchanges (DEX), and the second is decentralized lending protocols. The former leads to "price arbitrage strategies," which we won't discuss here, while the latter is the main source of "interest rate arbitrage strategies." Decentralized lending protocols allow users to use a certain crypto asset as collateral to borrow another crypto asset. The specifics vary depending on liquidation mechanisms, collateral requirements, and how interest rates are determined, but for now, let's focus on the most mainstream "over-collateralized lending protocols" in the current market to introduce this strategy. Take AAVE as an example: you can use any supported crypto asset as collateral to borrow another crypto asset. During this process, your collateral still enjoys native yield and lending yield from the platform, represented by the Supply APY. This is because most lending protocols use a Peer To Pool model, where your collateral automatically enters a unified liquidity pool as the source of funds for the platform's lending. Borrowers who need your type of collateral asset pay interest to this pool, which is the source of lending yield. What you need to pay is the borrowing interest rate for the asset you borrow, i.e., the Borrow APY.
These two interest rates are variable and determined by the interest rate curve in AAVE. Simply put, the higher the utilization rate of the liquidity pool, the higher the corresponding interest rate. The reason for this design is that, in Peer To Pool lending protocols, borrowing does not have the concept of a maturity date as in traditional financial markets. This simplifies the protocol's complexity and allows lenders' funds to be more liquid, without having to wait for debt maturity to retrieve principal. However, to ensure sufficient repayment constraints on borrowers, the protocol requires that as the remaining liquidity in the pool decreases, borrowing rates increase, forcing borrowers to repay and ensuring the pool's liquidity remains in dynamic balance, best reflecting real market demand.
With this basic knowledge, let's introduce how interest rate arbitrage is achieved. First, you need to find an asset with high native yield + Supply APY as collateral. Next, find a suitable borrowing path with a low Borrow APY to borrow assets. Finally, use the borrowed funds in the secondary market to buy more collateral and repeat the above steps to increase leverage.
Those with financial knowledge can easily spot two risks in this path:
- Exchange rate risk: If asset A depreciates relative to asset B, liquidation risk can arise. For example, if your collateral is ETH and you borrow USDT, a drop in ETH price can reduce your collateral ratio and lead to liquidation.
- Interest rate risk: If the Borrow APY of asset B is higher than the total yield of asset A, the strategy is in a loss position.
- Liquidity risk: The liquidity for exchanging between asset A and asset B determines the cost of entering and exiting the arbitrage strategy. If liquidity drops sharply, the impact can still be significant.
To address exchange rate risk, we see that most DeFi interest rate arbitrage strategies are designed so that the two assets involved have a certain price correlation and do not deviate significantly. Therefore, there are two main choices in this sector: the LSD path and the Yield Bearing Stablecoin path. The difference depends on the base currency of the managed funds. If the base is a risk asset, in addition to interest rate arbitrage, you can still retain the native asset's alpha yield, such as using Lido's stETH as collateral and borrowing ETH. This arbitrage path was very popular during the LSDFi Summer period. In addition, choosing correlated assets has another benefit: a higher maximum leverage, because AAVE sets a higher Max LTV for correlated assets, known as E-Mode. With a 93% setting, the theoretical maximum leverage is 14x. According to current yields, taking AAVE as an example, the lending yield for wstETH is the native ETH yield of 2.7% + 0.04% Supply APY, while the Borrow APY for ETH is 2.62%. This means there is a 0.12% interest rate spread, so the potential yield for this strategy is 2.74% + 13 * 0.12% = 4.3%.
As for interest rate risk and liquidity risk, they can only be mitigated by continuously monitoring both interest rates and related liquidity. Fortunately, these risks do not involve instant liquidation, so timely liquidation is sufficient.
How an AAVE Whale Earns 100% APR on $10 Million through Interest Rate Arbitrage
Next, let's look at how a DeFi whale uses interest rate arbitrage to achieve excess returns in practice. As mentioned in previous articles, AAVE accepted PT-USDe issued by Pendle as collateral a few months ago. This has fully unleashed the profitability of interest rate arbitrage. On AAVE's official platform, we can see that PT-USDe is always at its supply cap, showing the popularity of this strategy.
Let's analyze the fund allocation and potential yield of the largest DeFi whale in this market, 0x55F6CCf0f57C3De5914d90721AD4E9FBcE4f3266. The total asset size of this account has reached $22M, most of which is allocated to the above strategy.
As seen, this account allocates funds through two lending markets: $20.6M in the AAVE ecosystem and $1.4M in Fluid. As shown, the account uses $20M in principal on AAVE to leverage about $230M in PT-USDe assets, with corresponding borrowings of $121M USDT, $83M USDC, and $4M USDe. Let's calculate its APR and leverage multiple.
According to the PT-USDe interest rate at the time of position opening, the main locked-in rate occurred at 20:24 on August 15, meaning the account's entry rate was 14.7%.
Currently, the borrowing rate for USDT on AAVE is 6.22%, for USDC it is 6.06%, and for USDe it is 7.57%. We can calculate the leverage multiple and total yield as 11.5x and 104%. What an attractive number!
How DeFi Beginners Can Replicate Whale Strategies
In fact, for DeFi beginners, replicating such interest rate arbitrage strategies is not difficult. There are already many automated interest rate arbitrage protocols on the market that help ordinary users avoid the complex logic of looped lending and enable one-click position opening. Since I am writing from the perspective of the buy-side market, I will not mention specific project names here; you can search for them in the market yourself.
However, I must remind you of the risks of this strategy, mainly in three aspects:
- Regarding exchange rate risk, as introduced in previous articles, the AAVE official community has designed the Oracle logic for PT assets. Simply put, when the oracle is upgraded to capture PT asset price changes in the secondary market, you need to control leverage to avoid liquidation risk when the maturity date is far off and market price volatility is high.
- Regarding interest rate risk, users need to continuously monitor changes in the interest rate spread and adjust positions in a timely manner if the spread narrows or turns negative to avoid losses.
- Regarding liquidity risk, this mainly depends on the fundamentals of the target yield-bearing asset project. If a major trust crisis occurs, liquidity will quickly dry up, and the slippage loss when exiting the strategy will be significant. Users should remain vigilant and keep an eye on project developments.
