DeFi Thots: leveraged financing on DeFi protocols

****This is not investment advice. I am writing out my thoughts and trading experience******

To the hungry but optimistically (perhaps naively) risk averse crypto beginner, navigating the world of Decentralized Finance (DeFi) can be daunting. The sheer number of protocols now live in market as well as the amount of publicity every blockchain gives these projects makes an introduction into this space seemingly critical, though leaving you at quite at a loss; you may hear about these new applications of finance but what exactly do these protocols offer a newly introduced investor? More practically, what is offered by these projects that make them a more attractive investment platform than a traditional centralized exchange where you may pursue delta based strategies?

In this post I give an introductory understanding of DeFi with a focus on its financing applications, as well as the risks this trading strategy carries, with a particular goal of the defi trader: how can we trade independent of coin price fluctuations in a market neutral defi trade?

Arguably, defi starts with decentralized exchanges. Inside these exchanges, a flow of capital creates two needs that also act as possible investment techniques in DeFi: 1) liquidity for dex facilitation, and 2) financing.

Liquidity

Dexes capture liquidity primarily through a reward-incentivized liquidity pool. As an investment product in itself, this would be what an investor would consider: buy the two tokens that make up a liquidity pool, and discharge them into the pool to receive an LP coin instead. A % of each transaction in the dex will be set aside as rewards for these LP holders.

There is a widely known downside risk to these liquidity pool investments: impermanent loss. This connotes the “silent” loss to your investment relative to holding those two coins separately outside of the liquidity pool. The detailed mechanics can be found in multiple documentations available online by different dexes (try starting with Uniswap’s 50/50 model with a constant product factor), but what’s worth highlighting here is the effective yield trade that’s dependent on a non-fluctuating price of the two coins of the liquidity pool. In other words, this doesn’t align perfectly with the defi trader’s goal to be market neutral.

Financing

This brings our focus to the second dynamic of the defi world: financing via borrow and lending. The high level mechanics here are simple. We borrow at level x% and/or lend at level y%, making your annualized returns (y-x)%, weighted by the capital of borrowing/lending.

The basic steps to executing the financing trade looks like this:

1. Deposit a base asset that you already own and is considered a valid collateral from a wallet into the defi protocol, earning you a deposit interest rate

2. Use that asset as collateral to borrow a different asset, paying a borrow interest rate

Arbitrage opportunities can be found given the growing number of borrow and lending platforms across blockchains, as well as the different supply and demand (in addition to the reward incentives) dynamics in each.

A fundamental risk here is the collateral value in our LTV calculations. As asset prices fluctuate, the value of our collateral will fluctuate also that opens our positions to liquidation risk.

Hence, consider using pegged stable coins whose value are theoretically pegged to USD fiat. We can borrow stable coin #1 from platform A at x%, and lend the same coin in platform B at y%. If y > x + e, where e = transaction (gas) costs, we have a good trade.

This gets more interesting if we go one step further. What if stable coin #1 is considered a valid collateral in platform B? We now have borrow capacity in platform B; suppose we take a 80% loan (commonly the max LTV across platforms) for stable coin #2 at borrow rate z%. If there is another platform where stable coin #2 can be lent at a rate above z%, we can repeat the same trade as for stable coin #1. A continuous cycle of this gives us a compounded return level that starts to outperform a one dimensional borrow and loan trade between two platforms.

Below takes a look at how yields grow as we repeat this, using actual rates observed across Aave and Sushiswap.

Aave offered 4.15% deposit rates on USDC and a 1.73% borrow rate on DAI. Sushiswap on the other hand offered a 1% borrow rate on the USDC-DAI borrow pool (USDC borrow with DAI collateral). Both protocols offered these rates on the polygon chain, where transaction fees were minimal and hence excluded from return calculations. The cumulative yield on the original 1000 USDC capital grew by 34% to 5.54% after three cycles of borrowing and lending at an 80% LTV.

Admittedly, the absolute return rate hanging at mid-single digits here is not very attractive. However, this mechanism to compound your returns by identifying a financing arbitrage opportunity does seem to significantly grow your returns, all without having a direct exposure to coin price fluctuations.

A few last thoughts to finish this post:

1. This could be an interesting trade for an institutional investor who needs limited downside risk

2. As interest rates fluctuate in protocols, we do need to monitor and rebalance this trade periodically

3. Given the simple and repetitive logic behind this strategy, this is a prime target for automation