DeFi newbie entry guide (Part 1): See how Large Investors use 10 million USD to achieve 100% APR through interest rate Arbitrage - ChainCatcher

Author: @Web3Mario

Abstract: Recently, with changes in the regulatory environment, DeFi protocols have gained significantly higher interest rates than traditional financial wealth management scenarios, thanks to on-chain traders' enthusiasm for crypto assets. This has a positive significance for two groups of users. First, for some traders, after the prices of most blue-chip crypto assets have broken historical highs, appropriately reducing leverage and seeking low alpha risk wealth management scenarios is a good choice. At the same time, with the macroeconomic shift into a rate-cutting cycle, for most non-crypto office workers, allocating idle assets in DeFi can also yield higher returns. Therefore, the author hopes to start a new series of articles to help friends quickly get started with DeFi, and analyze the returns and risks of different strategies using the real trading data of DeFi whales, hoping for everyone's support. In the first issue, the author hopes to start with the recently popular interest rate arbitrage strategy and analyze the opportunities and risks of this strategy in conjunction with the capital allocation of AAVE whales.

What are the typical scenarios for arbitrage opportunities in the DeFi world?

First, we need to introduce the concept of interest rate arbitrage to those who are not familiar with finance. Interest Rate Arbitrage, also known as Carry Trade, is a financial arbitrage strategy that focuses on profiting from the differences in interest rates between different markets, currencies, or debt instruments. In simple terms, to engage in this business, one must follow a path: borrow at low interest, invest at high interest, and earn the interest rate differential. In other words, arbitrageurs borrow low-cost funds and then invest them in higher-yielding assets to earn the profit from the interest rate differential.

Taking the strategy most favored by hedge funds in traditional financial markets as an example, that is the USD/JPY Carry Trade. We know that Japan has maintained extremely low bond yields under the YCC policy, with real interest rates even at negative levels. Meanwhile, the USD remains in a high-interest environment, creating a yield spread between the two different financing markets. Hedge funds choose to use high-yielding US Treasuries as collateral to borrow Japanese yen from various financing channels, and then either purchase high-dividend assets from Japan's five major trading companies or exchange back to USD to buy other high-return assets (PS: one of Buffett's favorite strategies). The benefit of this strategy lies in its ability to increase capital leverage efficiency; just this arbitrage pathway alone can scale up to a level that influences global risk asset prices. This is also why, after the Bank of Japan abandoned YCC in the past year, every rate hike has significantly impacted risk asset prices.

In the world of DeFi, there are two main categories of core innovations. The first category is decentralized exchange platforms (DEX), and the second category is decentralized lending protocols (Lending). The former leads to "arbitrage strategies based on price differences," which will not be discussed in this article, while the latter is the primary source of "arbitrage strategies based on interest rate differences." A decentralized lending protocol allows users to use certain crypto assets as collateral to borrow another type of crypto asset. The specific subdivisions can vary based on different liquidation mechanisms, collateral ratio requirements, and methods for determining interest rates. However, we will focus on the currently most mainstream "over-collateralized lending protocols" to introduce this strategy. Taking AAVE as an example, you can use any of the supported crypto assets as collateral to borrow another crypto asset. In this process, your collateral still earns native yields, as well as the lending yields from the platform, which are represented by the Supply APY. The reason for this is that most lending protocols adopt a Peer To Pool model, where your collateral will automatically enter a unified fund pool as a source of lending funds for the platform. Therefore, borrowers who need assets of your collateral type will also pay interest to this fund pool, which is the source of the lending income. What you need to pay is the borrowing interest corresponding to the asset you borrowed, which is referred to by 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 level. The reason for this design is that in Peer To Pool lending protocols, borrowing does not have a maturity date concept like in traditional financial markets. The benefit of this approach is that it simplifies the complexity of the protocol, and lenders have higher liquidity since they do not need to wait until the debt matures to reclaim their principal. However, to have sufficient constraints on borrowers' repayments, the protocol requires that once the remaining liquidity in the pool decreases, the borrowing interest rate increases, compelling borrowers to repay through elevated rates. This ensures that the remaining liquidity in the pool is always in a state of dynamic equilibrium, maximizing the reflection of the market's real demand.

After understanding these basic concepts, let’s introduce how arbitrage on interest rate differentials is done. First, it is necessary to find native assets with high returns + Supply APY to use as collateral. Next, look for suitable borrowing paths with lower Borrow APY to lend the assets. Finally, use the borrowed funds to buy back the collateral in the secondary market and repeat the above operations to increase financial leverage.

Friends with financial knowledge can easily find that this path has two risks:

Exchange Rate Risk: If there is a depreciation in the price change of Asset A relative to Asset B, there is a risk of liquidation. Imagine your collateral is ETH and the borrowed asset is USDT; when the price of ETH falls, your collateral ratio is insufficient, which can easily lead to liquidation.

l Interest Rate Risk: If the Borrow APY of Pool B is higher than the total yield of Pool A, then the strategy is in a loss state.

l Liquidity Risk: The exchange liquidity of Fund A and Fund B determines the establishment and exit costs of this arbitrage strategy. If liquidity decreases significantly, the impact remains considerable.

To address exchange rate risks, we see that the two types of funds designed for most DeFi interest rate arbitrage need to have a certain correlation in price, without significant deviation. Therefore, the main asset selections in this track are of two types: LSD path and Yield Bearing Stablecoin path. The difference depends on what the managed funds are based on; if they are based on risk assets, in addition to interest rate arbitrage, they can still maintain the ability to yield native asset Alpha returns, such as using Lido's stETH as collateral to borrow ETH. This arbitrage path was very popular during the LSDFi Summer period. Additionally, choosing correlated assets has the advantage of allowing for a higher maximum leverage ratio, as AAVE sets a higher Max LTV for correlated assets, known as E-Mode, where under a setting of 93%, the theoretical maximum leverage is 14 times. Therefore, based on the current yield rates, taking AAVE as an example, the lending yield for wsthETH 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 would be 2.74% + 13 * 0.12% = 4.3%.

For interest rate risk and liquidity risk, they can only be mitigated through continuous monitoring of the bilateral interest rates and related liquidity. Fortunately, this risk does not involve immediate settlement, so timely settlement is sufficient.

How AAVE Whales Use 10 Million USD to Achieve 100**% APR through Interest Rate Arbitrage**

Next, let's take a look at how DeFi whales leverage interest rate arbitrage to achieve excess returns in real trading. In a previous article, it was mentioned that AAVE accepted PT-USDe issued by Pendle as collateral a few months ago. This has completely stimulated the profitability of interest rate arbitrage. We can find on the official AAVE platform that PT-USDe is always in a state of supply limitation, which also shows the popularity of this strategy.

We chose the DeFi whale 0x55F6CCf0f57C3De5914d90721AD4E9FBcE4f3266, which has the largest collateral scale in this market, to analyze his capital allocation and potential yield. The total asset scale of this account has reached $22M, but most of it is used to allocate to the aforementioned strategy.

It can be seen that the account has allocated funds through two lending markets, with 20.6M allocated in the AAVE ecosystem and 1.4M allocated in Fluid. As shown in the figure, the account utilized a principal of 20M in AAVE to leverage approximately 230M in PT-USDe asset scale, with corresponding loan allocations of 121M USDT, 83M USDC, and 4M USDe. Next, let's calculate its APR and leverage ratio.

According to the PT-USDe interest rate shown at the time of its position opening. The main locked interest rate occurred on August 15 at 20:24, which means the opening interest rate for this account is 14.7%.

The current borrowing rate for USDT in 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 return rate as 11.5 times and 104%. What an attractive number!

How Beginners in DeFi Can Replicate Expert Strategies

In fact, for newcomers to DeFi, replicating such arbitrage strategies is not difficult. There are already many automated arbitrage protocols on the market that can help ordinary users avoid the complex logic of circular loans, allowing for one-click positions. Here, since the author is approaching from the perspective of the buy-side market, specific project names will not be introduced, and everyone can collect them from the market on their own.

However, the author needs to remind that the risks of this strategy can be mainly divided into three aspects:

1 In terms of exchange rate risk, the design logic of the AAVE official community for the PT asset Oracle has been introduced in previous articles. In simple terms, when the oracle is upgraded to capture the changes of PT assets in the secondary market, this strategy needs to control the leverage ratio to avoid the risk of liquidation when the expiration date is far away and the market price is highly volatile.

2 In terms of interest rate risk, users need to continuously monitor the changes in the interest spread and adjust their positions even when the spread converges or becomes negative, to avoid losses.

3 In terms of liquidity risk, this mainly depends on the fundamentals of the target yield-bearing asset projects. If a major crisis of confidence occurs, liquidity will quickly deplete, and the slippage losses incurred by the exit strategy will be significant. Users should also remain vigilant and keep an eye on the project's progress.