Leverage routines may be a way to survive bugs: living from multiple perspectives under over-collateralized borrowing

Author: danny; Source: X, @agintender

The lending function, which seems to be a very “old” business, under the operation of card bug masters, arbitrage professionals and financial saws, in web3 has gone beyond the function of solving liquidity problems in the traditional sense, and has transformed into a dark pool that matches different funding needs. It also plays the role of converting static user deposited assets into a tool to drive the exponential growth of exchanges, and has also become a weapon to attack opponent protocols.

Today we will start from the perspective of different characters and see what kind of hidden gameplay can be played without following the instruction manual?

1. Retail Alchemy: Revolving Loans

1.1 “Money Lego” Cycle: The Mechanism of Revolving Loan

• core concepts: The user first provides an asset as collateral to a lending protocol, then lends the same asset, and then re-deposits the loaned asset into the protocol as new collateral.This process can be repeated multiple times to build a highly leveraged position.

The general steps are as follows:

1. Deposit: The user deposits $1,000 USDC into the protocol.

2. lend: Assuming the LTV of the asset is 80%, the user can lend USDC of 800 USD.

3. re-deposit: The user deposits the lent 800 USDC into the protocol again, and at this time the total collateral value reaches $1,800.

4. Lend again: Users can lend out 80% of their value again, which is 640 USDC, based on the newly added 800 USDC collateral.

5. repeat: By repeatedly executing this cycle, users can use a small amount of initial capital to greatly amplify their total position in the protocol, thereby amplifying their exposure to rewards.

Here is an interesting observation. The “unanchored” price point of USDe on Binance on 10.11 is also very particular. The price dropped to 0.91-0.86-0.75, which corresponds to the liquidation point of the revolving loan (9 times will be liquidated at 0.91, 8 times will be liquidated at 0.86, and so on)

1.2 Economic incentives: yield farming, airdrops and token rewards

The premise for this strategy to be profitable is that the annualized yield (APY) of the rewards paid by the protocol to depositors and borrowers (usually the protocol’s governance token) must be higher than the net borrowing cost (i.e., the borrowing rate minus the deposit rate).When a protocol attracts liquidity through high token incentives, the net interest rate for borrowing (borrowing interest rate – borrowing reward APY) may even be lower than the net interest rate for deposits (deposit interest rate + deposit reward APY), thus creating room for arbitrage.

1.3 Leverage on Leverage: Amplification of Risk

While the revolving loan strategy amplifies returns, it also amplifies risks in a non-linear manner.

• Liquidation risks are imminent: A revolving loan position is extremely sensitive to market changes.A small drop in the value of the collateral (even a stablecoin in an unanchored event), or a sudden spike in borrowing rates, could quickly push this highly leveraged position to the brink of liquidation.

• Interest rate fluctuation risk: Lending interest rates change dynamically.If pool utilization spikes due to a surge in external demand, borrowing rates could rise sharply, quickly making the revolving loan strategy unprofitable or even creating negative spreads.If users are unable to close their positions in time, the accumulating interest debt will erode the value of the collateral and eventually lead to liquidation.

1.4 Systemic impact and economic attacks

Revolving loans not only pose risks to individual users, but their large-scale existence may also have a systemic impact on the protocol and even the entire DeFi ecosystem.

• “Invalid” capital: Some view this strategy as “parasitic” because it artificially inflates the protocol’s TVL without providing real liquidity for diverse real lending needs.

• Infection risk: The collapse of a leveraged revolving loan strategy, especially when a whale user is involved, could trigger a cascade of liquidations.This will not only disrupt market prices, but may also leave bad debts on the protocol due to slippage in the liquidation process, thus triggering systemic risks.

• Economic Attacks and Poison Pill Strategies: The mechanism of revolving loans can also be exploited by malicious actors or competitors as a means of economic attack.An attacker can use a large amount of capital to establish a large revolving loan position on the target protocol, artificially driving up its utilization and TVL.They can then suddenly withdraw all liquidity, causing the protocol’s utilization to collapse in an instant and interest rates to fluctuate wildly, triggering a chain of liquidations that destabilizes the protocol and damages its reputation.This strategy aims to make rival protocols unattractive to real users by temporarily injecting large amounts of capital and then quickly withdrawing it, forcing their liquidity providers to leave, similar to the “poison pill” defense in corporate finance, but here used as an attack method.

2. Market Maker’s Playbook: Capital Efficiency and Leveraged Liquidity

Market makers are core participants in financial markets, and their main function is to provide liquidity to the market by simultaneously providing buy and sell quotes.The collateral lending system provides market makers with powerful tools to improve their capital efficiency and execute more complex strategies.

• Get trading inventory and working capital: Market makers usually need to hold a large amount of underlying assets (such as project token ABC) and quoted assets (such as stable currency USDT) to operate effectively.

• Borrow native tokens: A common model is that the market maker borrows its native token (ABC) directly from the project party’s treasury as trading inventory.

• Unlock capital value: Instead of letting these borrowed tokens sit idle, market makers can deposit them into DeFi or CeFi lending platforms as collateral to lend out stablecoins.In this way, they can obtain the stablecoins needed for market making without investing all of their own capital, thus greatly improving capital efficiency.

• Leveraged market making strategy: Market makers can build more complex leverage chains to further amplify their working capital.For example, a market maker can:

1. Borrow ABC tokens worth $1 million from the project.

2. Deposit ABC tokens into the lending protocol and lend $600,000 USDC at 60% LTV.

3. Use this $600,000 USDC to purchase highly liquid, high LTV assets such as BNB.

4. Then deposit BNB worth $600,000 into the lending agreement and lend USDC of $480,000 at an LTV of 80%.

Through this process, the market maker leveraged the initially borrowed ABC tokens and ultimately obtained over $1 million in stablecoin liquidity (600,000 + 480,000), which can be used for market making activities on multiple trading pairs and exchanges.Although this leveraged approach can amplify returns, it also significantly increases liquidation risk and requires monitoring the price fluctuations of multiple collaterals.A similar method is the cross-margin leverage mode, and the principle is almost the same, so I won’t go into details here.

3. The project party’s treasury: non-dilutive financing and risk management

For projects/teams, Treasury management is crucial because it is directly related to the long-term development and viability of the project.Pledge lending provides project parties with a set of flexible financial management tools.

• Non-dilutive working capital: One of the biggest challenges faced by the project side is how to fund daily operations (such as paying employee wages, marketing expenses) without damaging the market price of the token.Selling large amounts of Vault tokens directly on the open market would create massive selling pressure that could cause prices to plummet and shake community confidence.

• Borrow instead of sell: By using native tokens in the vault as collateral, projects can borrow stablecoins from the lending protocol to pay for expenses.This is a non-dilutive method of financing because it allows projects to continue to hold their native tokens while obtaining the liquidity they need, thereby preserving the potential for future appreciation of the tokens.

• Maximize returns on treasury assets: Assets (whether native tokens or stablecoins) sitting idle in a vault are unproductive.Project parties can deposit these assets into the liquidity pool of the DeFi lending protocol to earn interest or protocol rewards.This creates an additional revenue stream for the project and improves capital efficiency.

• OTC: Collateralized lending can also be used as a tool to facilitate more flexible OTC transactions with large investors or funds.Instead of directly selling a large number of tokens at a discount, the project team can reach a structured loan agreement with the buyer: (fake loan, real cash out)

1. The project party uses its native token as collateral to obtain a stablecoin loan from the buyer (as the lender).

2. The parties can negotiate a lower interest rate and longer repayment period, which effectively gives the buyer a cost advantage over holding the token.

3. If the project party chooses to “default” (ie does not repay the loan), the buyer will obtain the mortgaged tokens according to pre-agreed terms, which is equivalent to completing the acquisition at a fixed, possibly discounted price.This method provides a more hidden and structured solution for large transactions, while providing instant liquidity to project parties.

The treasury’s primary exposure is the price of its native token.If the token price drops significantly, it may cause the vault’s collateral to be liquidated, which will not only cause asset losses, but also send a strong negative signal to the market, possibly triggering panic selling.There are also some brokers who maliciously manipulate prices, causing treasury tokens to change hands.

4. Monetization of CEX treasury – using borrowing to leverage high-leverage transactions

CEX’s lending model is essentially the same as the deposit and loan business of traditional commercial banks.The basic logic is: the exchange pays relatively low interest to users who deposit assets (depositors/lenders), while charging relatively high interest to users who borrow these assets (borrowers).The interest rate difference between the two (called Net Interest Margin, NIM) constitutes the gross profit of the lending business

In essence, CEX’s lending business is an asset-liability management business, rather than a simple service charging business.Its success depends on its ability to effectively manage interest rate risk (interest rate fluctuations), credit risk (institutional borrower defaults) and liquidity risk (concentrated withdrawals by depositors) like traditional banks.But this is actually not the main profit point

The Great Multiplier – How Lending Is Detonating Trading Income

Although the lending business can generate considerable direct profits through net interest margins, its greatest strategic value in the CEX business model is not its own profitability, but its role as a catalyst that exponentially amplifies the exchange’s core revenue source – transaction fees.

For example:

A trader with 1,000u decides to use 10x leverage.This means that the exchange, backed by its large pool of user assets, lent 9,000u to this trader.In this way, the trader can control a trading position with a total value of 10,000 u with a principal of 1,000 u.This 9,000u loan is the most direct application scenario of the exchange lending function.

CEX’s transaction fees are calculated based on the total notional value of the transaction, not on the trader’s own principal invested.Therefore, through this leveraged transaction, the exchange charged 9x more handling fees.

Based on the above logic, it is not difficult to understand why exchanges are generally keen to provide highly leveraged products, such as perpetual contracts that provide leverage of up to 100 times or even higher.Higher leverage means that traders can use less principal to leverage greater nominal trading volume, which directly translates into higher fee income for the exchange.

Remember: the profitability of an exchange is positively related to the risk (leverage level) taken by its users.

In high-leverage contract transactions, the loan/mortgage function is added as a prerequisite, and the liquidation variable here is not simply x2, but increases exponentially – which further confirms this sentence: For exchanges, the most profitable customers are often those who engage in the highest risk trading behaviors.

postscript

Seeing that everyone here is destined, I don’t have the answer here. Instead, I will give you a question. Assuming that you are a market maker/project developer/large investor, how would you combine and link the above routines to maximize your profits?

You must know that in this circle, the identities of the project party/market maker/large accountant/trader can not only be used at the same time, but also interchangeable in different time periods – beyond the imagination of the identity is the first step to get stuck.

Lego has been given to you, is it Burj Khalifa?Or a Ferrari sports car?Or Harry Potter’s Magic Castle?It just depends on your imagination.