DeFi Beginner's Guide (Part 1): How AAVE Whales Use $10 Million to Arbitrage Interest Rate Spreads and Achieve 100% APR

Author: @Web3Mario

Summary: Recently, with changes in the regulatory environment, DeFi protocols have been offering much higher interest rates than traditional finance 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 some low-alpha risk wealth management scenarios. At the same time, as we enter a rate-cutting cycle at the 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 newcomers quickly get started with DeFi, and, combined with real trading data from DeFi whales, analyze the returns and risks of different strategies. I hope for your support. For the first installment, I want to start with the currently popular interest rate arbitrage strategy, and analyze its opportunities and risks using the fund allocation of large AAVE holders.

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 (Interest Rate Arbitrage), also known as carry trade (Carry Trade), is a financial arbitrage strategy that profits from the interest rate differences between different markets, currencies, or debt instruments. Simply put, the process involves borrowing at a low rate, investing at a high rate, and earning the spread. In other words, arbitrageurs borrow low-cost funds and invest them in higher-yielding assets to earn the interest rate differential.

Take the most favored strategy by hedge funds in traditional financial markets as an example: the USD-JPY Carry Trade. We know that under Japan's YCC policy, bond yields are extremely low, with real rates even in negative territory. Meanwhile, the US dollar remains in a high-interest environment, creating an interest rate differential between the two funding markets. Hedge funds use US Treasuries, a high-yielding asset, as collateral to borrow yen from various 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. The scale of funds involved in this arbitrage path is large enough 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 core innovations: the first is decentralized exchanges (DEX), and the second is decentralized lending protocols (Lending). 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 one type of crypto asset as collateral to borrow another. 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." Using AAVE as an example, you can use any supported crypto asset as collateral to borrow another asset. During this process, your collateral continues to earn native yield and platform lending yield, represented by Supply APY. This is because most lending protocols use a Peer To Pool model, where your collateral is automatically pooled as a source of lending funds. Borrowers who need your collateral asset pay interest to the pool, which is the source of lending yield. What you need to pay is the borrowing interest for the asset you borrow, i.e., the Borrow APY.

These two rates are variable and determined by the interest rate curve in AAVE. Simply put, the higher the utilization rate of the pool, the higher the interest rate. The reason for this design is that, in Peer To Pool lending protocols, there is no concept of maturity as in traditional finance. This simplifies the protocol and allows lenders to withdraw principal at any time. However, to ensure borrowers repay, the protocol increases borrowing rates as pool liquidity drops, forcing borrowers to repay and keeping the pool in dynamic balance, reflecting real market demand.

With these basics covered, let's explain how interest rate arbitrage is achieved. First, find an asset with high native yield + Supply APY as collateral. Next, find a borrowing path with a low Borrow APY, borrow the asset, use the borrowed funds to buy more collateral on the secondary market, and repeat the process to increase leverage.

Those with financial knowledge will easily spot two risks in this path:

l  Exchange Rate Risk: If asset A depreciates relative to asset B, liquidation risk arises. For example, if your collateral is ETH and you borrow USDT, a drop in ETH price can lead to insufficient collateral and liquidation.

l  Interest Rate Risk: If the Borrow APY for asset B exceeds the total yield for asset A, the strategy is loss-making.

l  Liquidity Risk: The liquidity for exchanging between asset A and asset B determines the cost of entering and exiting the arbitrage. If liquidity drops sharply, the impact can be significant.

To address exchange rate risk, most DeFi interest rate arbitrage strategies use two assets with correlated prices to avoid large deviations. The main choices in this sector are the LSD path and the Yield Bearing Stablecoin path, depending on the base asset. If using a risk asset as the base, you can still capture native asset Alpha yield in addition to interest rate arbitrage, e.g., using Lido's stETH as collateral to borrow ETH. This arbitrage path was popular during the LSDFi Summer. Another benefit of using correlated assets is higher maximum leverage, as AAVE sets a higher Max LTV for correlated assets, known as E-Mode. With a 93% setting, the theoretical max leverage is 14x. Based on current yields, for example in AAVE, wstETH lending yield is ETH native yield 2.7% + 0.04% Supply APY, and ETH Borrow APY is 2.62%. This means a 0.12% spread, so the potential yield for this strategy is 2.74% + 13 * 0.12% = 4.3%.

As for interest rate and liquidity risks, these can only be mitigated by continuously monitoring both rates and related liquidity. Fortunately, these risks do not involve immediate liquidation, so timely unwinding is sufficient.

How AAVE Whales Use 10 million USD to Earn 100% APR through Interest Rate Arbitrage

Next, let's look at how DeFi whales use interest rate arbitrage to earn excess returns in practice. As mentioned in previous articles, AAVE accepted Pendle's PT-USDe as collateral a few months ago, which has fully unleashed the profitability of interest rate arbitrage. On AAVE's official platform, PT-USDe is always at its supply cap, showing the popularity of this strategy.

We chose the DeFi whale with the largest collateral in this market, 0x55F6CCf0f57C3De5914d90721AD4E9FBcE4f3266, to analyze their fund allocation and potential yield. This account's total assets reach $22M, most of which are allocated to the above strategy.

As shown, this account allocates funds through two lending markets: 20.6M in the AAVE ecosystem and 1.4M in Fluid. In AAVE, the account uses 20M principal to leverage about 230M in PT-USDe assets, with corresponding borrowings of 121M USDT, 83M USDC, and 4M USDe. Let's calculate the APR and leverage multiple.

According to the PT-USDe rate at the time of position opening, the main locked-in rate was on August 15th, 20:24, meaning the account's entry rate was 14.7%.

Currently, the USDT borrowing rate in AAVE is 6.22%, USDC is 6.06%, and USDe 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 loop lending logic and open positions with one click. Since I am writing from a buyer's perspective, I won't mention specific project names; you can search the market yourself.

However, I must remind you of the risks of this strategy, mainly in three areas:

1.  For exchange rate risk, as mentioned in previous articles, the AAVE official community has designed the Oracle logic for PT assets. In short, when the oracle is upgraded to capture PT asset price changes in the secondary market, leverage must be controlled to avoid liquidation risk when the maturity date is far off and market price volatility is high.

2.  For interest rate risk, users need to continuously monitor changes in the spread and adjust positions promptly if the spread narrows or turns negative to avoid losses.

3.  For liquidity risk, this mainly depends on the fundamentals of the target yield asset project. If there is a major trust crisis, liquidity will quickly dry up, resulting in significant slippage losses when exiting the strategy. Users should remain vigilant and keep track of project developments.