Why DeFi speculators are borrowing Ethereum as the merger looms

Why DeFi speculators are borrowing Ethereum as the merger looms

Decrypt DeFi is Decrypt’s DeFi email newsletter. (drawing: Grant Kempster)

With the Ethereum merger event just days away, the entire industry is gearing up for the most anticipated network upgrade.

Bounty hunters are on the lookout for any bugs in the code; blockchain company ConsenSys launches so-called “durable” NFTs to celebrate the occasion; and crypto exchanges make way for another potential fork of the Ethereum blockchain.

DeFi degens are also keeping a close eye on any possible forks. If this were to happen, it would mean that anyone holding ETH at the time of the fork would also earn another airdropped token for the new chain.

For those who traded crypto in 2017, you will recall that Bitcoin holders earned free Bitcoin Cash (BCH), Bitcoin Gold (BTG), and even something called Bitcoin Diamond (BCD) through various forks of the original cryptocurrency.

A well-known Chinese crypto miner, Chandler Guo, is currently leading the charge for an Ethereum proof-of-work fork. Indeed, after the merger, Ethereum will no longer need mining machines to sustain itself, leaving many mining operations out in the cold.

There are a lot of issues here.

And while Guo tries to rally the mining troops to execute their fork, the degens are borrowing tons of ETH in hopes of also cashing in on a bargain from the forked coin (which will apparently carry the ETHPoW ticker).

Borrowing has been so excessive that some protocols are taking steps to limit the amount that can be distributed. Aave, the popular lending and borrowing protocol, has actually just suspended ETH borrowing due to this massive demand.

Ethereum borrowing rate on Aave. (via Aave)

And since the yield you earn from lending on Aave is demand-driven, Ethereum deposit interest rates have also entered double-digit territory. Right now, you can earn 10.54% on your ETH.

Ethereum’s supply side pricing on Aave. (via Aave)

Instead of suspending borrowing, rival protocol Compound imposes a 100,000 ETH cap on the amount users can borrow. The current proposal also states that if the utilization rate of the platform reaches 100% (which some predict), then the cost of borrowing could reach 1,000%.

The utilization rate is a measure that Challenge protocols like Aave and Compound use to reflect how much of an asset in a given pool is on loan. A high utilization rate indicates that the borrowing demand for an asset is close to the total amount of said asset available.

Ciaran McVeigh of 0xA Technologies put it this way: “If I have a pool with $100 worth of Dai and $80 of that Dai has been borrowed, that’s an 80% utilization rate.”

What is the problem ? In the open crypto market, strong demand will also be met by attractive supply-side pricing, right?

While this is certainly true, high utilization rates can still cause two key issues.

First, once 100% of all funds in a pool are used, depositors will no longer be able to withdraw their money from the system. Second, a high usage rate can lead to liquidation issues for these platforms. When there is no collateral in the system because everything is borrowed, liquidators will not be able to close out certain positions, potentially leaving the protocol under-collateralized (which is just a fancy way of saying insolvent). And that would be really, really bad.

Finally, Ethereum borrowers should be reminded that none of these platforms will call you and tell you that the cost of borrowing just skyrocketed to 1000%. It will just happen.

And if you are borrowing specifically to speculate on a potential airdrop if the network forks, you are also betting that this new token will also soar. If not, you are in for a world of pain.

Good luck there.

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