Decentralized finance (DeFi) is experiencing a surprising comeback, as the recent surge in cryptocurrency prices has extended to the sector that has struggled since last year’s high-profile collapses and the rise of interest rates on traditional markets.
Interest rates for borrowing stablecoins, such as USDC and Tether, which are meant to track the US dollar, have skyrocketed to more than 10% on Aave, the biggest DeFi lender. This higher rate indicates that traders are leveraging their crypto bets. The rates had been low for months, as DeFi’s once-lucrative returns were nowhere to be seen amid the historically high yields of the traditional bond market.
Data from Coinglass shows that the open interest-weighted funding rate for tokens, such as XRP, has become positive this past weekend. This implies that speculators betting on a price surge are willing to pay those expecting a decline to maintain their bullish positions open. XRP rose 11% to 72.6 cents on Monday, and other main alt-coins like Dogecoin are also trading higher.
Gauntlet co-founder Tarun Chitra comments that “there have been various ‘wealth effects’ which usually cause a rise in lending demand when there is a huge increase in a certain token”. He adds that “there is also short-side lending demand from big holders”. According to him, leverage in DeFi is reflexive, meaning that as prices go up, there is a natural desire from those who want to place long-term speculative bets on the market to increase their leverage.
The surge in Bitcoin prices in October, the greatest monthly gain since January, has spurred the speculation that the US Securities and Exchange Commission (SEC) will soon approve exchange-traded funds (ETFs) that directly invest in the original cryptocurrency. This has resulted in the rally of smaller tokens, such as Solana, which is one of the top performing cryptocurrencies this year despite its close link to FTX co-founder Sam Bankman-Fried, who was convicted of fraud last week.
The high borrowing rates in DeFi and funding rates in the perpetual futures market has also created arbitrage opportunities for traders to benefit from the differences between the two. Spencer Hallarn, a derivatives trader at crypto investment firm GSR, states that “Aave and perp rates are generally correlated, as you can arbitrage between the two. This speaks to the demand to own crypto in the derivatives market.”
BlockFi’s collapse last year left DeFi lenders as some of the only available venues for leveraged trades, according to Chitra. Darius Sit, founder and chief investment officer at Singapore-based crypto investment firm QCP, noted that the lending demand on OTC desks is not elevated.
Noelle Acheson, author of the Crypto Is Macro Now newsletter, comments that “lending and leverage is definitely coming back”. She adds that “this is a natural consequence of not only the increasing investor interest, but also an increase in volatility. Volatility encourages leverage and, therefore, the demand for lending.”