Borrowing to short is an important use-case of DeFi lending protocols. Since other ways of shorting tokens are not always available, lending protocols provide valuable liquidity to short-sellers. From the protocol’s point of view, however, strong demand for certain tokens for shorting can pose challenges to risk management and interest rate strategy.
The main risk of a token being heavily borrowed for shorting is the protocol’s supply may. become nearly 100% utilized. If this condition persists, there will be insufficient liquidity if a large supplier chooses to withdraw. If the token is also enabled as collateral, there may be unpredictable liquidation slippage as the collateral is not immediately available. To avoid the risks that come with excessive utilization, protocols can adjust the interest rate parameters of heavily shorted tokens to discourage overuse.
Specifically, the protocol may choose to increase borrowing and supply rates at high utilization, as in the example above. On Aave v2, USDT borrowing has seen persistently high demand since launch, likely from short-sellers speculating on a depegging of the token. In November 2022, we proposed and later executed the interest rate adjustment shown to reduce USDT borrowing at high utilization levels.
