Recursive Lending Strategy
Automatically “looping” assets in lending protocols to earn boosted liquidity mining incentives
This article examines one of the earliest yield-generating strategies in the DeFi playbook. This one is known by several names, including “recursive lending,” “looping strategy,” among others. The strategy operates on lending protocols within DeFi, it involves the lending and borrowing of the same asset to accumulate the rewards distributed by the protocol to its users. Emerging DeFi protocols frequently participate in incentive campaigns, where they distribute a portion of their governance tokens as rewards to attract liquidity to their platforms.
Recursive Lending Strategy Overview
How exactly does the recursive lending strategy function, and how does it generate profit?
For the recursive lending strategy to be effective, the targeted protocol must incentivize its liquidity. This setup requires that the supply APY (Annual Percentage Yield) of the markets exceeds the borrowing cost APY of the same market.
The Moonwell protocol on Base is actively incentivizing their liquidity. The markets depicted show a higher supply APY compared to the borrowing APY for the same asset, making the strategy feasible.
For instance, consider the ETH market highlighted, which has a normal (without incentives) supply APY of 1.0%, while its borrowing APY stands at 2.1%. Once the incentive rewards are factored in, an additional 5.5% in WELL rewards is credited to suppliers of this market. This brings the total supply APY, combining the base APY and WELL rewards, to a 6.5% supplying APY.
Since the supply APY exceeds the borrowing APY, users can supply an asset and then borrow the same one without incurring a loss. By redepositing it into the same market, they create a loop, thus optimizing their positions to maximize their accumulation of WELL rewards. Projected returns from a leverage staking strategy are directly proportional to the level of leverage applied. The greater the leverage, the higher the potential APY — however, this also increases the risk of liquidation.
Strategy Risks
As with anything in life, higher yields come with greater risks. So, what are the potential pitfalls of this strategy?
The key factor that users should monitor in this strategy is the market interest rates, as the success of the strategy hinges on these rates. Thoroughly analyze the protocol’s incentive plan to determine if it aligns well with the strategy. Keep a close watch on the market’s available liquidity. This can change rapidly and may alter the conditions of the interest rates, potentially rendering the strategy unprofitable.
Moreover, it’s also crucial to ensure that the protocol has undergone rigorous technical audits and that its code is robust, as many DeFi protocols are vulnerable to attacks.
The displayed image presents the interest rate curves of a market within the Aave protocol, providing insights into the utilization rate. This metric indicates the available liquidity in the market compared to the borrowed amount and pinpoints the “Kink” or “Optimal” point where the borrowing interest rates start to shift dramatically.
Risks Monitoring
Remember, available liquidity can change either through increased borrowing by users or when users withdraw their liquidity from the market. Either of these changes could significantly alter the market’s interest rates and potentially place the strategy in an unprofitable position.
This indicator monitors the largest lenders in the market relative to the available liquidity of it, it depicts the DAI market on Moonwell base. As shown, the largest lender in this market holds a position greater than the available market liquidity. At any moment, this address could withdraw its position, causing the market to reach a 100% borrowing rate. This would trigger the borrowing APY and potentially render the recursive lending strategy unprofitable.
The number of times users decide to loop their positions also increases their risk exposure. The more loops they engage in, the higher the likelihood of a user being liquidated in their position. As users loop their positions more, their leverage increases. If the protocol rewards are not compounded and redeposited into the position correctly, the borrowing debt could surpass the supply gained, exposing users to the risk of liquidation.
The graphic shown illustrates the distribution of health factors for recursive lending across positions in the Moonwell protocol. A health factor of a position reveals its proximity to liquidation; positions with a health factor below 1 are at risk of being liquidated, potentially leading to a loss for the borrower.
This indicator is valuable for analyzing the diverse range of borrowers within the protocol. If a significant portion of the supply has a low health factor, it signals that the solvency of the pool/protocol is at risk due to potential large-scale liquidations. This indicator can offer insights into the liquidity risk of a DeFi lending protocol. It can serve as an early warning for both depositors and liquidators, enabling users and investors to respond proactively.
IntoTheBlock’s Risk Management & Execution
As part of the IntoTheBlock Smart Yields platform, the ITB recursive lending strategy offers fully automated deployment and risk management that can be customized to each client’s profile. Each strategy is deployed individually for each client, ensuring that funds are not co-mingled. The contracts are non-upgradable and non-custodial, guaranteeing the highest security standards.
The position manager smart contract handles the receiving, allocation, and eventual withdrawal of funds into the strategy. The strategy executes a flash loan, enabling it to deposit collateral, borrow the asset, and rehypothecate it all within a single transaction. This simplifies and significantly reduces the cost of the process, which would otherwise require dozens of transactions to execute manually depending on the desired amount of leverage.
Next, the strategy manager contract acts as the primary connector with ITB’s risk engines and the liquidation monitor. These risk engines are off-chain models that run simulations on a block-by-block basis to track the strategy’s exposure to economic risks. If the models detect a risk exceeding the client’s risk tolerance, they send a signal to the strategy manager contract, prompting automatic disassembly of the position and sending funds back to the position manager.
About IntoTheBlock Smart Yields
IntoTheBlock Smart Yields is an institutional-grade product that ensures access to some of the most compelling opportunities in DeFi while prioritizing security and risk management. Leverage staking is merely the beginning; our platform offers over 100 strategies, all safeguarded by an advanced layer of risk management. These strategies are deployed across more than ten blockchains, providing extensive coverage of assets and protocols.
We’ll be introducing additional strategies via our Medium channel in the coming weeks. In the meantime, if you’re eager to learn more or interested in testing out the ITB Smart Yields platform, feel free to reach out to us for further information.
