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Why DeFi Speculators Are Borrowing Ethereum as Merge Looms

Why DeFi Speculators Are Borrowing Ethereum as Merge Looms

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

With the Ethereum Merger event just days away, the entire industry is gearing up for the most anticipated update on the web.

Bounty hunters look for bugs in code; blockchain firm ConsenSys is launching so-called “durable” NFTs to mark the occasion; and crypto exchanges are making way for a new potential branch of the Ethereum blockchain.

DeFi degens also keep a close eye on potential forks. If this were to happen, it would mean that anyone with ETH during the fork would also earn another airdropped token for the new chain.

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

Well-known Chinese crypto miner Chandler Guo is currently leading the charge for Ethereum’s proof-of-work fork. This is because after the merger, Ethereum will no longer need miners to sustain itself, and many mining operations will be left out in the cold.

There’s quite a lot at stake here.

And while Guo is trying to rally the miners to implement his fork, the degens are borrowing tons of ETH hoping to also enjoy the fork coin (which apparently has the ETHPoW token).

The borrowing has been so excessive that some protocols are taking steps to limit how much can be shared. Aave, a popular lending and borrowing protocol, has actually just suspended ETH lending due to this massive demand.

Ethereum loan rates on Aavella. (via Ghost)

And to the extent that the return you earn on an Aave loan is a function of demand, Ethereum deposit rates have also entered double-digit territory. Currently you can earn 10.54% of your ETH.

Ethereum supply side prices on Aave. (via Ghost)

Instead of suspending lending, rival protocol Compound puts a 100,000 ETH limit on how much users can borrow. The current proposal also stipulates that if the platform’s utilization rate reaches 100% (which some expect will happen), the cost of the loan could rise to 1,000%.

Utilization is a metric that DeFi used by protocols such as Ghost and Compound to describe how much assets in a given pool are being borrowed. A high utilization rate indicates that the loan demand for an asset is close to the total amount available for that asset.

Ciaran McVeigh of 0xA Technologies put it this way: “If I have a pool with $100 worth of Dai products and $80 of those Dai products are borrowed, the utilization is 80 percent.”

What’s the big deal? In the free market of crypto markets, high demand is met with equally attractive prices on the supply side, right?

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

Firstly, as soon as 100% of all funds in the pool are used, depositors cannot withdraw their money from the system. Second, high utilization can cause liquidation problems for these platforms. When the system is uncollateralized because it’s all on loan, liquidators can’t close out certain positions, potentially leaving the protocol undercollateralized (which is just a fancy way of saying insolvent). And that would be really, really bad.

Finally, Ethereum borrowers should remember that none of these platforms will call you and tell you that the cost of the loan has just increased to 1000%. It just happens.

And if you’re borrowing specifically to speculate on a possible airdrop if the network forks, you’re also betting that the new token will skyrocket. If not, you’re in for a world of hurt.

Good luck there.

Decrypting DeFi is our DeFi newsletter headed by this essay. Subscribers to our emails get to read the essay before it goes on the site. Order here.

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