Compound and Aave have emerged as trailblazers in the variable rate lending arena during the previous bull cycle, amassing a peak total value locked (TVL) of over $31 billion combined. Not only did they stretch the limits of on-chain possibilities, but they also set the foundation for collateralized lending – an essential DeFi component expected to play a central role for many years ahead.
However, despite their significant achievements, variable rate lending does come with certain drawbacks. It's often subjected to recurrent 'liquidity squeezes', characterized by sudden surges in borrow rates. These frequent liquidity squeezes can detract from the potential yield-farming returns. In extreme situations, they may even trigger abrupt and unexpected liquidations.
To demonstrate the magnitude of this phenomenon, we gather on-chain data of Aave V2’s average and maximum deposit and supply rates from December, 2020 to May, 2023. Data is from Dune Analytics and sampled at an hourly frequency.
The charts shown above for USDT, USDC and DAI exhibit similar patterns, with Tether standing out by having frequent and recurring liquidity squeezes even in recent history — specifically around the collapse of FTX and Silicon Valley Bank (SVB). The charts show that borrow rates are extremely unstable during bull markets where borrow demand is high. Moreover, these periods of extreme interest rate volatility cannot be explained solely by a lack of liquidity — spikes in the second half of 2021 coincide with periods of peak TVL on Aave.
Liquidity squeezes in blue-chip lending markets, in contrast, occur much less often than their stable-coin counterparts. Nevertheless they have been known to show up in a big way around major risk events. ETH borrow rates, for example, spike above 60% apy around the Merge (September 15, 2021).
While the length and duration of these liquidity squeezes last from just hours to days, its impact on realized funding cost, even spread out over a 1-month horizon, is quite significant. Below in Fig 3 we plot the difference between the 1-month rolling geometric mean average borrow rate and the 1-month median borrow rate for both USDT and ETH. We see that around the collapse of SVB and the ETH Merge, the spread between realized and median funding costs over a 1-month lookback widened as much as 500bps. We use geometric rather than arithmetic means to capture the impact of compounding.
While short-term liquidity squeezes benefit depositors to some degree, depositor receive only about a quarter to a half of the increase in borrow rates during such periods. Fig 4 shows that for the vast majority of the time, depositors can expect to earn one to two-percent below the median borrow rate with short but muted outperformance in time of stress.
Our analysis above highlights a few of the drawbacks of variable lending in DeFi. To summarize, variable rate lending in DeFi is:
Fixed-rate lending on Term Finance allows borrowers to lock in a borrow (to sell short or hedge yield farming exposure and/or fund their existing long positions) without risk of significant and unexpected increase in funding cost. On the lending side, lenders receive the full benefit of any liquidity supplied because both lenders and borrowers in Term Finance auctions transact at a single market clearing price. There is no spread and no slippage for fixed-rate lending on the protocol, although borrowers pay a servicing fee.
