The lending function, a seemingly very "old" business, has gone beyond solving the traditional liquidity problem in web3 under the operation of bug-fixing masters, arbitrage professionals and financial saws. It has transformed into a dark pool that matches different funding needs, plays the role of converting static user deposited assets into a tool to drive exponential growth of exchanges, and has also become a weapon to attack rival protocols.

Today we will start from the perspective of different characters and see what hidden ways we can play by not following the instruction manual.

1. Retail Investor Alchemy: Revolving Loans

1.1 “Money Lego” Cycle: The Mechanism of Revolving Loans

Core concept: A user first provides an asset as collateral to a lending protocol, then borrows the same asset, and then deposits the borrowed asset back into the protocol as new collateral. This process can be repeated multiple times to build up a highly leveraged position.

The general steps are as follows:

1. Deposit: The user deposits $1,000 USDC into the protocol.
2. Lending: Assuming the LTV of the asset is 80%, the user can lend $800 USDC.
3. Redeposit: The user deposits the borrowed 800 USDC back into the protocol, bringing the total collateral value to $1,800.
4. Re-lending: Based on the newly added 800 USDC collateral, the user can lend out 80% of its value, or 640 USDC.
5. Repeat: By repeatedly executing this cycle, users can greatly amplify their total position in the protocol, and thus their exposure to rewards, with a small amount of initial capital.

An interesting observation is that the price of $USD on Binance at 10.11 "off-pegged" was also quite specific. The price dropped to 0.91 - 0.86 - 0.75, which correspond to the liquidation points of revolving loans (9 cycles will be liquidated at 0.91, 8 cycles at 0.86, and so on).

1.2 Economic Incentives: Yield Farming, Airdrops, and Token Rewards

The strategy's profitability depends on the annualized yield (APY) of the rewards (typically the protocol's governance token) paid by the protocol to depositors and borrowers being higher than the net borrowing cost (i.e., the borrowing rate minus the deposit rate). When the protocol attracts liquidity through high token incentives, the net borrowing rate (borrowing rate - borrowing reward APY) may even be lower than the net deposit rate (deposit rate + deposit reward APY), creating arbitrage opportunities.

1.3 Leverage on Leverage: Amplification of Risk

While the revolving loan strategy amplifies returns, it also amplifies risks in a nonlinear manner.

• Liquidation risk is imminent: A revolving loan position is extremely sensitive to market fluctuations. A slight drop in the value of the collateral (even a stablecoin depegging) or a sudden spike in borrowing rates can quickly push this highly leveraged position to the brink of liquidation.
• Interest rate volatility risk: Borrowing and lending rates are dynamic. If the utilization rate of the capital pool soars due to a surge in external demand, borrowing rates could rise sharply, quickly rendering revolving lending strategies unprofitable or even generating negative spreads. If users fail to close their positions in a timely manner, the accumulating interest debt will erode the value of their collateral, ultimately leading to liquidation.

1.4 Systemic Impact and Economic Attacks

Revolving loans not only pose risks to individual users, but their large-scale existence may also have a systemic impact on the protocol and even the entire DeFi ecosystem.

• “Invalid” capital: Some argue that this strategy is “parasitic” because it artificially inflates the protocol’s TVL without providing real liquidity for diverse, real lending needs.
• Contagion risk: The collapse of a leveraged revolving loan strategy, especially when involving a "whale" user, could trigger a cascade of liquidations. This would not only disrupt market prices but also potentially leave the protocol with bad debts due to slippage during the liquidation process, thereby triggering systemic risks.
• Economic Attacks and Poison Pill Strategies: Revolving loan mechanisms can also be exploited by malicious actors or competitors as a means of economic attack. An attacker could leverage a large amount of capital to establish a large revolving loan position on a target protocol, artificially inflating its utilization rate and TVL. They could then abruptly withdraw all liquidity, causing the protocol's utilization rate to collapse instantly and interest rates to fluctuate wildly, triggering cascading liquidations that destabilize the protocol and damage its reputation. This tactic aims to render a competitor's protocol unattractive to real users by temporarily injecting a large amount of capital and then quickly withdrawing it, forcing its liquidity providers to leave. It's similar to the "poison pill" defense in corporate finance, but employed here as an offensive tactic.

2. Market Maker’s Playbook: Capital Efficiency and Leveraged Liquidity

Market makers are core participants in the financial markets, whose primary function is to provide liquidity by simultaneously offering buy and sell quotes. The collateralized lending system provides market makers with powerful tools to improve their capital efficiency and execute more complex strategies.

• Obtaining trading inventory and operating capital: Market makers usually need to hold a large amount of underlying assets (such as project token ABC) and quote assets (such as stablecoin USDT) to operate effectively.
• Borrowing native tokens: A common pattern is that market makers borrow their native tokens (ABC) directly from the project's treasury as trading inventory.
• Unleashing Capital Value: Instead of leaving these borrowed tokens idle, market makers can deposit them into DeFi or CeFi lending platforms as collateral to lend stablecoins. This allows them to obtain the stablecoins needed for market making without investing all of their own capital, greatly improving capital efficiency.
• Leveraged Market Making Strategies: Market makers can construct more complex leverage chains to further amplify their operating capital. For example, a market maker can:

1. Borrow $1 million worth of ABC tokens from the project.
2. Deposit ABC tokens into the lending protocol and borrow $600,000 USDC at 60% LTV.
3. Use this $600,000 USDC to purchase highly liquid, high LTV assets such as BNB.
4. Then deposit $600,000 worth of BNB into the lending agreement and borrow $480,000 worth of USDC at an LTV of 80%.

Through this process, the market maker leveraged the initially borrowed ABC tokens to ultimately secure over $1 million in stablecoin liquidity (600,000 + 480,000), which they could use for market making across multiple trading pairs and exchanges. While this leveraged approach can amplify returns, it also significantly increases liquidation risk and requires monitoring the price fluctuations of multiple collateral assets. A similar approach is the cross-margin leverage model, which operates on similar principles and will not be further elaborated here.

3. Project Coffers: Non-Dilutive Financing and Risk Management

Treasury management is crucial for projects and teams, as it directly impacts their long-term development and viability. Pledge lending provides projects with a flexible set of financial management tools.

• Non-dilutive operating funds: One of the biggest challenges facing projects is how to fund day-to-day operations (e.g., employee salaries, marketing expenses) without damaging the token's market price. Selling a large number of treasury tokens directly on the open market would create significant selling pressure, potentially causing a price crash and shaking community confidence.
• Borrowing instead of selling: By posting the native tokens in the treasury as collateral, projects can borrow stablecoins from lending protocols to cover expenses. This is a non-dilutive funding method because it allows projects to obtain the required liquidity while continuing to hold their native tokens, thereby preserving the potential for future appreciation of the tokens.
• Maximizing the returns of treasury assets: Assets idle in the treasury (whether native tokens or stablecoins) are unproductive. Projects can deposit these assets into DeFi lending protocols' liquidity pools to earn interest or protocol rewards. This creates an additional revenue stream for projects and improves capital efficiency.
• Over-the-counter (OTC) transactions: Collateralized lending can also be used as a tool to facilitate more flexible over-the-counter transactions with large investors or funds. Instead of directly selling a large number of tokens at a discount, the project can enter into a structured loan agreement with the buyer: (pretend to be a loan, but actually cash out)

1. The project party uses its native token as collateral to obtain a stablecoin loan from the buyer (as the lender).
2. The two parties can negotiate a lower interest rate and a longer repayment period, which effectively provides the buyer with a cost advantage in holding the token.
3. If the project chooses to “default” (i.e., not repay the loan), the buyer will obtain the mortgaged tokens according to pre-agreed terms, which is equivalent to completing the acquisition at a fixed, possibly discounted price.

This approach provides a more concealed and structured solution for large-scale transactions while providing immediate liquidity to project parties.

The treasury's primary risk exposure is the price of its native token. A significant drop in the token's price could lead to the liquidation of the vault's collateral, which would not only result in asset losses but also send a strong negative signal to the market, potentially triggering a panic sell-off. Some brokers, in particular, maliciously manipulate prices, causing treasury tokens to change hands.

4. Monetization of CEX Treasury: Leveraging Leveraged Trading with Loans

The CEX lending model is essentially the same as the deposit and lending business of traditional commercial banks. The basic logic is that the exchange pays relatively low interest to users who deposit assets (depositors/lenders), while charging relatively high interest to users who borrow these assets (borrowers). The difference between the two (called the Net Interest Margin, NIM) constitutes the gross profit of the lending business.

Essentially, CEX's lending business is an asset-liability management business, not a simple service fee-based business. Its success depends on whether it can effectively manage interest rate risk (interest rate fluctuations), credit risk (institutional borrower defaults), and liquidity risk (depositor withdrawals) like traditional banks. However, this is not the main profit point.

The Great Multiplier: How Lending Can Explode Trading Income

Although the lending business can generate considerable direct profits through net interest margin, its greatest strategic value in the CEX business model is not its own profitability, but its role as a catalyst in exponentially amplifying the exchange's core source of revenue - transaction fees.

For example:

A trader with 1,000 U assets decides to use 10x leverage. This means the exchange, backed by its vast user asset pool, lends the trader 9,000 U assets. This allows the trader to control a trading position with a total value of 10,000 U assets with their 1,000 U assets. This 9,000 U loan is the most direct application scenario for the exchange's lending function.

CEX transaction fees are calculated based on the total notional value of the transaction, rather than the trader’s own capital. Therefore, through this leveraged transaction, the exchange charged a 9x higher transaction fee.

Based on this logic, it's easy to understand why exchanges are generally keen on offering high-leverage products, such as perpetual swaps with leverage of up to 100x or even higher. Higher leverage means traders can leverage larger notional trading volumes with less capital, which directly translates into higher transaction fees for the exchange.

Remember: the profitability of an exchange is positively correlated with the risk (leverage level) taken by its users.

In high-leverage contract trading, the lending/mortgage function is added as a prerequisite, and the liquidation variable here is not a simple x2, but increases exponentially - this further confirms the statement: for exchanges, the most profitable customers are often those who engage in the highest-risk trading behaviors.

postscript

Those who have read this far are destined to be here. I don’t have the answer here, but I would like to give you a question. If you are a market maker/project owner/big investor, how would you combine and link the above routines to maximize your profits?

You should know that in this circle, the identities of project party/market maker/big investor/trader can not only be held simultaneously, but can also be interchanged in different time periods - exceeding the imagination of identity is the first step to catching bugs.

Lego has already given you the chance. Is it the Burj Khalifa? A Ferrari? Harry Potter's Magic Castle? It all depends on your imagination.