Is it worthwhile to borrow ETH at an annualized interest rate of 1000% to get the airdrop?

If you are uncomfortable with the uncertainty of the future, it is best to withdraw ETH and not participate.

Original text: "Euler Finance founder: Investors who plan to borrow ETH before the merger, please pay attention to these issues"

Written by: Michael Bentley, Founder of Euler Finance

Compiled by: Dongxun

If you borrowed ETH before the merge, you might want to read this. In the coming days, we’ll get a clearer picture of what the DAO is doing to prepare for the merger and how it affects lenders and borrowers.

The three largest lending protocols on Ethereum are now moving in different directions:

- Compound Finance proposes to increase the maximum interest rate

- Aave is pausing borrowing

- Euler Finance proposes to do nothing

If you are currently an ETH lender or borrower, pay close attention. In the coming days, the interest rates and utilization of these protocols may vary greatly, which may affect your profit and loss (P&L, i.e. loss and gain, also known as financial results). Let's see how traders can affect the lending market.

Merged transactions on the lending protocol are very simple: people borrow ETH in order to get "free" $powETH from the PoW fork immediately after the merge.

Of course, nothing is “free” in this world. Borrowing ETH costs you ETH. How much interest you pay depends on when you start borrowing, as well as the variable interest rate you pay at every moment.

However, some people are very excited about this trade, and it has now driven up ETH lending rates, especially on Aave, which has prompted Aave to take action: in order to prevent withdrawal issues, liquidation issues, and prevent the profitability of leveraged staking from further declining, the Aave community has voted to suspend further lending in an attempt to prevent utilization from rising again.

Meanwhile, Compound Finance has put forward a different type of proposal, raising the maximum lending rate for ETH to 1,000% APY to limit the potential for maximum utilization.

How well do these proposals work? What impact would they have on traders? Let’s use some simple game theory to explore some very hypothetical scenarios.

First, note that at the time of writing, $powETH is valued at ~3% of ETH’s value on the futures market.

We can use this to price the maximum amount of interest a borrower should be prepared to pay in order to receive powETH. For every $100 of ETH borrowed, they should pay no more than $3 in total ETH interest until consolidated.

So if we are 1 day away from the merge, there is ETH available for borrowing, and the annual percentage rate (APY) is below 1095%, then you might as well borrow that ETH.

You should be prepared to pay 1/365 × 1095% APY for a 1-day loan, as this is equivalent to a 3% annualized return (the return on powETH).

To make a profit, you should obviously borrow at a lower interest rate. You should also save borrowing until the last minute, if possible, to minimize the interest rate. But what about front-running? If you're late, utilization won't be 100%, and you've missed out?

Yes, but that doesn’t mean borrowing ahead of time is a good strategy.

In fact, if you have already taken out pre-loans on Compound Finance, Aave, and Euler Finance, there may be bad news here.

The problem is that when you try to predict your borrowing costs, you have to price in latecomers who are likely to push utilization to 100%, even if only for a short time. Why?

Because, if your chosen lending protocol supports a maximum lending APR of 1000% (e.g., as per the Compound governance proposal), then anyone who had not borrowed below this rate the day before the merge could easily make money.

So even if you’re only paying 5% APY to protect your position now, you’re almost factoring in an annualized borrowing cost of “1/365 × 1000% APY ~ 2.7%” on the last trading day before the merger.

Because of this, I’d wager that many people borrowing ETH now will be paying more in interest than they could have hoped to earn in $powETH when the merger comes.

In contrast, if your lending protocol supports a maximum borrowing APR of 100%, then you can "safely" borrow the maximum APR for nearly 11 days before the merge and not pay more ETH interest than you earned in powETH.

Because "11/365 * 100% APY ~ 3%" is annualized. So, even if the interest rate of the lending agreement rises to 100% APY tomorrow, when the powETH token enters your wallet in about a week, you will still be able to break even.

The possibility of locking in “profitable” trades early like this could increase utilization of such lending protocols in the coming days, long before a merger occurs. Wouldn’t that be terrible?

Maybe so, but lending protocols don’t exist in a vacuum. Since such lending protocols (such as Euler) offer higher interest rates than other protocols, new lenders may be tempted to migrate to earn higher APYs.

In fact, many lenders may be happy to earn a higher ETH APY and sacrifice a day or two of withdrawal time rather than directly holding ETH to earn POWETH.

After all, the latter is a token of questionable value that may be difficult to dispose of after the merger. Why not lock in some profits by lending ETH directly?

As for whether the moratorium protects lenders, I personally think it is unlikely to achieve this goal. This is because the moratorium does not guarantee low utilization, it just creates a one-sided market.

In my opinion, one-sided markets almost never end well and should generally be avoided, as I said before the StETH “depeg” debacle.

Lenders have just as good reasons to withdraw their ETH before a merge as borrowers to borrow before a merge. Lenders withdrawing ETH supply has the same impact on utilization as borrowers borrowing ETH.

If utilization is not 100% on the last day, why not withdraw your ETH and claim PowETH and re-deposit ETH shortly after? This way you can get all the benefits of speculative lending before the event and get some PowETH.

As a lender, you may also want to exit for many other reasons, perhaps worrying about your leveraged collateralized position being liquidated, or concerned about the risk of ETH price after the merger, or simply seeing high interest rates on another lending protocol.

In summary, regardless of the strategy, it seems likely that borrowing rates will spike before the merger, and that utilization rates on lending protocols could reach 100%. How long this lasts will likely depend on the protocol’s maximum interest rate and whether borrowing is suspended.

If you are currently lending and are uncomfortable with the uncertainty of the future, it may be best to withdraw your ETH and not get involved. However, no one really knows what will happen. These are just my personal, speculative thoughts on the matter.