I’ve seen lots of defiers touting the strategy for shorting USDT through Aave and I’m wondering if they’ve missed a key consideration.
In case you’re not familiar with this strategy, it goes something like this:
1. Deposit collateral on a lending dApp like Aave.
2. Borrow USDT against your deposits on Aave with the expectation that Tether will someday lose its peg and become worthless.
3. Exchange borrowed USDT for some other asset to make more $.
A potential hole in this strategy is the fact that the interest rate for USDT fluctuates based on the amount of USDT reserves on Aave. In the event of a run on Tether, I would expect the following sequence of events:
1. Tether holders sell as much USDT as they can to recover losses which means depleting lending reserves like those on Aave.
2. As reserves of USDT approach zero, the borrow rate on Aave approaches …….a higher number? Infinity?
3. As the borrow rate approaches infinity, some amount of collateral is liquidated to pay for your deficit.
If this liquidation event comes to pass, I wonder how accurately the liquidation mechanism would work to reconcile the deficit. For example, if the rate skyrockets, and the protocol believes that your LTV has gone over the limit, the real cost of paying off your debt may now be pretty inconsequential but I believe that there is also a liquidation fee.
I just don’t know enough to understand how this last part would play out and was hoping someone else could clarify.
That’s not how AAVE works. Interest rates can only go up to 64% APR for USDT when the entire pool is utilized. In the long term this is big, but in the short term is absolutely tiny. One week of interest at completely full utilization is <2%, and this is far beyond a pessimistic estimate. Short term fluctuations will simply not materially affect your borrowing interest on AAVE.
The consequences of a price collapse of Tether will more likely be that liquidity vanishes, so withdrawals and borrows won’t be available until positions and prices adjust appropriately.
In such an extraordinary circumstance they might also simply just seize your deposited collateral to make themselves whole.
Theoretically the risk premium of holding USDT is baked into the interest rate (which exceeds that of USDC, DAI)