The lending function, which seems like a very "old" business, has, under the operation of various bug-fixing experts, arbitrage professionals, and financial manipulators, transcended its traditional role of solving liquidity issues in web3. It has transformed into a dark pool that matches different funding needs, serves as a tool to convert static user-locked assets into a driver for exponential growth in exchanges, and has also become a weapon against rival protocols.

Today, let's explore hidden gameplay from the perspectives of different roles, without adhering to the user manual, and see what can be played out.

1. Retail Alchemy: Circular Lending

1.1 "Currency Lego" Cycle: The Mechanism of Circular Lending

Core Concept: Users first provide an asset as collateral to a lending protocol, then borrow the same asset, and subsequently deposit the borrowed asset back into the protocol as new collateral. This process can be repeated multiple times to establish a highly leveraged position.

The general steps are as follows:

1. Deposit: The user deposits $1,000 USDC into the protocol.
2. Borrow: Assuming the asset's LTV is 80%, the user can borrow $800 USDC.
3. Re-deposit: The user re-deposits the borrowed $800 USDC into the protocol, bringing the total collateral value to $1,800.
4. Re-borrow: Based on the newly added $800 USDC collateral, the user can borrow 80% of its value again, which is $640 USDC.
5. Repeat: By repeatedly executing this cycle, the user can significantly amplify their total position in the protocol with a small initial capital, thereby increasing their reward exposure.

An interesting observation here is that the "de-pegging" price points of $usde on Binance on October 11 are quite telling, with prices dropping to 0.91 — 0.86 — 0.75, which correspond to the liquidation points of circular lending (liquidation occurs at 0.91 after 9 cycles, at 0.86 after 8 cycles, and so on).

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

The profitability of this strategy hinges on the annualized yield (APY) of the rewards paid by the protocol to depositors and borrowers (usually the protocol's governance tokens) being higher than the net borrowing cost (i.e., borrowing rate minus 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: Amplifying Risks

While the circular lending strategy amplifies returns, it also amplifies risks in a non-linear manner.

• Liquidation risk is imminent: A circular lending position is extremely sensitive to market changes. A slight drop in collateral value (even stablecoins during a de-pegging event) or a sudden spike in borrowing rates can quickly push this highly leveraged position to the brink of liquidation.
• Interest rate fluctuation risk: Borrowing rates are dynamically changing. If the utilization rate of the liquidity pool surges due to external demand, borrowing rates may spike sharply, quickly rendering the circular lending strategy unprofitable or even resulting in negative spreads. If users cannot close their positions in time, the accumulating interest debt will erode the collateral value, ultimately leading to liquidation.

1.4 Systemic Impact and Economic Attacks

Circular lending poses risks not only to individual users but also has the potential for systemic impact on protocols and the entire DeFi ecosystem.

• "Ineffective" capital: Some argue that this strategy is "parasitic" because it artificially inflates the protocol's TVL without providing genuine liquidity for diverse real borrowing needs.
• Contagion risk: The collapse of a leveraged circular lending strategy, especially involving a "whale" user, can trigger a series of liquidations. This not only disrupts market prices but may also leave bad debts for the protocol due to slippage during the liquidation process, leading to systemic risk.
• Economic attacks and "poison pill" strategies: The mechanism of circular lending can also be exploited by malicious actors or competitors as a means of economic attack. Attackers can use large amounts of capital to establish a massive circular lending position on the target protocol, artificially driving up its utilization rate and TVL. They can then suddenly withdraw all liquidity, causing the protocol's utilization rate to collapse, interest rates to fluctuate violently, triggering a chain of liquidations, undermining the protocol's stability, and damaging its reputation. This strategy aims to make the competitor's protocol unattractive to real users by temporarily injecting large amounts of capital and then quickly withdrawing it, similar to a "poison pill" defense in corporate finance, but used here as an attack method.

2. The Market Maker's Script: Capital Efficiency and Leveraged Liquidity

Market makers are core participants in financial markets, primarily providing liquidity by simultaneously offering buy and sell quotes. Staking and lending systems provide market makers with powerful tools to enhance their capital efficiency and execute more complex strategies.

• Acquiring trading inventory and operational capital: Market makers typically need to hold a large amount of underlying assets (such as project tokens ABC) and quote assets (such as stablecoin USDT) to operate effectively.
• Borrowing native tokens: A common pattern is for market makers to borrow native tokens (ABC) directly from the project's treasury as trading inventory.
• Unlocking capital value: Market makers do not need to let these borrowed tokens sit idle; instead, they can deposit them into DeFi or CeFi lending platforms as collateral to borrow stablecoins. This way, they can obtain the stablecoins needed for market making without deploying all their own funds, significantly enhancing capital efficiency.
• Leveraged market-making strategies: Market makers can construct more complex leverage chains to further amplify their operational capital. For example, a market maker can:

1. Borrow $1 million worth of ABC tokens from the project.
2. Deposit the ABC tokens into a lending protocol to borrow $600,000 USDC at a 60% LTV.
3. Use the $600,000 USDC to purchase high liquidity, high LTV assets like BNB.
4. Deposit $600,000 worth of BNB into the lending protocol to borrow $480,000 USDC at an 80% LTV.

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

3. The Project's Treasury: Non-Dilutive Financing and Risk Management

For projects/teams, managing the treasury is crucial as it directly relates to the project's long-term development and survival capability. Staking and lending provide project teams with a flexible financial management toolset.

• Non-dilutive operational funding: One of the biggest challenges faced by projects is how to fund daily operations (such as paying employee salaries, marketing expenses) without harming the token's market price. Directly selling large amounts of treasury tokens on the open market can create immense selling pressure, potentially leading to price crashes and shaking community confidence.
• Borrowing instead of selling: By using native tokens in the treasury as collateral, project teams can borrow stablecoins from lending protocols to cover expenses. This is a non-dilutive financing method, as it allows projects to retain their native tokens while obtaining the necessary liquidity, preserving the potential for future appreciation of the tokens.
• Maximizing returns on treasury assets: Idle assets in the treasury (whether native tokens or stablecoins) are non-productive. Project teams can deposit these assets into liquidity pools of DeFi lending protocols to earn interest or protocol rewards. This creates an additional revenue stream for the project, enhancing capital efficiency.
• Over-the-counter (OTC) trading: Staking and lending can also serve as a tool to facilitate more flexible OTC trading with large investors or funds. Instead of directly selling large amounts of tokens at a discount, project teams can reach a structured loan agreement with buyers (borrowing to cash out):

1. The project team uses its native tokens as collateral to obtain a stablecoin loan from the buyer (as the lender).
2. Both parties can negotiate a lower interest rate and a longer repayment term, effectively providing the buyer with a cost advantage for holding the tokens.
3. If the project team chooses to "default" (i.e., not repay the loan), the buyer will receive the collateralized tokens according to the pre-agreed terms, effectively completing the acquisition at a fixed, possibly discounted price.

This method provides a more discreet and structured solution for large transactions while offering immediate liquidity to the project team.

The main risk exposure for the treasury is the price of its native tokens. If the token price drops significantly, it may lead to the liquidation of the treasury's collateral, resulting not only in asset loss but also sending a strong negative signal to the market, potentially triggering panic selling. This scenario may also involve brokers maliciously manipulating prices, leading to the transfer of treasury tokens.

4. Monetizing CEX Treasuries—Leveraging Lending for High-Leverage Trading

The lending model of CEX is essentially similar to the deposit and loan business of traditional commercial banks. The basic logic is that exchanges pay 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 (known as Net Interest Margin, NIM) constitutes the gross profit of the lending business.

Essentially, the lending business of CEX is an asset-liability management business rather than a simple service fee business. Its success depends on effectively managing interest rate risk (interest rate fluctuations), credit risk (institutional borrower defaults), and liquidity risk (concentrated withdrawals by depositors), just like traditional banks. However, this is not the main profit point.

The Great Multiplier—How Lending Ignites Trading Revenue

Although the lending business can generate considerable direct profits through net interest margins, its greatest strategic value in the CEX business model is not its own profitability but its role as a catalyst that exponentially amplifies the exchange's core revenue source—trading fees.

For example:

A trader with $1,000 decides to use 10x leverage. This means the exchange, backed by its vast pool of user assets, lends the trader $9,000. Thus, the trader can control a total trading position worth $10,000 with an initial capital of $1,000. This $9,000 loan is the most direct application of the exchange's lending function.

CEX trading fees are calculated based on the total nominal value of the trade, not on the trader's own capital invested. Therefore, through this leveraged trade, the exchange collects 9x the trading fees.

Based on the above logic, it is easy to understand why exchanges are generally keen to offer high-leverage products, such as perpetual contracts with leverage of up to 100 times or even higher. Higher leverage means traders can control larger nominal trading volumes with less capital, which directly translates into higher fee income for the exchange.

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

In high-leverage contract trading, the introduction of lending/collateral functions as a precursor means that the liquidation variable is not simply x2 but rises exponentially—this further confirms the statement: For exchanges, the most profitable customers are often those engaging in the highest-risk trading behaviors.

Postscript

Those who have read this far are kindred spirits. I don't have answers here; rather, I pose a question to everyone: If you were a market maker/project team/whale, how would you combine and link the above strategies to maximize your profits?

In this circle, the identities of project teams/market makers/whales/traders can not only coexist but can also be exchanged at different times—exceeding the imagination of identity is the first step to bug-fixing.

Lego has been given to you; is it the Burj Khalifa? A Ferrari? Or Harry Potter's magical castle? It all depends on your imagination.

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