DeFi users have rushed to lending protocols like Aave and Compound to borrow ETH in the hopes of a fork on the network. The fork would produce new tokens which will be airdropped to ETH holders.
With the Ethereum Merge estimated date closer than ever, DeFi users are flooding on protocols to borrow ETH. The industry will witness the most complicated blockchain upgrade. Users flooding on DeFi platforms in hopes of borrowing ETH and earning forked tokens isn’t an out-of-the-blue speculation but has sparked after the mining community sending hints on forking the blockchain.
The crypto industry is tirelessly preparing for the Ethereum Beacon chain Merge. Bug bounties being rolled for developers to find out any technical glitches on the network. Crypto exchanges are stretching their room to accommodate any forked crypto tokens that may or may not happen. DeFi degens are keeping a close eye on ETH fork that could result in them receiving forked ETH.
In an event of a hard fork, users who have their ETH holdings in noncustodial wallets will get ETH tokens through an airdrop. On September 5, 2022, Aave – a leading DeFi platform laid a proposal to halt ETH borrowing because of users wiping off ETH’s liquidity on the platform. The proposal was passed as most members upvoted the proposal. Compound, another DeFi platform has put a cap on ETH lending to minimize the chance of illiquidity.
Aave’s process of setting interest rates is rather complex and it uses algorithms to determine the rate of interest based on the liquidity and demand on the platform.
“Once the ETH borrow rate reaches 5%, which happens shortly after 70% utilization rate (we are at 63% right now), stETH/ETH positions start becoming unprofitable,” – from Aave’s proposal.
Compound has set a cap on borrowing at 100,000 ETH in the interim of the Merge that is slated to go live by September 20, 2022.
In addition to setting a cap, the platform has also spiked the interest rate on ETH borrowing. It has introduced the jump rate model which basically will increase the interest rate if the borrowed funds are utilized exceeding 80% of the total ETH loan.
Proposal 122 prepares for the Merge and a potential POW fork by protecting cETH user liquidity.
It imposes a borrowing cap of 100,000 ETH, and introduces a new interest model with very high upper bounds.
— Compound Labs (@compoundfinance) September 2, 2022
The possibility of a possible fork on the Ethereum blockchain comes from individuals like Chanler Guo, who have been into ETH mining and are looking for a window to fork the chain to keep ETH mining alive.
Why is ETH lending on DeFi a warning bell for many?
DeFi protocols use a metric called utilization rate. If the utilization rate reaches beyond a certain threshold the liquidity of assets will see a shakedown. When utilization of these assets reach a peak, the interest rates and other conditions change as it can be difficult for DeFi platforms to issue loans beyond a certain limit.
The high utilization of these assets will pose two challenges:
- Just when 100% of the assets are lent out, users won’t be able to withdraw their collateral. If and when an event like this occurs where all the collateral has been utilized by DeFi platforms to balance the liquidity chances are that the protocol may become under collateralized or perhaps even collapse.
- The second most important issue with overutilization of assets is that borrowers may have to pay high-interest rates as soon as they utilize the loan beyond a certain percentage. It is crucial to remember that these protocols are decentralized which means if the protocol faces liquidity issues the users will end up paying more interest than the principal amount borrowed.
Additional Read: Will Ethereum Mining Cease To Exist After The Merge?
Source: Decrypt, CoinDesk