Have you heard of “looping”? It’s a risky trading technique that has come to the world of crypto and offers potentially eye-popping returns to those with the stomach to try it.
As decentralized finance publication The Defiant reports, a platform called Radiant Capital has been dangling the promise of 60% yields—a return more than 12 times as high as even the best traditional savings accounts—using automated looping. Other protocols, including Metronome, are also offering a way to automate the risky trading strategy.
Bloomberg recently dubbed looping “crypto sorcery,” but what is it exactly?
The basics
At traditional banks, customers safeguard their cash and earn interest on their savings. To make a profit, banks lend out some customer deposits to borrowers, who in turn pay a higher interest rate. Banks make money from the spread, or difference between the rate they pay customers to safeguard their money and the rate they are paid by borrowers.
Among DeFi lending protocols, the same logic applies—but with a caveat. Many protocols issue their own tokens and hand them out to depositors as an incentive to use the platform. These tokens are worth something, and “because of that, you get into this weird situation where the lending APR actually exceeds the borrower APR,” Sunny Aggarwal, cofounder of Osmosis Labs, which supports the eponymous DeFi exchange, told Fortune.
This presents an opportunity. A crypto investor can, for example, deposit $100 worth of Bitcoin as collateral in a lending protocol. The “bank” pays her 8% interest on her deposit along with 2% in its own token, resulting in a composite rate of 10%, greater than the bank’s borrowing rate. The investor then borrows $80 of Bitcoin, deposits it again, borrows a little bit less, deposits that, and so on. Eventually, an investor has ballooned the Bitcoin she’s put into the protocol and is earning 60% or more in interest on the original amount.
There are analogues to, say, the housing market, notes Mark Lurie, CEO of Shipyard, which develops specialized decentralized exchanges for the crypto market. A real estate investor can buy a property, rent it, and then take out a loan against the house to buy another property. Then, the investor rents it out, takes out another loan, and “loops” the investment yet again.
“The higher you do that, a little change in the housing market can cause it to unravel,” Lurie tells Fortune.
The risks
Like real estate investors buying up properties and renting them out through loans, looping puts traders on “a balance beam,” says Lurie.
The delicate equilibrium may suddenly be upset if, for example, a protocol changes its lending and borrowing rates or decides to stop issuing its own native tokens to lenders. “The more people who do this and pile into a trade, the more efficient the lending market becomes, and so the arbitrage goes away,” Lurie tells Fortune.
There are also platform risks, says Ahmed Ismail, founder and CEO of Fluid, which plans to use machine learning to aggregate prices for cryptocurrencies across different exchanges. Hacks of DeFi protocols are still common, and sometimes hundreds of millions can be lost. “You borrow, you lend, you borrow, you lend,” he tells Fortune. “You multiply the risk.”
Moreover, some looping techniques rely not on the interest differential provided by a DeFi protocol but interest from yield-bearing tokens, which provide holders yield in addition to the changing price of the asset itself.
One of the most common examples is stETH, which represents how much Ether someone has effectively staked, or put into escrow to help the Ethereum blockchain run. Similar to the earlier scenario where protocols hand out native tokens to incentivize people to deposit, traders can deposit stETH in a lending protocol and earn interest on their collateral as well as the interest the token naturally provides. This combined rate exceeds the cost of borrowing, which presents another opportunity to loop.
However, similar to the variability in interest rates on lending protocols, the yield from stETH can change, and the higher a tower an investor builds, the more easily it can crumble when stETH’s interest rate moves just slightly. “This is more risky than the other one,” Aggarwal of Osmosis tells Fortune, in reference to looping with stETH as opposed to looping with, say, Bitcoin on a protocol where the rate to lend is higher than the rate to borrow.
Automated looping
Looping as a crypto trading strategy has existed for some time, at least since DeFi lending protocols first emerged and enticed users by issuing native tokens. Its popularity waxes and wanes according to the state of the larger crypto market, says Lurie of Shipyard. “In bull markets, this happens a lot,” he tells Fortune.
Now, as the technology powering DeFi has become more sophisticated and transaction fees have decreased owing to the rise of so-called layer-2s, some developers are making the trading strategy more efficient, says Jordan Kruger, a cofounder of Metronome and Vesper who also leads DeFi at Bloq. “It becomes really difficult to do this repetitive looping manually,” she tells Fortune.
This is why Metronome, a DeFi protocol that Bloq developed, lets traders automate what yield-bearing tokens they decide to loop. And because traders don’t have to manually monitor changing interest rates, Kruger says, some of the risk disappears. Radiant Capital, the protocol highlighted in The Defiant’s newsletter, also offers automated looping.
That being said, the more an investor loops, the more risk they take on. But for those exploring the Wild West of crypto, risk comes with the territory.
“People in crypto love taking on extra risk for extra reward,” Josh Fraser, cofounder of Origin Protocol, tells Fortune.
