Recursive lending is a very popular strategy in DeFi. It involves lending and borrowing on Compound / AAVE in order to harvest the maximum reward possible. This strategy was very profitable at the beginning of 2021. However, returns have dropped considerably as more money flew into the strategy and the value of the Compound token fell from $800 in May '21 to$125 at the end of January '22.

In this blog post, we show that given current market conditions, there are simpler, and more rewarding alternatives for DeFi users that are uncorrelated to token prices. One of these alternatives is fixed rate lending on Notional Finance. The latter is even more compelling in the DAI pool, as Compound returns have been historically lower versus USDC. Lending on Notional Finance increases on average your lending returns by 4 to 5% based on current prices.

## Recursive lending in a nutshell

Recursive lending is a strategy on Compound (or Aave) that takes advantage of the fact that the net borrowing rate (after rewards) is lower than the net lending rate. COMP incentives make the borrowing rate lower than the lending rate. For example, as of Feb 2nd, the supply rate is 2.25% and the borrow rate 3.77% p.a for the USDC pool. On top of these yields, lenders will receive 0.93% p.a in COMP tokens and borrowers 1.38% p.a. Including those incentives, one can borrow USDC at 2.39% and supply it at 3.18% p.a on Compound.

In that configuration, one should deposit stable coins and borrow as much as possible in the same token. Borrowing on Compound needs to be over collateralized so you cannot leverage indefinitely. The platform has a collateral factor (cf) of 80% meaning that if you deposit $100 of collateral, you can only borrow$80 worth of tokens. With a $100 initial lending deposit, one will borrow$80 against it in the same currency. Those $80 will then be re-deposited on Compound and used to borrow$64 (80% of $80) and so on …. As the collateral ratio is 80%, we can therefore lend$5 with $1 of capital and borrow$4. This enables us to get ~10x more COMP reward if we had loaned only $1. The total return of the strategy equals therefore Lending Rate + 4*(Lending- Borrow Rate) with the lending Rate and borrow rate being net of COMP rewards. People do not borrow 4x times their initial stake as after a certain amount the gas fees become too high versus the interest they expect. Also, they might want to have some margin of safety on their collateral to avoid liquidations. Instadapp and Yearn are using a 4 to 4.6x leverage (i.e. borrow 3x to 3.6x their initial stake instead of 4x). ## Historical returns for DAI and USDC We look at the historical daily APY of the recursive lending strategy since November 1st 2021, which is the launch date of Notional V2. We have assumed a 4.6x leverage in our calculations. The strategy APY has been quite volatile in the last three months and returns have been consistently higher for the USDC pool versus DAI. Since Nov 1st, the annualized return was 6.34% for DAI and 8.88% for USDC. So far, net supply rates have been above borrow rates for both lending pools, apart from a brief period in December for DAI. The returns have also been declining since November and the current APY for DAI and USDC (as of Feb 1st) are respectively 5.58% and 4.22%. Those rates are much lower than the current rates one can lock until the end of March on Notional. Notional offers lenders a net return of 9.34% for USDC and 9.25% for DAI. These are 5% superior to the expected returns of a recursive strategy on DAI and ~3.8% higher for USDC. ## Main drivers of the recursive strategy As we have seen previously the returns of a recursive strategy are quite volatile through time. They will depend on 1) the value of COMP token, 2) the utilization rate of the pool, 3)how much AUM in the pool is sharing those rewards 4) ethereum prices. COMP token price A recursive lending strategy is subsidized by the COMP rewards a user will receive for borrowing and lending. With supply rates before rewards being close to 2%, COMP rewards represent between 50% and ⅔ of the total returns. Most of the volatility of the strategy comes from the COMP token volatility. As you can see below, the strategy APYs are extremely correlated to the COMP token price. As a result, market neutral users will try to lock in returns by hedging in advance the amount of COMP token they expect to receive using futures on platforms like Binance or Perpetual Protocols. With hindsight, it would have been the best strategy to adopt early November 2021 when the COMP token was close to$400. However, hedging at current rates will guarantee you suboptimal returns between 4 and 5% annualized. Using Notional fixed rates looks like a much more attractive alternative.

If the rewards are left unhedged, your returns can be wiped out by a sharp decline in COMP prices, like the one we have experienced in the last three months.

We have plotted below the return achieved by the strategies for various COMP price scenarios.

To achieve Notional’s 9.3% annualized return, the recursive strategy needs COMP token to be worth $170 for USDC and$185 for DAI vs a current price as of time of writing of $125. But COMP prices cut both ways, if they were to fall to$50, returns would fall to 0.

If you want to keep some exposure to COMP, one interesting strategy for lenders would be to lend on Notional and buy some COMP tokens upfront for the amount of interest you will receive. This way you will be guaranteed to outperform a recursive strategy whatever the future COMP price.