When Onchain Leverage Meets Reality

The past week in DeFi has been a stress test, one that revealed how interconnected our lending markets have become. Between the $128M Balancer exploit and the unwind happening across isolated vaults tied to xUSD collateral, we’re seeing leverage, risk, and composability hit a wall in real time.

In the post below, I share a breakdown of what’s I see believe is happening beneath the surface: how protocols like Morpho, Euler, and Silo are functioning as designed, what we should see when curators overextend themsleves, and why the spike in interest rates across isolated markets is a natural (and necessary) step in a near term reset. For lenders, borrowers, and loopers alike, this moment is a reminder that with greater freedom onchain comes greater responsibility for us to manage and understand risk.

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Here’s a few insights on what I think is happening and how it's likely to affect us all as DeFi lenders and borrowers in the coming days/weeks...

The Balancer Exploit
The shocking nature of the Balancer exploit is that it hit a very trusted protocol, one no believed would ever be hacked after so many years, and wiped out $128M. That money is gone for good, and its lasting impact is just fear of what happens if I'm exploited in a blue chip protocol. But I don't think this matters as much as others think. Maybe smarter money will purchase cover from Nexus Mutual to sleep better at night, after having assumed they were safe in more trusted protocols with a clean track record.

Morpho / Euler Vaults Are Working as Intended
In terms of Morpho / Euler style vault protocols, they are working as intended. They will take some heat cuz everyone loves to point the finger the minute they fuck up with their own money but truth is, Morpho/Euler were never about curating markets, they just allow for maximum freedom to access markets built on their protocol.

Too Many Vaults, Too Much Curation
What's happened in the last year is that there were too many vaults being created by curators IMO. The market demanded isolated markets for more long tail assets and the curators were there to meet the demand. I am a proponent of having this ungated access to any/all markets—let users decide where they deploy, and if they blow themselves lending to shit borrowers, so be it. I don't want anyone to tell me what I should or shouldn't have access to. Onchain, we decide, but with great power comes great responsibility: the responsibility to know what the fuck you're lending to.

What the Curators Really Are
Morpho, Euler, Silo, Gearbox, etc all provide powerful tools and templates for creating a lending/borrowing market, often but not always stamped with some approval by a curator who carries whatever credibility to say: “This market has been vetted by us. We're not guaranteeing it's always safe or that you'll enjoy instant liquidity to withdraw, but we are endorsing that you should be able to lend and withdraw when necessary, and borrowers should enjoy competitive (maybe even underpriced) borrowing rates for their favorite collateral — collaterals no one else could support in shared pooled money markets like Aave.”

The Fallout from Bad Collateral
Now that someone finally blew up on bad collateral, that means there's lenders who are going to incur real losses — as they should, as painful as that may be. But the curators are not just curators — they also run liquid strategies themselves and act as lenders/borrowers who have benefitted from artificially low DeFi interest rates in good times. They move massive amounts of liquidity vault to vault, allowing them to maintain competitive borrowing rates — rates that they and other parties use to loop for very profitable yields.

For example, if you were holding a Pendle PT with a fixed APY of 15%, the ability to borrow at 86.5% LTV, at 6-10%, is pretty awesome! Just deposit the PT, borrow maximum USDC, swap on Pendle for more PT, deposit PT, and repeat until you achieve about 6-7x leverage, resulting in a net yield of ~50+% APY.

Panic and Withdrawals
The problem is now that there's a real loss among stablecoin lenders for those who were lending to xUSD-collateralized borrowers, and for those who straight up held xUSD, there's some panic to withdraw from other markets — a realization that there's some real risk, even though nearly all of these existing isolated markets have zero exposure to the damage from xUSD. Nearly all these loopers can unwind positions safely. And as they do, certain lenders might choose to withdraw for whatever reason they have (fear, panic, worry over contagion).

The Unwind Begins
So with that desire to exit other markets, there's a demand that suddenly cannot be met without borrowers paying back their debt — but with so much looping, many of the largest lenders are also borrowers, because they were looping too. That means we will simply see more market participants, including curators who are running their own liquid strategies, unwind their looped stablecoin positions. In order for that to happen, interest rates had to spike on many of these isolated markets to scare loopers and incentivize them out of their positions.

My Own Experience
I woke up this morning to a few of my own looped-up positions, which although they were safe and unexposed to any of the xUSD debacle, the markets were suddenly 100% utilized because other lenders have withdrawn excess stablecoin liquidity to either exit completely or move to other markets. For someone like me in a looped PT-stablecoin position, it's not a big deal — just means my looping is no longer profitable as I earn 15-20% fixed on collateral while borrowing at 30-40% in debt. So I'll unwind it by withdrawing PT collateral, swapping back to USDC, paying back my USDC, withdrawing more PT collateral, etc. As I do so, it will free up capital for lenders to withdraw, even though I'm a small fish in a big pond.

There's nothing to stop me from unwinding right now; it just takes a few minutes of effort. My guess is bigger money is doing the same thing because there's no more certainty that rates will return back down and the same liquidity will generously be allocated by MMs/curators to sustain lower interest rates in these curated markets.

We Are Still Better Off Than Last Cycle
I am optimistic that we have come a long way since 2021/2022 and despite a number of blow-ups yet to surface from Oct 10th and the lost money from this xUSD meltdown, a lot of this is relatively safe stablecoin leverage that was flying high due to mispriced borrowing rates — and so now it needs to unwind a bit. My advice is if you're not 100% certain of what you're lending to or exposed to, or you just have trouble sleeping on any exposure, just unwind it and exit. I exited leveraged PT looping in profit. If you looped up with locked-in higher PT rates, that's a consideration too, but for the most part, there's always more Pendle PT lending opportunities so exiting now shouldn't weigh too much on you.

Final Thoughts
At the end of the day, this isn’t the same kind of contagion we saw in 2022 — it’s a market self-correcting after a year of mispriced risk. The tools worked. The systems held. What’s happening now is a healthy flush of over-leveraged yield chasing. If you’re uncertain, unwind and sleep better — but remember, DeFi always rebuilds stronger, and smarter, with each cycle.

Note: I normally edit my thoughts more carefully but for once, I’m just publishing my more unfiltered thoughts on this situation still unfolding. It’s not a nothing-burger but DeFi is working.