Looping: how a supply, borrow, swap cycle builds leverage, and where the health factor bites

A yield-bearing asset can be supplied to a lending market as collateral. The market lets the supplier borrow against it up to a loan-to-value ratio. If the borrowed asset is swapped back into the yield-bearing one and supplied again, the position now earns yield on more than it started with, and owes interest on the difference. Repeat, and each pass adds a smaller increment of exposure. That is a loop.

The canonical example pairs a liquid staking token with the asset it represents: supply staked ether, borrow ether, stake it, supply the result. Lido’s documentation of the strategy on Aave describes exactly this recursive structure, and Aave’s efficiency mode, which raises the permitted loan-to-value when collateral and debt are correlated, exists largely to make it capital efficient. A dedicated Aave market for the pair, with its own rate curve, was launched to house it.

The arithmetic of the loop

If each pass borrows a fraction of the collateral equal to the loan-to-value ratio, total exposure after many passes converges to one divided by one minus that ratio. A ratio of four fifths converges toward five times the starting capital; nine tenths toward ten times. Several protocols and aggregators now execute the whole sequence in a single transaction using a flash loan, which removes the execution risk of being caught mid-loop but changes nothing about the finished position.

The position’s return is the spread between what the collateral earns and what the debt costs, multiplied by the leverage. That sentence contains the whole risk. A spread of a fraction of a percent, multiplied by high leverage, produces a return that looks attractive and a position that a small change in either rate can turn negative. Borrow rates on lending markets are set by utilization and rise steeply when the market is heavily borrowed, which is precisely what a popular loop does to the market it runs in.

The health factor

Aave expresses a position’s distance from liquidation as a health factor: collateral value weighted by each asset’s liquidation threshold, divided by debt. Below one, the position can be liquidated. A looped position has a health factor that depends on the price of the collateral in terms of the debt asset, and for a staked-asset loop that price is close to one and moves little. Close is not the same as fixed. A liquid staking token can trade below its redemption value when holders want to exit faster than the protocol’s withdrawal queue allows, and a loop built at high leverage can be liquidated by a discount that reverses a week later.

• Health factor: liquidation-threshold-weighted collateral divided by debt; liquidation begins below one
• Liquidation threshold: the collateral ratio at which liquidation is permitted, set above the loan-to-value ratio used for borrowing
• Efficiency mode: higher loan-to-value for correlated collateral and debt, which raises the achievable leverage and lowers the buffer
• Liquidation bonus: the discount a liquidator receives for repaying debt and seizing collateral, paid by the position

Unwinding under stress

A loop is unwound in reverse: withdraw a slice of collateral, swap it to the debt asset, repay, repeat until the position is flat. Each step needs liquidity in the swap market and headroom in the lending market. In a stressed period both shrink at once. The swap from the staked asset to the underlying widens as other loops unwind through the same pools, and the lending market’s utilization rises as suppliers withdraw, pushing borrow rates up on the debt that has not yet been repaid. The unwind path has to be tested against available depth before the loop is built, because it cannot be tested afterwards.

Stablecoin loops

The same structure works with a yield-bearing stablecoin or tokenized Treasury as collateral and a plain stablecoin as debt. Price risk between the legs is small; what the loop carries is the collateral’s peg and the borrow rate. Stablecoin borrow rates spike when leveraged demand for dollars rises, which tends to be when markets rally, and a loop whose spread was positive at entry can pay more in interest than it earns within a day of a change in sentiment.

Looping does not create yield. It amplifies a spread, and it amplifies every risk attached to that spread by the same multiple. Built with a wide health-factor buffer, in markets with tested unwind depth, and reduced automatically as the buffer compresses, it is a legitimate way to size a small, persistent spread. Built to maximize the headline figure, it is a liquidation waiting for a catalyst.