Contributor: FinNexus takes a deep dive into DeFi borrowing in this analysis.
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What Is Leverage?
In finance, leverage is a strategy that relies on using borrowed money to increase the potential return of an investment. In simple terms, an investor or a trader borrows funds to amplify the exposure to a certain type of assets, projects or instruments, more so than would be possible by relying only on his own capital. Normally, with leverages, investors will be able to multiply their buying power in the market.
Leverage is common in everyday life, too. When you are using a credit card to buy a TV, or when you are using mortgages to buy a house, you are borrowing money and using leverages.
Leverages in Cryptoasset Trading
The use of leverages is one of the most important and commonly applied features in cryptoasset trading. Shortly after the establishment of centralized exchanges, trading with leverages became more and more popular, despite the fact that the crypto market already displays high volatility.
Just like in traditional finance, traders take on leverages either to simply borrow money to increase their purchasing power, or to exploit different kinds of financial derivatives, like futures and options.
The leverage ratios have also been increasing from 3x, 5x to more than 100x. Higher leverages mean higher risks, but as shown by the growing volumes of leveraged trading witnessed by most CEXes, this is a danger aggressive traders are willing to undertake, in pursuit of higher returns.
Leverages in DeFi
Furthermore, other differences exist between different DeFi financial models.
Leverages in DeFi Borrowing
DeFi borrowing and lending is one of the earliest and the biggest DeFi applications, with giants already operating on the market, like MakerDao, Compound, AAVE, Venus, etc.
The logic of taking leverage through borrowing cryptoassets is simple.
Similarly, if you are bearish, you can choose to deposit stable coins and borrow ETH. If the ETH price drops, you can buy it back at a cheaper price on the market and repay your debt.
Note that in case, since you would be borrowing funds from a decentralized protocol, if the value of collaterals decreases or the value of what you borrow increases beyond a certain threshold, you might get liquidated.
Leverages in Margin Trading
Margin trading is a method of trading assets using funds provided by other parties. Similar to direct borrowing, it provides traders with greater sums of capital, allowing them to leverage their positions.
However, there is one important difference — while the margin position is open, the trader’s assets act as collateral for the borrowed funds.
DYdX is perhaps the best known decentralized margin trading platform, and allows for up to 5x leverages. In dYdX’s margin trading, traders use their own funds as a guarantee, magnify their original principal by several multiples and use these magnified funds to make larger investments.
Traders need to pay an interest fee as well as the costs associated with the transaction. The position is not synthetic and it involves real borrowing and purchasing/selling.
If the market moves in an unfavorable direction, a trader’s assets may not be able to fully recover the loan borrowed. To prevent this from happening, the protocol will liquidate your position before getting to a certain liquidation ratio.
A closer look at how the leverage may change in margin trading —
Suppose you are longing ETH 3x in margin trading, but feel reluctant to adjust the exposure from time to time.
You are holding $100 USDC, borrowing another $200 USDC and trading for $300 ETH in order to take the desired ETH long position. The leverage level is $300/$100=3x.
If the price of ETH rises by 20%, your profit will be $300(1+20%)-$300=$60. You are safer from being liquidated and the real leverage level is decreased to $360/($360-$200)=2.25x. In other words, you are automatically deleveraged by the ETH price rise.
If the price of ETH drops by 20%, your loss will be $300(1-20%)-$300=-$60. You are in a more dangerous position as far as liquidation is concerned and the real leverage level is increased automatically to $240/($240-$200)=6x. In other words, you are re-leveraged by the ETH price drops, which shows you are in a more risky position than before.
Leverages in Perpetual Contracts
Perpetual contracts are similar to traditional futures contracts, but there is no expiry. Perpetual Contracts mimic a margin-based spot market and hence trade close to the underlying reference index price.
There are a number of DeFi projects providing perpetual contracts for traders, like dYdX, MCDEX, Perpetual Protocol, Injective, etc.
Many traders may find it hard to tell the difference between trading on margin and perpetual contracts — indeed, they both involve users’ getting leveraged.
- Perpetuals are a type of derivative product trading synthetic assets that are margined. The tracking of the underlying asset price happens in a synthetic way, without the need to trade the real underliers. But margin trading involves real borrowing and transactions of the actual cryptoassets.
- Along with perpetuals comes the concept of funding rates, which aim to keep the traded price of the perpetual contract in line with the underlying reference price. If the price of the contract is above the spot price, longs will pay shorts. In other words, traders face an ongoing cost for borrowing funds.
- Leverages in perpetuals are normally higher than in margin trading and can go up to 100x.
The liquidation and real leverage mechanisms are the same as in margin trading.
Leverages in Leveraged Tokens
The biggest difference between leverages tokens and margin trading/perpetuals is that leveraged tokens will rebalance themselves periodically or when reaching a certain threshold, in order to maintain certain leverage.
This is obviously different from both margin trading and perpetuals - products whose real leverages are is constantly changing according to price fluctuations, even though traders may have designated a leverage level initially.
Let us take a look at how the rebalancing works following the 3x ETH example above.
You are holding $100 USDC and purchase an ETHBULL (3x) leveraged token. The protocol will automatically borrow $200 in USDC and trade for $200 ETH.
Suppose the price of ETH increases by 20% and the ETHBULL (3x) token price rises to $300*(1+20%)-$200=$160 before rebalancing. Now, your real leverage becomes 2.25 ($360/$160), lower than the targeted leverage.
As part of the rebalancing process, the protocol will borrow more USD from the stablecoin pool and purchase extra ETH tokens to shift the leverage back to 3x. In our example, the protocol would borrow another $120 and exchange it for ETH. The total leverage would thus become ($360+$120)/$160=3x again.
Suppose the price of ETH decreases by 20%, and the ETHBULL (3x) token price decreases to $300*(1-20%)-$200=$40 before rebalancing. Now, your real leverage would become six ($240/$40), higher than the targeted leverage.
In this case, the protocol would sell ETH tokens and repay the outstanding debt to deleverage. In the example, the protocol would sell $120 ETH for USD and pay back to the pool. The debt would become $80 and the total leverage would once again be ($240-$120)/$40=3x.
In other words, the leveraged token will automatically re-leverage in profit and deleverage in loss, to restore its targeted leverage level. If the mechanism works smoothly, even in unfavorable market trends, the leveraged token holders will never be liquidated, as the deleverage mechanism will constantly lower the effective leverage level for the users.
The lending pool in the leveraged token model will thus be exempted from the risk of liquidation failure and more secure than lending pools in margin trading.
Leverages in Options
An option is essentially a right that can be exercised in the future. In order to acquire such a right, the buyer pays a sum and the consideration is called the risk premium.
Options naturally produce leverages as every contract represents a unit of the underlying asset while costing only a fraction of the price. This allows options traders to control their exposures on the same number of assets but at a much lower cost.
Assume you have $1000 and wish to invest in ETH. ETH is at $2000 with $2000 strike price call options traded at $100. In this case, you could use all your available funds to own 0.5 unit of ETH, or you could buy 10 call options with a strike price of $2000 — meaning you’d be exposed to the volatility of 10 ETH!
In our example, with the same amount of money, you could have 20 times more exposure to ETH than you would normally be able to by just buying the asset itself. That’s how leverage works in options trading.
Following the example above:
If the ETH price grows by 20% to $2400 and you are holding 0.5 units of ETH, your profit in USD would be $200.
However, if you are holding 10 calls on ETH, by exercising the call, your profit is 10*($2400-$2000)-$1000=$3000. The rate of return is $3000/$1000*100%=300%. The actual leverage is 300%/20%=15x.
You are automatically exposed to a leveraged position by holding a call.
If the ETH price grows by 10% to $2200, by exercising the call, your profit is 10*($2200-$2000)-$1000=$1000. The rate of return is $1000/$1000*100%=100%. The actual leverage is 100%/10%=10x.
If the ETH price grows by 30% to $2600, by exercising the call, your profit is 10*($2600-$2000)-1000=$5000. The rate of return is $5000/$1000*100%=500%. The actual leverage is 500%/30%=16.67x.
Leverages can bring higher gains, but also higher risks. Different financial products may have very different ways of providing leveraged exposure for traders. Especially in DeFi, leveraged products may be powered by innovative models and new liquidity solutions that are not seen in traditional finance.
Before trading on leverage, users should pay attention to the models deployed and do their own extensive research.