Background
I never considered using leverage to make investments before I discovered DeFi. In my conservative family, it was fopaux consider trading stocks with a margin account, borrowing money to make investments, and risk was basically a four letter word. I was brought up to never leave a balance on my credit card (thanks Dad), pay bills on time, and only borrow money for a house, car, or student loan.
Speaking of houses, cars, or student loans, those are all benefits of leverage. We use it all the time, we just don’t know it. Here are examples about how we can get leverage:
Credit
A bank will issue you a line of credit based on your credit history. There are companies like Equifax who keep track of how reliably you pay your bills, whether you’ve defaulted on a loan, not paid a bill, and develop a score that’s somewhat objective for making credit decisions.
Credit rating helps you apply for loans. These loans are backed by your credit history, the assets in your bank account, and your paychecks
Collateral
Physical assets (e.g. your house, art) can be leveraged to get a loan. The process of filing paperwork, having your loan reviewed by an underwriter, and the fees/time required is agonizing. However, this is how the legacy system has worked and often gets people a significant amount of liquidity - perhaps more than the value of the asset being leveraged!
Financial assets (e.g. stocks, trusts) can be leveraged for borrowed liquidity. Same as the above, overleveraged is the norm for a lot of people (e.g. they have a Loan To Value or Debt:Equity ratio >1).
Digital assets - Crypto and NFTs are now able to be leveraged and get liquidity, instantly, without the need for KYC/credit check, as long as there is a market for the collateral. There’s a very good argument to be made that DeFi has created a safer system than TradFi because loans are always overcollateralized. Users’ equity will always be greater than their debt, else their collateral would be sold programmatically.
The concept of composability has enabled DeFi users and protocols to get leverage on their digital assets instantly and at a very low up front cost. Smart contracts on various blockchains (Ethereum, Avalanche, Cosmos, etc) are a way to safely deposit collateral and borrow other assets provided by other DeFi lenders (users or protocols). Digital collateral can be crypto or NFTs!
Thanks to improved token economics that capture value through a staked derivative (e.g. stETH, rETH, xSUSHI), users can rehypothecate their assets as superfluid collateral. This means they can generate yield while lending their assets out and often earn more interest/yield than the cost of the borrowed asset interest. This is essentially free liquidity when you net it out. I’m very bullish on a protocol called Curvance for this very reason.
Leverage has many types and varying levels of RISK:
Liquidation - This means a borrower’s collateral is worth less than the amount of their outstanding loan (in USD), and the counterparty needs to sell some of the borrower’s collateral in order to make things even. Every major DeFi protocol requires overcollateralized loans, which limits the amount anyone can borrow. Liquidation requires the depositor to become a forced seller of their crypto collateral and pay a hefty fee (upwards of 10%) to the protocol.
Zero liquidation leverage - Should a borrower deposit stablecoins and borrow stablecoins (pegged 1:1), there is no risk of collateral liquidation because the two sides of the ledger (deposited and borrowed) are always equal.
Price volatility - However, if the two assets’ prices move up or down, a depositor must be mindful of the ratio of deposited:borrowed asset in order to prevent being liquidated. A common mistake new DeFi borrowers make is to take leverage out on a token that has performed very well in an up only, bull market. (E.g. ETH goes from $300 to $2,500 and your borrowing power soars). This new borrower takes out a loan using 80% of the value of the collateral, expecting the ETH price to continue to go up, but the price of ETH drops 20% and instantly liquidates the depositor’s collateral. This is a painful lesson in price volatility risk.
Counterparty/Smart Contract - DeFi users must always be cognizant of smart contract risk in DeFi, and thorough due diligence is a requirement. Check for a reputable audit from a good firm, make sure there is ample liquidity or high total value locked, double check smart contracts using etherscan.io, and you should avoid losing funds from a hack or exploit. This is still a major risk in DeFi though, and very smart people are working on this problem.
Since most counterparties in DeFi are protocols, which are just code with tokenholder governance, insolvency is less likely. The DeFi protocols have maximum loan to value (LTV) ratios to have more collateral deposited than loans issued, and adjust interest rates in order to attract liquidity during a bank run situation.
Solvency - If you borrow assets against your collateral, the counterparty can do what they please with your deposit, including lending it out or staking it in another protocol to generate yield. There’s not always a guarantee there will be enough collateral for you when you repay your loan (read bank run above).
What can leverage be used for?
Buying things!
Use Alchemix to deposit collateral that generates yield, take a loan, and it will pay itself back!
Starting a business
Making money by leveraging your capital
This has been coined “Yield Farming” by the DeFi community. Putting your assets to work to earn more is called capital efficiency, and can be an effective use of leverage depending on the situation.
How to use leverage in DeFi
Here’s a practical lesson for those of you who are interested in some basic leverage strategies. Always be mindful of the liquidation risk and pay attention when prices are volatile! For those of you using DeFi money markets, are you being capital efficient? These might give you some ideas:
Borrow the same assets that you lend - Why would anyone do that? A couple of reasons.
Avoid capital gains taxes - Yield farming opportunities abound for liquidity providers (LPs) who provide two-sided liquidity to a new decentralized exchange (DEX). This requires you to hold both assets already, which is quite unlikely for most people. OR you can buy one or both of the assets and LP them for yield.
If you sell your crypto for another asset, you are going to have to pay taxes on the swap, based on the original cost basis of your crypto. Your ETH cost basis might be a lot cheaper than the current price, and you’d be stuck with a capital gains burden.
Rewards - Oftentimes new money markets incentivize both lenders and borrowers with governance tokens (yield). A common strategy is “folding,” which has no liquidation risk. You simply lend and deposit the same asset over and over again until you hit your maximum and can boost the yield by up to 5X!
Borrow assets that have price movements that are highly correlated to your collateral. If you lend out ETH and borrow LINK or other DeFi tokens, you are unlikely going to have significant liquidation risk over short time frames. Longer duration loans have more divergent price movements and can require close monitoring to prevent liquidation.
Borrow stablecoins and purchase another asset (long). Speculators often borrow money to purchase assets they expect to appreciate. This involves taking some price volatility risk on your borrowed capital, so it’s very important to watch both your LTV ratio and the underlying value of the asset you’re buying on leverage. Having a ‘stop loss’ or maximum amount you’re willing to lose is something to consider in this situation.
Borrow an asset and sell it for stablecoins (short). Same situation as above, however, you expect the asset you’re borrowing to go down in price and plan on buying it back cheaper in the future to repay your loan.