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January 11, 2022

What Is Leverage in DeFi?

DeFi lending and borrowing protocols like Umee provide several benefits for savers, investors, and traders. One of these benefits is the ability to use borrowed funds for trading and investing, otherwise known as using leverage.
By AJ Scolaro
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TLDR

Leverage can be a useful tool for experienced DeFi users to maximize their profits, but exposes users to greater risk.

What is Leverage?

DeFi lending and borrowing protocols like Umee provide several benefits for savers, investors, and traders. One of these benefits is the ability to use borrowed funds for trading and investing, otherwise known as using leverage.

Some of the benefits of using leverage include:

  • Users are able to use less capital to achieve desired positions in their assets of choice
  • Users have the ability to open larger positions than they would be able to without leverage
  • Profits are magnified.

Potential downsides of using leverage include:

  • If volatile assets are being used as collateral, they have the risk of liquidation
  • Users are unable to recover some/all of their collateral in the event of a liquidation
  • Losses are magnified

The ability to use DeFi protocols for leverage trading/investing provides users with incredibly lucrative opportunities, since they have access to capital they otherwise would not be able to use. Trading with leverage can bring people from rags to riches, but can also generate massive losses when risk is not properly managed. On the other hand, leveraged staking allows more risk-averse users to use leverage to their advantage.

If you’re new to crypto, I recommend you familiarize yourself with lending and borrowing in DeFi before continuing. It’s important to have an understanding of loan-to-value ratios and liquidations before using leverage.

Leveraged Trading

Assumptions:

  • Jack trades against USD and is very bullish on Atom
  • Jack can borrow up to 0.6x against his collateral provided
  • The price of Atom and stablecoins remain constant
  • All rates — lending, borrowing, liquidator discount — are undefined (to keep things simple)
Jack purchases and deposits 1,000 Atom into Umee while Atom is trading at $10. Jack chooses to use his Atom as collateral to borrow 6,000 USDC. Since Jack is extremely confident Atom will continue to appreciate against USDC, he uses the 6,000 USDC to purchase 600 more Atom from a DEX.
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Now:

  • Jack has used 1.6x leverage on his Atom position
  • Jack’s loan to value (LTV) ratio is 6,000:10,000 USDC, or 0.6
  • Jack has exposure to 1,600 Atom although he originally only purchased 1,000 Atom with his own money
  • Jack is earning lending interest on the 1,000 Atom deposited
  • Jack owes 6,000 USDC + borrowing interest payable in USDC
  • Jack’s potential profits and losses on Atom are both magnified by 1.6x
While Jack is happy with his 1.6x leverage, he thinks Atom is a moonshot and wants to make as much money as possible. Jack decides to deposit the 600 additional Atom he acquired as collateral to borrow 3,600 more USDC. Jack immediately uses this USDC to purchase 360 more Atom, which he deposits as collateral once more to borrow 2,160 more USDC and purchase 216 more Atom. Jack repeats this process one last time to borrow 1,296 USDC and purchase about 129.6 more Atom. He chooses not to deposit this Atom into Umee.
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Now:

  • Jack has used 2.3x leverage on his Atom position
  • Jack has exposure to 2,305.6 Atom valued around $23,056

1,000 + 600 + 360 + 216 + 129.6

  • The value of Jack’s collateral is approximately $21,760

(1,000 + 600 + 360 + 216) * $10

  • Jack owes around 13,056 USDC + borrowing interest

6,000 + 3,600 + 2,160 + 1,296

  • Assuming Atom still trades at exactly 10 USDC, Jack’s LTV ratio is still 0.6

13,056/21,760

  • Jack’s potential profits and losses are magnified by ~2.3x

The following two scenarios showcase how a change in the price of Atom can affect Jack’s position:

1) Atom gains 10% to $11.00

Now:

  • Jack’s LTV ratio is ~0.55

13,056/23,936

  • This is a healthier LTV ratio; since the value of Jack’s collateral has increased against the amount he owes, Jack can now borrow more USDC without depositing additional collateral
  • Jack can begin selling his Atom to pay off all of his USDC loans for profit
  • If Jack pays off all of his loans and chooses to sell the original 1,000 Atom he deposited he will now have 12,305 USDC minus borrowing interest
  • This is a realized profit of 2,305 USDC minus borrowing interest
  • If Jack had not leveraged his Atom, he’d be able to realize a profit of 1,000 USDC

2) Atom falls 2% to $9.80

Now:

  • Jack’s LTV ratio is ~0.61

13,056/21,324.8

  • The position is eligible for liquidation since it is no longer properly over-collateralized

0.61 > 0.6

  • A liquidator steps in to pay off a portion of Jack’s loan (in USDC) in return for some of Jack’s Atom collateral at a discount
  • Jack’s LTV ratio returns to a healthier level that is properly over-collateralized

LTV < 0.6

  • Jack has been forced to realize losses on his Atom position that are greater than they would have been if he had not used leverage

In order to further improve his LTV ratio and decrease his risk of liquidation, Jack can:

  • Pay off part of his USDC loan
  • Deposit more collateral
  • Borrow smaller amounts relative to collateral provided in the future

Leveraged Staking

Since Umee is a Proof-of-Stake blockchain that acts as the gateway to the Proof-of-Stake based Cosmos ecosystem, users can stake their PoS assets for the most risk-free and steady yield available in crypto. Umee will allow users to participate in leveraged staking to discover new yield opportunities.

Assumptions:

  • Alison tracks her gains against USD
  • Alison can borrow up to 0.8x against her collateral provided
  • Stablecoins hold their pegs perfectly
  • All deposit rates are ~3% APY
  • All borrow rates are ~4% APY
  • Atom staking rates are ~15% APR

Alison deposits 10,000 USDC onto Umee to start earning a lending yield (~3% APY).

The following two scenarios showcase how Alison can benefit from using leverage with little to no liquidation risk:

1) Alison decides to use her USDC as collateral to borrow 7,500 more USDC (~4% APY). Alison uses this USDC to purchase 750 Atom from a Cosmos-based DEX @ 10 USDC/ ATOM. Alison proceeds to stake all 750 Atom for ~15% APR.

Now:

  • Alison is still earning ~3% APY on the 10,000 USDC she deposited

This is ~$300/yr → (0.03*10,000) * $1

  • Alison’s borrowing interest owed on her 7,500 USDC loan begins to accrue at ~4% APY

This is ~$300/yr → (0.04 * 7,500) * $1

  • If rates remain stable, Alison’s deposit APY earned essentially cancels out the borrowing interest she owes
  • Alison has no liquidation risk since she is borrowing the same asset she provided as collateral
  • Alison is earning ~15% APR on her 750 Atom staked

~112.5 ATOM/yr which is equivalent to ~$1,125/year if the price of Atom remains constant → (0.15 * 750) * $10

  • Alison can choose to compound her staking rewards as frequently as she’d like in order to earn greater staking rewards
  • Alison has exposure to Atom without giving up any of her USDC

2) Alison decides to use her USDC as collateral to borrow 750 Atom. Alison immediately stakes all 750 Atom for ~15% APR.

Now:

  • Alison is still earning ~3% APY on the 10,000 USDC she deposited

This is ~$300/yr → (0.03*10,000) * $1

  • Alison’s borrowing interest owed on her 750 Atom loan begins to accrue at ~4% APY

Since the interest on the loan is payable in the asset borrowed, this is ~30 ATOM/yr or ~$300/yr if the Atom price remains constant → (750 * 0.04) * $10

  • If the price of Atom remains constant, Alison’s deposit APY essentially cancels out the borrowing interest she owes
  • Alison is earning ~15% APR on her 750 Atom staked

~112.5 ATOM/yr which is equivalent to ~$1,125/year if the price of Atom remains constant → (0.15 * 750) * $10

  • Alison has exposure to Atom through accumulating staking rewards, even though she never directly purchased Atom
  • Alison needs to actively monitor the price of Atom and protect her position; if the Atom price increases significantly and Alison has not added more collateral or paid off part of her loan she is at risk of liquidation

If the Atom price rises 20% to $12, Alison’s LTV ratio changes from 0.75 to 0.9 and is liquidatable since Alison is no longer properly over collateralized (0.9 > 0.8)

In order to maintain a healthy LTV ratio, Alison can choose to use some of her staking rewards to gradually pay off the Atom loan

Later on this year, Umee will allow staked assets to be used as collateral. This means users can deposit staked Atom, borrow Atom against the staked Atom with no liquidation risk, stake the borrowed Atom, and so on essentially leveraging their staked Atom in order to earn a greater staking yield.

Conclusion

As you can see, leverage is a helpful tool that can give users the ability to magnify their profits. It’s important to acknowledge that leverage works both ways, and anyone using leverage should create a strategy beforehand.

Umee will facilitate interchain leverage, allowing users to deposit assets on one blockchain in order to borrow assets on another. This novel concept opens up countless new DeFi opportunities.

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