DeFi has revolutionized the way we think about finance by offering innovative solutions that are transparent, accessible, and decentralized. One such innovation is leverage, which allows users to increase their exposure to assets to amplify gains.
Understanding DeFi leverage blog series aims to explore how DeFi leverage works, dive into the intricacies of various protocols and mechanisms, the types and purposes of leverage available, and the associated risks and rewards.
Leverage is the concept of using borrowed capital as a funding source. The fundamental reason behind taking leverage is increasing exposure, ie, the size of a position beyond what would be possible with the user’s own capital alone. This is achieved by using collateral, to secure the borrowed funds. The amount of leverage available depends on the collateral ratio required by the protocol, with lower ratios allowing for higher leverage.
One can take on leverage through a variety of methods in DeFi (non-exhaustive list):
Lending has always been one of the largest sectors within DeFi, currently with ~$27Bn in TVL. The largest lending protocols include Aave, Spark, Compound, Venus, etc. Collectively, there are over 300 lending protocols across networks.
Collateralized debt positions: A collateralized debt position (CDP) is the position created by locking collateral in a smart contract to generate a decentralized stablecoin. This system was introduced into DeFi by MakerDAO and is how its decentralized stablecoin DAI is created. MakerDAO still commands ~$6Bn out of the ~$10.2Bn TVL across CDP protocols. Some other prominent CDP protocols are Liquity, Prisma Finance, etc.
Derivatives: Derivatives are financial contracts that derive their value from an underlying asset, group of assets, or benchmark. Derivatives are typically a leveraged instrument that increases their potential for risk and reward. Derivatives are useful tools to hedge a position, speculate on directional movements, or give leverage to holdings. The most common types of derivatives are futures, forwards, swaps, and options. DeFi derivatives protocols hold a TVL of ~2.3Bn, the biggest ones being GMX, dydx, Hyperliquid, etc.
The primary actions required by the user to take a debt position in DeFi lending protocols are
Choose the lending protocol and connect your wallet
Choose which asset to deposit as collateral
Approve and deposit collateral asset
Choose which asset to borrow
Specify the borrow amount and sign the txn
While it is as simple as it sounds, it's important for users to carefully consider their risk tolerance and manage the positions effectively in accordance with the mechanics of the underlying protocol (we’ll be diving into these mechanisms in subsequent blogs).
The biggest consideration while dealing with leverage is for users to be aware of the potential liquidations, which is a process of the user’s collateral being sold off to recoup their debt if the value of collateral no longer covers their loan/debt value. A position’s eligibility for liquidations is measured through its health factor, which is a function of the total collateral value, borrowed value, and the collateral’s liquidation threshold.
While leverage can amplify profits, it also comes with increased risk. Some key risks to consider while taking on the position include smart contract risks, protocol risks, liquidity risks, oracle risks, regulatory risks, etc. (more on this later).
Leverage is a powerful tool that can be used to amplify gains in DeFi. The increasing number of protocols building in the sector speaks to the growing opportunity but also comes with challenges around assessing risks, and optimally discovering/managing leverage positions across protocols and networks.
Users should carefully consider their risk tolerance and understand the mechanics of the protocols they are using before engaging with lending/CDP protocols. Lucidity aims to aggregate the leverage liquidity and allow users to efficiently discover optimal leverage that agrees with their risk appetite, and make it easy to open, manage, and monitor positions across lending/CDP protocols through a single interface.
We’ll be talking about a lot of topics relevant to DeFi leverage over the subsequent blogs.