Introduction
Decentralized finance (DeFi) has emerged as an innovative force for the world of Web3 and finance, as it continues to build out infrastructure and services to allow for borderless, permissionless, and censorship-resistant financial services. One of the more exciting aspects of DeFi is the ability to utilize leverage, which allows users to magnify their potential profits from small price movements. However, using leverage can be a double-edged sword, amplifying losses as well as gains. As such, it’s important for individuals to understand the risks and benefits of using leverage in DeFi before diving in. In this blog post, we’ll explore the key considerations, strategic significance and history of leverage in DeFi.
What is Leverage? Explain Like I’m 5.
Utilizing leverage is like doubling down on a bet. Just like how you have to be careful when you decide to double down (i.e. you may earn more money, but you may also lose more), you have to be careful when you use leverage because it can be risky.
In DeFi, users can borrow cryptocurrencies like WBTC, ETH or USDC from others by using DeFi protocols made of smart contracts. They can use the borrowed asset to buy even more cryptocurrency, hoping to make a profit when they sell it later. This is called “leverage” because they are borrowing in order to increase their buying power and potential profits.
Why Would Someone Utilize Leverage?
- Capital Constraints: If users have limited capital, they may use leverage to take larger positions. An average user without leverage will have limited upside opportunities or profit potential, even if their decision or trade is “right”.
- Increase Potential Returns: People with strong conviction in a directional strategy may choose to use leverage to amplify their position. There’s a different type of risk involved, but leverage may give a blue chip (like ETH) the potential upside of small market cap assets.
- Hedging and Portfolio Protection: People can use leveraged derivatives like options, futures, and swaps to hedge their portfolios. For instance, buying put options (which increase in value when the underlying asset’s price falls) can help protect against potential losses in a different position.
- Yield Farming: Users may choose to magnify a Liquidity Provider (LP) position or yield farming/liquidity mining position. This offers users more LP tokens to generate even more fees and share in the upside of the underlying LP or native token. There are also variations of this which involve stablecoins and delta neutral strategies, but that is deserving of its own post.
Key Considerations and Significance of Using Leverage
DYOR and Gain Deeper Understanding:
Before using leverage, it is important to understand the risks and benefits of using leverage. It is crucial to have a solid understanding of the market and the asset being traded, as well as the specific risks associated with using leverage.
Risk Management:
One of the most important considerations for using leverage is risk management. To mitigate potential losses, users should have a clear risk management strategy in place, which includes setting stop-loss orders and taking profits at predetermined levels. This can help limit the amount of capital at risk and prevent the strategy from becoming too volatile.
Understand Specifics of Each Platform/Product:
Different platforms, protocols and vaults have different leverage requirements, implementations and fees, so it is important to understand them before using leverage. For example, some platforms may require users to maintain a certain margin level, others may have algorithmic/automatic logic and others still may have specific fees associated with using leverage.
Pros and Cons of Utilizing Leverage
Using Leverage in DeFi
Within DeFi, there are similar strategies or concepts to traditional finance that can utilize leverage:
- Yield Farming: Yield farming is a popular DeFi strategy that involves staking or lending cryptocurrency to earn interest or rewards in return. By using leverage, investors can amplify their returns on yield farming. For example, they can borrow stablecoins and use them to invest in a liquidity pool to earn more rewards.
- Liquidity Provision: Liquidity provision involves adding liquidity to a decentralized exchange (DEX) or automated market maker (AMM) by depositing funds into a pool. By using leverage, investors can increase the amount of liquidity they provide and earn more transaction fees and rewards.
- Flash Loans: Flash loans are short-term loans that allow users to borrow funds without any collateral. By using leverage, traders can borrow a larger amount of funds and execute larger trades within a short period of time.
- Margin Trading: Margin trading is a popular strategy in traditional finance that allows traders to borrow funds from a broker to execute trades. In DeFi, margin trading allows users to borrow cryptocurrency to buy or sell assets with leverage. This strategy can amplify profits but also increases the risk of losses.
- Synthetic Assets: Synthetic assets are a type of DeFi token that tracks the price of an underlying asset, such as a stock, commodity, or cryptocurrency. By using leverage, investors can amplify their exposure to synthetic assets and potentially earn higher returns. However, this strategy also increases the risk of losses.
History of Leverage in DeFi
The use of leverage in crypto markets has existed almost since the beginning of Bitcoin. The first platform to offer leverage for Bitcoin trading was the centralized exchange Bitfinex in 2013. Fast forward to 2017 and beyond, DeFi projects such as Compound and Aave also offered leverage through over-collateralized loans.
Later, derivatives and synthetics protocols like dYdX and Synthetix introduced margin trading, where users could borrow a certain asset to open a leveraged position without needing to deposit collateral. Also, innovations around flash loans created new ways to utilize leverage, which introduced new risks for the space. Most recently, derivatives platforms like GMX have supercharged and iterated on these existing models and designs.
Additionally, leveraged yield farming / liquidity mining became popular with protocols like Alpaca Finance beginning to introduce this concept on BNB Chain. Leveraged yield farming is still a relatively new strategy when compared to leveraged trading, and as such, the ecosystem and services around these strategies are still being built out and innovated.
But, as previously highlighted, leverage is a double-edged sword. Though it has helped support liquidity, adoption and user growth for crypto, it has also resulted in increased volatility and risk. In 2018, the high levels of leverage used by traders contributed to the dramatic market crash that saw BTC’s value drop from ~$20k to ~$3k in a matter of months. This led to increased scrutiny and regulation of leverage in crypto markets, with some exchanges and platforms implementing lower maximum leverage limits to mitigate risk. This was also evident during the market crash in May 2021, where a sharp drop in prices triggered a cascade of liquidations in highly leveraged positions and once again in 2022 with the crash of LUNA/UST and subsequent cascading troubles of 3AC and others.
Specific Examples of Platforms that Provide Leverage in Crypto
Centralized
- Many centralized platforms allow leverage
Decentralized
- GMX
- Alpaca Finance
- Seashell
Conclusion
Leverage can be a powerful tool for DeFi users, but it also comes with significant risks. Users should understand the risks and benefits of leverage before using it in their strategies.
Seashell is on a mission to maximize user’s DeFi experiences through easy to use tools and front ends.
Checkout Seashell’s initial suite of front ends built for vaults on Arbitrum.
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