How is trading on margin different from borrowing?

marginfi is a decentralized margin protocol for trading across Solana. The protocol makes it easy for traders to access margin, manage risk, and improve capital efficiency across the entire Solana ecosystem from one unified place.
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Hello, traders! Our latest article explaining margin received a lot of positive feedback and we are very thankful to all of you who reached out and participated on discord. Let’s continue with the finance fundamentals. Today’s article answers a natural question: how is trading on margin different from simply borrowing money?

Quick recap

We discussed before that trading on margin refers to borrowing money to buy financial assets. When you open a margin account, you post margin to that account (that’s depositing your equity, or getting your “skin in the game”). When you place a trade, you specify how much leverage you would like to take out to execute the trade. The asset that you buy is then used to collateralize the margin loan and helps the lender manage the risk that you might default on your loan.

What if you want to borrow assets from elsewhere?

Let’s say for a moment that you want to take a different approach to getting leverage. Instead of trading on margin, you could take out a loan and then use the capital from that loan to make a trade. How would it work?

In DeFi you’ll need to start with a lending protocol. There are many options. Generally speaking, you’ll need to deposit an asset as collateral before you can borrow. The lending protocol will provide you with a borrowing limit based on a predetermined collateralization ratio — and since lending protocols are currently over-collateralized, the value of assets you deposit must be greater than the value of assets you borrow. Each lending pool offers their own interest rates based on the utilization ratio of pool’s deposited assets.

Once you’ve borrowed on a lending protocol, you can go to a trading protocol. Since you have USDC in your wallet, you can buy options, futures, or other assets just like you normally would.

The example above sounds easy, but borrowing in one place and purchasing in another increases operational complexity and makes it easy to make mistakes. This process takes time. Once the trade is in place, you are exposed to liquidation risk on one protocol while your capital is locked up on another protocol.

Let’s make it concrete

Putting some numbers to the story will also help explain why it’s difficult to lever up unless you are trading on margin.

Let’s say you go to a lending pool to borrow and that lending pool requires an initial 200% collateralization ratio. Remember, collateralization is the ratio between the collateral and the loan amount. This means if you deposit $100 USDC, you can borrow $50 USDC. Let’s say you take that $50 USDC to another trading protocol and you purchase $50 worth of SOL (~0.33 SOL). Your exposure is now $100 USDC (locked up on the first exchange) and 0.33 SOL (on the second exchange).

Now instead imagine you are trading on margin. You have 100 USDC and you link your wallet directly to the second trading protocol. Let’s assume that protocol offers the same 200% collateralization ratio. Since the asset you are buying serves as the collateral for the loan, you can put up your same 100 USDC, borrow 100 USDC, and buy $200 worth of SOL (~1.32 SOL). This works because your whole $200 of SOL is serving as collateral for the $100 loan.

Key differences

You may have already pieced it together, but let’s make a list of the key features that make margin special:

• When you are trading on margin, the act of borrowing capital and buying an asset is all rolled into one step. You don’t have to borrow in one place, transfer money to another place, execute a trade, and then remember to do the reverse of all of this when you sell the position and want to pay down your debt.
• When trading on margin, the asset you purchased is used as collateral for the margin loan. This gives lenders some reassurance that they can recuperate losses in the event of a default, and in return it means that you can borrow more capital and at lower rates than you might otherwise have available.

Up next: Why do some assets require margin?

So far we’ve talked about what margin is and why a trader might want to trade on margin — but sometimes margin is not optional. Certain types of financial assets require the buyer (or seller) to take on a future obligation to pay their counterparty. In those instances, margin must be posted as collateral against the obligation.

This issue applies to futures contracts and certain types of options contracts, which we’ll discuss next. Follow us to stay updated, or join the discord to get the alpha first.

As always, no marginfi content should ever be considered financial advice and no reference to financial assets, securities, derivatives, or other financial products should be considered an endorsement of the aforementioned. Please consult a licensed financial advisor before making any and all investment decisions, and please do your own research.