Shifting Gears in DeFi: Gearbox’s Innovative Path to Leveraged Lending
Crypto users love leverage. They love leverage so much that Bitcoin perpetual futures, the primary form of leverage in Crypto, make up 70%+ of Bitcoin trading volume. However, perpetual futures, lovely providers of leverage though they are, have some flaws. Red flags you might say. First, they’re expensive — peaking at 66% APR in 2023. Second, they serve only a single purpose — to increase leverage on price movement. Lastly, they can be liquidated by extreme wicks.
Gearbox is using account abstraction to create a new DeFi primitive: credit accounts. Gearbox’s credit accounts enable high-leverage borrowing. High-leverage borrowing simply means getting a loan for more than the money you put in (for example: you deposit $10 and borrow $100). In the short term, this is important because it allows traders to increase leverage at much lower rates and with greater flexibility. In the long term, Gearbox may have cracked the code on bringing mortgages, student loans, business loans, and other purpose-built loans on-chain.
This article will be the first of a series on Gearbox. This article will act as a primer, explaining the problem Gearbox is solving and its unique approach to it. Without further ado, let’s dive in.
Why High-Leverage Borrowing is Important
I’ll start small and then zoom out. Crypto is widely used as a tool for speculation. Put simply, lots of users, maybe even most users, primarily use crypto to gamble. As I established earlier, these users love to use perpetual futures to increase the leverage of their bets.
While perpetual futures have real benefits and will likely continue to be an important financial instrument in the crypto space, Gearbox’s leveraged borrowing has several key advantages over perpetual futures.
First, leveraged borrowing is often cheaper. Compare futures funding rates to the borrow rates on Gearbox. Second, leveraged borrowing offers more optionality. You could borrow funds to put them in high-yield farms, arbitrage a price imbalance in stablecoins, or put them in a vault with an automated trading strategy. You receive real funds, so the composable and wide world of DeFi is available at your fingertips. Lastly, since you are trading with spot, you have access to DEX spot liquidity which is 4x the depth of DEX futures liquidity.
Crypto traders are going to seek leverage and there should be instances where it simply makes more sense to leverage using Gearbox rather than futures.
Zooming out, there is currently $235T of global debt — that is 238% of global GDP. Whatever your political beliefs are in regards to the morality of debt, the reality is we live in a debt-based economy. Debt is used to transfer money from those who have it (savers) to those who need it (borrowers). Debt allows entrepreneurs to build businesses and products and allows consumers to make bigger purchases like a home or a car. If crypto is going to be the future of finance, it must create lending/borrowing primitives that match the current financial system.
Overcollateralized borrowing (when you borrow less than you deposit as collateral) was a sensible starting point for the DeFi space. The goal of a lending protocol is to a.) protect lender capital and b.) provide capital to borrowers at competitive rates. Overcollateralization makes it very easy to protect lender capital since the borrower’s collateral acts as a buffer. For example, in 2022, when the total crypto market cap shrank from $3T to $0.75T, major firms like 3AC, Celsius, and Voyager blew up but overcollateralized DeFi lenders stayed whole.
Overcollateralized borrowing was a safe starting point, but it has limited uses. Imagine you wanted to start a restaurant and needed to borrow $100K to buy equipment and supplies, but you had to lock up $150K in a bank account — not a big help. It is the ability of entrepreneurs and consumers to borrow more than they have which enables wealth creation and productivity gains.
Why High-leverage Borrowing is Hard
High-leverage borrowing is important, but it’s extremely hard. The biggest on-chain lenders (JustLend, Aave, Compound, Maker) are all overcollateralized. The three main factors that make on-chain high-leverage borrowing hard are math and a lack of on-chain reputation.
What do I mean by math? As I explained earlier, overcollateralized borrowing provides lenders with a lot of buffer. If a borrower deposits $100 in ETH as collateral and borrows $50 in USDC, lenders are safe unless the borrower is liquidated when his ETH collateral is under $50. Even if the borrower were to lose all the $50 USDC they borrowed, the lenders would still be whole as long as the ETH collateral was worth over $50
Take the same situation but with a 10x leveraged loan. The borrower would deposit only $5 in USDC to borrow $50 in ETH. In this scenario, if the price of ETH drops just 20%, then the borrowed amount would drop to $40 and the collateral would only cover $5. Therefore the lender is now exposed to the $5 ($50–$40-$5) loss.
The second is a lack of on-chain reputation. Think about a traditional mortgage. If you go to the bank and ask for a loan they can see your credit score, verify your income, and any outstanding debts you have. They use this information to determine how risky of a borrower you are. However, since none of this information lives on-chain, if the borrower has $100K in credit card loans and lost their job 3 months ago that would all be invisible.
This lack of reputation makes it difficult to assess the riskiness of the borrower. To make matters worse, this lack of reputation-checking attracts borrowers who have bad reputations, worsening the pool of borrowers. Without a reputation to protect, lenders also lose a tool for enforcement. Lenders in the offline world can mark bad borrowers by lowering their credit score, however, this isn’t possible to do on-chain (today). Therefore, lending schemes must be protected purely by code and rules.
Gearbox’s Solution to High-leverage Lending
Gearbox uses account abstraction to de-risk high-leverage lending. In Gearbox, your deposited and borrowed funds get moved to a Credit Account (CA). This Credit Account is a smart contract wallet and is programmed to only allow certain contracts and tokens and can be liquidated if it falls below a certain health threshold (think of this as the risk to the lender that the borrower cannot repay if all funds in the account are liquidated)
Because the Credit Account is fully transparent and can only interact with pre-approved smart contracts and tokens, it obviates the need for trust or reputation. In traditional lending, the lender doesn’t know what you’ll do with the money once it's withdrawn. They only know if you are paying your bills on time and if you stop they can take your collateral and damage your reputation.
However, because all the funds borrowed remain in the Credit Account and you can only interact with audited and trusted smart contracts, you don’t need to “trust” the borrower. It’s like if you lent $500 to your brother Steve who is a gambler, but the $500 was locked up in a special bank account that you had full view access, could pull the money back if needed, and could only be put in high-interest savings accounts or index funds. You wouldn’t need to worry about him spending his money at the casino or at the horse races. Plus, you don’t need to worry about getting your money back because at any point you can pull the emergency lever and get your funds back.
Gearbox’s solution is uniquely advantageous because it gives its users more freedom. There are ways to increase lending leverage today. You can loop lending on Aave continually recycling your deposit into more lending. With a 70% LTV ratio, you can get up to 5.67x leverage. These kinds of looping strategies are often structured as vaults, where you deposit funds and enter a pool of capital where a looping strategy is executed. Large size is needed since looping is both annoying to manage and gas-intensive.
However, as the name implies, vaults are static. With Gearbox, you can treat the Credit Account as a normal wallet (with restrictions of course). You can swap, mix strategies, and trade more dynamically with Gearbox. It more closely mimics the freedom you get with traditional lending.
Watch out for my next article where I dive deeper into the innovations of V3 including: new tokenomics, Quotas, PURE liquidity, and Gearbots
