Why Leverage Is Destroying DeFi

Leverage. An inherently bad instrument if you’re willing to believe a large number of “veteran” traders on Twitter.

To be fair, extremely degenerate and irresponsible use of leverage blew up Three Arrows Capital, one of the most renowned and respected hedge (lol) funds in all of crypto.

We can’t help but wonder though.. if it’s so bad, how come leverage is so present in our day-to-day lives?

And, if it’s merely an instrument, how can it be inherently bad?

Let’s get a little crazy here: Could leverage actually be a good thing if used responsibly?

Jump in, we’re going to find out. But remember, none of this is financial advise or can be construed as such. The below information is purely educational (and hopefully, somewhat entertaining).

What is leverage really?

What better place to start than the Oxford Dictionary of the English language? This is what those dear old chaps have to say:

Leverage

/ˈliːv(ə)rɪdʒ,ˈlɛv(ə)rɪdʒ/

verb

Use borrowed capital for (an investment), expecting the profits made to be greater than the interest payable.

“Without clear legal title to their assets, they own property that cannot be leveraged as collateral for loans”

So essentially, we’re talking about taking a loan against some kind of collateral. This is done because the expected value of the investment we make with this loan is higher than the interest payable.

Let’s look at some examples of how this might be applied.

(1) Jack buys a car

Jack works at McDonald flipping burgers full-time. He earns about 1400$ a month after taxes, and like tens of millions of Americans, he is living paycheck to paycheck with under 1000$ in liquid savings. He used to have more cash, but back in 2021 he was worth tens of thousands of dollars earning over 69000% APY in something called “Wonderland”, so he spent quite a bit of his liquid money on bottles for club girls. Oops.

To get to work, Jack has to walk 6 minutes to the bus stop, then sit on the bus for 24 minutes, get off to transfer and wait 7 minutes, and then ride another bus for 11 minutes. Finally he walks another 2 minutes to the restaurant location. He changes into his work clothes on site (because he can’t pull bus stop QTs wearing McDonalds gear) which takes him another 4 minutes. This costs him a combined 54 minutes. On the way home, the process repeats.

Jack is wasting two full hours per workday commuting. Over the span of a week, this adds up to 10 hours. 40 hours — a full working week worth of time per month.

If Jack were to own a car, however, he could cut down his commuting time to just 30 minutes per day. No more waiting at bus stops, and wearing a McDonalds uniform doesn’t look half as bad when you’re sitting in the driver’s seat of your own car.

This means Jack would free up 30 hours a month that he can use to create additional income for himself. What’s more, Jack could use his car to drive to a grocery store that’s a bit further away, but offers much cheaper and healthier products than the one close to his apartment.

Sure, Jack has to pay for gas and insurance, but overall he comes out ahead by quite a bit. So Jack decides goes to the bank to get a loan for a second hand car. The loan officer assesses his case: little savings, but a steady job for over half a year now, and a history of paying off credit card bills on time. He decides to grant Jack the loan.

Jack levered up on his collateral of savings + steady job + good credit history, to invest in a car that will save him a lot of time. The expected value of using this time to make more money outweighs the interest that he’s paying on the car loan.

Jack calculated his risks, and used a small amount of leverage to improve his life. Well done, Jack.

(2) Jack buys a house

Fast forward a few years. Jack figured out that he’s actually pretty good at talking to new people, and convincing them to buy something. He started out doing online customer support during the 30 hours that he freed up with the car, but quickly worked his way to a sales position. He now works full time as a business development representative at a SaaS company and earns a comfy salary.

He moved to a different city for the job, and is currently renting a nice condo near a neighborhood that has great restaurants and night life. Jack managed to save up some more money, and a couple of the shitcoins that he bought in 2021 actually survived the bera and are looking pretty green right now.

Jack also met a girl through a conference that he was attending for work. They’ve been steadily dating for a while now, and are very happy together. Recently, they’ve been talking about starting a family. They’d also like to stop spending a significant chunk of their income on rent every month.

One day, Jack makes a decision. With a heavy heart and quite some FOMO, he sells off most of his shitcoins for a healthy profit, puts some money aside for taxes, and deposits the remaining gains to his savings account.

Jack and Jill go to the same credit officer that gave Jack the financial leverage to buy a car on a loan. They explain how they’d like to buy a house to start a family together. They have about 20% of the total cost for a starter home in savings, and own other collateral like Jack’s car (paid off now, boosting his credit score further), Jill’s jewelry, and 12 rare Pepe NFTs. Finally, they both work a steady job with a good salary.

Once again, the loan officer decides to give them the leverage to purchase a house. Jack and Jill levered up responsibly to invest in a house. Now they don’t have to pay rent anymore. Even better, they will create probably the most valuable thing in the world: new life.

Once again, Jack calculated his risks, and used a medium amount of leverage to improve his life. Good job, Jack.

(3) Jack builds a diversified investment portfolio

Pause play, drag the timeline slider another number of years to the right. Resume. Jack and Jill bought a place, made a little noob, and are finally starting to get some more sleep and time to themselves again.

Jack never stopped working to improve his skillset, and he now manages a sales team responsible for half the country. Jill is working only a few days a week now, but Jack’s advance on the corporate ladder means their disposable income has increased well past covering all living expenses, bills, and loan payments.

As the head of the household, Jack recognizes his responsibility to safeguard the financial future of his family. One night, he sits down in his study, turns on his desktop and greets an old friend: DeFi.

The landscape looks quite different now, but many of the blue chips have survived. The number of users has exploded in recent years, greatly improving the revenue earned by legitimate, value-producing protocols.

Jack draws up a simple plan. He will allocate around 50% of his crypto portfolio to BTC and ETH tokens by dollar cost averaging a set amount each month. He will keep another 30% in stablecoins to produce steady yield, and finally allocate 20% towards riskier assets.

He does a bit of research, and happens across a protocol that became quite popular while he was out of the game. It uses an internal engine that enables safe undercollateralized loans for a variety of whitelisted tokens. Better yet, it has vetted strategies for the best DeFi protocols.

Jack deposits some of his ETH and stablecoin tokens as collateral, and levers up on a Curve stablecoin pool strategy, boosting his yield. The user interface even shows him the sweet spot for maximizing returns while keeping a low risk profile.

By responsibly using leverage for part of his portfolio, Jack succeeds in outpacing inflation and building his wealth over time.

Good for you, Jack.

Be like Jack. Use leverage responsibly.

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