Compared with traditional amounts, the innovative models and liquidity solutions in DeFi leveraged products give investors more different choices.
Written by: Ryan Tian, ​​co-founder and CFO of Phoenix Finance
This article analyzes and compares the representative economic models with leverage characteristics that appear in several types of DeFi, and the summary is shown in the figure below.
It is worth noting that leveraged tokens is an innovative decentralized leverage model, which is a new on-chain solution that can give users leveraged positions in specific currencies. Users do not need to actively manage leveraged positions, and what’s more interesting is this This model has no risk of liquidation. This model currently only has Tokensets and Phoenix Finance online. Interested readers can find related introductions here and here .
What is leverage? What is leverage?
In the financial field, leverage is an investment strategy that relies on borrowed funds to increase the holding position of the underlying asset, thereby increasing the potential return. Simply put, investors or traders not only invest the funds they actually hold, but also borrow funds to increase their holdings of certain types of assets, projects or financial instruments. Generally speaking, leverage can increase the purchasing power of investors in the market.
In fact, leverage can be seen everywhere in daily life. In our daily consumption or investment, buying daily necessities through credit cards or buying houses with loans is a common form of leverage application.
Further reading:
Leverage in crypto asset trading
The application of leverage is one of the most important and commonly used functions in crypto asset trading. Although the crypto market is highly volatile, this trading method has become more and more popular since the creation of leveraged trading on the Centralized Exchange (CEX).
Leveraged trading in the encrypted market is similar to the traditional financial market. Traders can obtain leverage through borrowing, or they can use financial derivatives such as futures and options to increase their purchasing power.
Depending on the product and the risk appetite of investors, the leverage ratio also varies from high to low, ranging from 3 times, 5 times, or even more than 100 times. The higher the leverage, the greater the risk. However, it can be seen from the rising number of leveraged transactions on most centralized exchanges that aggressive traders are willing to take on the high risks brought by high leverage in pursuit of higher returns.
Leverage in DeFi
In traditional finance and encrypted finance, the concept of leverage is basically the same, the main difference lies in the lending behavior itself. Since the only identity of a trader on the blockchain is only a string of letter codes, it is more difficult to take credit loans in traditional finance. In other words, lending activities in DeFi are usually secured by complete collateral.
In addition, there are some slight differences between different DeFi financial models.
Leverage in DeFi lending activities
DeFi lending is the first to start and is still the largest DeFi application so far. At present, there have been some large-scale projects based on lending activities in the market, such as MakerDao, Compound, AAVE, Venus, etc.
The logic of leveraging by borrowing crypto assets is actually very simple.
Suppose you hold $10,000 of ETH and you are bullish on ETH, and you have no plans to sell ETH in the short term, then you can deposit your ETH into Compound as collateral, and lend out $5000 USDC, and then decentralize The exchange exchanges $5000 ETH, which is equivalent to an investment of $15,000 ETH with an initial capital of $10,000 and a leverage of 1.5 times.
Similarly, if you are short on ETH, you can choose to borrow ETH on the DeFi lending platform and exchange it for a stable currency on a decentralized exchange. If the price of ETH falls, you can buy ETH in the market at a lower price and repay the debt of ETH.
It should be noted that because funds are borrowed through a decentralized agreement, if the value of the pledge decreases or the value of the borrowed asset increases beyond a certain threshold, it may face the risk of liquidation.
Leverage in margin trading
Margin trading is a method of borrowing third-party funds for asset trading. Like direct lending, it can provide traders with more funds by lending funds to increase the leverage of their positions.
But there is an important difference between the two. When the margin position has not been cancelled or liquidated, the trader uses the assets purchased by the individual as the collateral for the borrowed funds.
dYdX can be said to be one of DeFi’s most famous decentralized margin trading platforms, allowing the use of up to 5 times leverage. In dYdX’s margin trading, traders use their purchased assets as a guarantee, and expand their original principal several times to make a larger investment.
In the lending activities of margin trading, traders need to pay interest and other transaction fees, which involve real asset transactions, that is, such margin trading positions are not synthetic assets, but involve real borrowing and purchase/sale of underlying assets.
If the market fluctuates in a direction that is not conducive to their own positions, traders may not be able to repay their borrowings due to fluctuations in asset prices. In order to prevent such situations, the agreement will liquidate the trader’s position before reaching a certain liquidation ratio.
Next, we use specific examples to analyze the changes in leverage in margin trading.
Suppose you are bullish on ETH in the short term, and you buy 3 times ETH in a margin transaction, and you have not adjusted your risk exposure in the transaction. You now hold $100 USDC, you borrowed $200 USDC through margin trading, and use this $300 USDC transaction to exchange the equivalent ETH to obtain a long position in ETH. Your leverage level is $300 / $100 = 3x. It is worth noting that this $300 USD of ETH is used as collateral for your borrowed $200 USDC asset.
If the price of ETH increases by 20%, you will get a profit of $300 (1 + 20%)-$300=$60, and the possibility of liquidation decreases. At the same time, as the market price rises, because the asset you borrow is a stable currency, the actual leverage The level is automatically reduced to $360 / ($360- $200) = 2.25x. In other words, an increase in the price of ETH will automatically lead to deleveraging.
If the price of ETH drops by 20%, your loss will be $300 (1-20%)-$300=-$60, and the possibility of liquidation increases. Because your borrowed asset is a stable currency, the actual leverage level will automatically increase to $240 / ($240- $200) = 6x. In other words, a fall in the price of ETH will automatically increase leverage and increase your risk.
Therefore, in the absence of active position adjustment, although you may think that your trading leverage has always been 3 times, the real-time leverage is constantly changing. For a detailed analysis between leverage and price changes, please click here .
Leverage in Perpetual
Perpetual contracts are similar to traditional futures contracts, except that they have no expiry date. The transaction price of perpetual contracts is always anchored to the spot market price based on margin, so it is close to the spot index price. There are currently many DeFi projects that provide traders with perpetual contract transactions, such as dYdX, MCDEX, Perpetual Protocol, Injective, etc.
Many traders find it difficult to distinguish between margin trading and perpetual contracts. The two do have similarities, and both involve the use of leverage. But in addition, there are differences between the two in terms of leverage mechanism, costs and leverage levels. For more detailed analysis, please refer to the comparison provided by dYdX.
Perpetual contracts are a type of derivative products that track the price of underlying assets through synthetic assets without the need to deliver actual commodities. However, margin trading transactions involve actual borrowing and trading of actual encrypted assets.
Along with the perpetual contract, the concept of interest rate of funds emerged, the purpose of which is to keep the transaction price of the perpetual contract consistent with the spot index price. If the contract price is higher than the spot price, the long position will pay the short position. Traders of margin trading need to continue to pay the cost of borrowing funds.
The characteristics of synthetic assets make the leverage of perpetual contracts usually higher than the leverage of margin trading, up to 100 times.
The clearing and leverage mechanism of perpetual contracts is basically the same as that of margin trading.
Leverage in leveraged tokens
Leveraged tokens or leveraged tokens are a kind of special tokenized derivatives developed on the basis of leveraged trading. It can provide holders with constant leverage in the cryptocurrency market in a simple way. This simplification is reflected in the fact that although leveraged tokens can directly provide leverage exposure to holders, it does not require holders to bother to study matters such as margin, liquidation, collateral or financing interest rates. In other words, holding this token/token means holding a constant leveraged position in a certain crypto asset.
The biggest difference between leveraged tokens and margin trading and perpetual contracts is that in order to maintain a constant target leverage ratio, leveraged tokens will rebalance their own leverage ratios periodically or when a certain threshold is reached.
In margin trading and perpetual contract trading, even if the trader initially specifies the leverage level, the actual leverage will still be affected by the price and change constantly.
Phoenix Finance launched a centralized leveraged token model on Polygon, BSC and Wanchain in the third quarter of 2021. For details, please refer to here .
Taking the 3 times ETH bullish leveraged token ETHBULL (3x) as an example, let’s take a closer look at how leveraged tokens work.
Suppose you use USDC holding $100 and purchase ETHBULL (3x) leveraged tokens. The leveraged token agreement will automatically borrow $200USDC from the borrowing pool through a smart contract and exchange it for $200 ETH.
Assuming that the price of ETH increases by 20%, the price of ETHBULL (3x) will increase accordingly, which will increase to $300 * (1 + 20%)-$200 = $160, or $100 * 20% * 3 = $160. Now, your actual leverage becomes 2.25 times ($360 / $160), which is lower than the 3 times target leverage of the ETHBULL (3x) token.
At the agreed self-balancing time point, the ETHBULL (3x) token will start the leverage self-balancing process. Through smart contracts, the leveraged token agreement will borrow more USDC from the stablecoin pool and purchase additional ETH tokens to increase the change and increase the leverage ratio from the current 2.25 times to 3 times. Specifically, in this example, the leveraged token agreement will borrow an additional $120 USDC and exchange it for ETH on the decentralized exchange, and the total leverage will again become ($360 + $120)/ $160 = 3x.
Assuming that the price of ETH has dropped by 20%, the price of ETHBULL (3x) will drop to $300 * (1-20%)-$200 = $40 before rebalancing, or $100 * (1-20% * 3) = $40. Then your actual leverage will become ($240 / $40)=6, which is higher than the target leverage.
In this case, the agreement will sell ETH tokens and repay part of the loan. In this example, the agreement will sell ETH worth $120 and exchange it for USDC to be repaid to the fund pool. The asset holdings in the leveraged token will drop from $240 to $120. The borrowing will become $80, and the total leverage will again become ($240- $120)/ $40 = 3x.
In other words, leveraged tokens will automatically increase leverage when they are profitable and deleverage when they lose money to maintain their target leverage level. If the mechanism runs smoothly, even under the unfavorable market trend relative to the leveraged positions, the self-balancing mechanism will continuously adjust the effective leverage of users to ensure that leveraged token holders will never face liquidation risks.
Therefore, in this sense, in the leveraged token model, users have no risk of leveraged liquidation, which is safer than leverage in margin trading.
Leverage in Options
An option is essentially a right that can be exercised in the future. In order to obtain this right, the buyer pays a price called an option premium. To better understand how options work, please refer to here . At present, many platforms have emerged that focus on decentralized options , but overall, their development is still at an early stage.
The option itself has its own leverage attribute, because each option contract represents the right to purchase or sell a unit of the underlying asset, but its cost is only a small part of the price of the underlying asset. This allows option traders to be able to track the price ups and downs of the same amount of assets at a much lower cost, which actually provides them with effective leverage.
Suppose you have $1000 and want to invest in ETH. The current price of ETH is $2000; the transaction price of an ETH call option with an exercise price of $2000 is $100.
In this case, you can use all available funds to buy 0.5 ETH, or you can buy 10 call options with a strike price of $2000/ETH. Then, you will get the profit and loss caused by the fluctuation of 10 ETH. In other words, using the same amount of funds, the risk and return of buying options have a magnifying effect. This is the basic working principle of leverage in option trading.
Continue to use the above example:
If the price of ETH increases by 20% to $2400 USD, and you hold 0.5 units of Ether, your USD gain will be $200 USD.
And if you hold 10 ETH call options, by exercising the option, your income will be: 10 * ($2400- $2000)-$1000 = $3000. The rate of return is $3000 / $1000 * 100% = 300%, and the actual leverage ratio is 300% / 20% = 15 times.
In this way, by holding a call option, you automatically obtain the relevant leveraged position.
If the price of ETH increases by 10% to $2200, by exercising the call option, your return is: 10 * ($2200- $2000)-$1000 = $1000. The rate of return is $1000 / $1000 * 100% = 100%. The actual leverage ratio is 100% / 10% = 10 times.
If the price of ETH increases by 30% to 2600 USD, by exercising the call option, your gain will be: 10 * ($2600- $2000)-1000 = $5000. The rate of return is $5000 / $1000 * 100% = 500%. The actual leverage ratio is 500% / 30% = 16.67 times.
You may have noticed, the actual leverage ratio options are not fixed, and with the price changes in the underlying assets and changes .
Summarize
While leverage brings high returns, it also brings high risks. Different financial products provide traders with different ways of providing leverage. In particular, the innovative models and new liquidity solutions in DeFi leveraged products have given investors different choices with the help of smart contracts compared to traditional amounts.
At the same time, we also remind investors that before conducting leveraged transactions, users should pay attention to and carefully study the leverage model of investment.
Source link: coinmarketcap.com
