Leverage in simple terms is using borrowed money to multiply your purchasing power to invest in various assets.
To invest in crypto assets one can use various CEXes which also provide leverage to users , else they can use their decentralized counterparts.
There are various ways one can use leverage while interacting with DeFi protocols.
- Lending and Borrowing in DeFi (AAVE , Compound)
- Margin trading (dydx)
- Perpetual swaps (Perpetual protocol , dydx)
- Leveraged tokens (Index-coop)
Let’s dive into each one of them and understand how they work
i) Using lending and borrowing : Let’s say Bob has $1000 ETH and he thinks ETH price can go up in coming days and wants to buy more ETH . Bob goes to a lending protocol and uses ETH as collateral to borrow USDC . Now he takes this USDC and swaps it for more ETH on any DEX like Uniswap and again uses this ETH as collateral to get more USDC and continues to do so until he gets a desired long position. If the value of collateral decreases bob is at a risk of liquidation.
(Note : As all this debt positions are over collaterlized one cannot get leverage more than a certain number which depends on the collaterlization ratio of the pair)
ii) Margin Trading : Protocols like dydx allow for upto 5x leverage on certain pairs of ETH-USDC , ETH-DAI etc. Suppose Bob has 1000 USDC and wants to go long on ETH, he can borrow upto 4000 USDC (5x leverage) and buy ETH worth 5000 USDC . Here the 1000 USDC he had act like collateral.In this your leverage changes as the price of the asset changes . Let’s say bob bought ETH at at a price of $2500 and after a few days ETH is priced at $3000 , now the leverage will be 6000/2000 = 3x . Thus if price of the asset moves in your favour you get deleveraged on the other hand if price of asset falls below a certain level your funds can get liquidated.
iii) Perpetual swaps : Perpetual swaps are derivatives similar to futures contracts except that they don’t have any expiry date and their price strictly follow the price of spot market. In derivatives the real asset is not affected unlike margin trading in which the underlying assets are used to borrow the funds. These instruments are useful when someone needs high leverage(50x , 100x) and they are easy to short when you are bearish on the underlying asset. These contracts are very risky as slight change in price can cause liquidations. These contracts are manly using for hedging your main position from volatility.
A concept of funding rate is introduced in perpetual swaps unlike a futures contract. Here if price of contract is higher than the underlying asset price the longs have to pay the shorts and vice versa. The funding rate depends on difference between the prices , the more the difference the greater is the funding rate.
iv) Options : Options are derivatives in which the buyer has the right to exercise the contract at a later time . There are two types of options call and put. Call options are bought when you expect the price of underlying asset to increase beyond the strike price . There are various number of call options available based on the strike price . The option holder has to pay a upfront premium per each unit of asset . Suppose bob has 1000 USDC and ETH is trading at $3000 , instead of buying on spot bob can purchase call options with a $3000 strike price and $100 premium per contract. So now bob can buy 10 call options , here leverage will depend on price at which contract is exercised. Lets suppose at the exercising date ETH is trading at $3600 i.e 20% up so profit is 10 *(3600–3000) -1000 = $5000 in profits . In spot a 20% percent rise in price would mean $200 profit .
v) Leveraged tokens : Index coop provides 2 leveraged token ETH-2x FLI and BTC-2x FLI (Flexible leveraged index as leverage ranges from 1.7x to 2.3x). These leveraged tokens are used to get leverage about 2x on ETH and BTC . The difference between margin trading and leveraged tokens is that they re balance after a specific amount of time i e unlike margin trading in which the leverage changes with price in leveraged token after rebalancing we get a nearly constant 2x leverage , therefore there are no liquidation risks involved in holding them . Also the profits are reinvested so as to maintain the same leverage of 2x thereby holders get compounded returns.But there are certain risks involved , like volatility decay . These tokens should only be bought for short term as volatility in long term can eat into your profits, thus they are great instruments to hold in an up trending market. FLI tokens rebalance to maintain a flexible leverage ratio of 1.7x to 2.3x this helps in reducing the effect of volatility decay. FLI tokens remove the hassle of borrowing and lending and swapping to get leverage and thus reduces GAS fee paid to do these operations.