Leverage Explained

While your capital is always limited, there are ways to increase your exposure to trading and borrowing opportunities. This is called leverage and margin trading. Though it sounds very intimidating, it can be a profitable investment method. There are also useful and important best practices that one needs to take into consideration before engaging in any trading endeavor that involves leverage and margin. 

In this article, I will explain what leverage is, how it can be helpful with some considerations, how it is used in DeFi, and finally, what MELD will bring to this sphere.

What is Financial Leverage?

Financial leverage is achieved by using debt to fund investments to grow a company's or individual’s asset base and generate returns from the extra capital that becomes available as a result. 

Leverage is an investment strategy that uses borrowed money (specifically, the use of various financial instruments or borrowed capital) to increase the potential return on investment. Simply put, you take some debt to execute your trading strategy with the expectation of a higher return rate. 

Usually, if an individual or a company is highly leveraged, its debt-to-asset ratio is quite high. For an individual to measure it, one can check how much debt an individual has against their monthly income and assets combined. 

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In trading, you can leverage your existing position to increase your profits. If you are successful (or lucky), you will be earning much more compared to only using the initial cash that you had in the first place. 

Additionally, leverage offers much bigger opportunities to traders and investors that would not be available without leverage. Needless to say, the downside is also highly possible, and a rational investor or trader must consider it. 

Using leverage involves much higher risk, sometimes resulting in losses greater than your initial capital investment. On top of that, brokers and contract traders will charge fees, premiums, and margin rates. Even if you lose on your trade, you'll still be on the hook for extra charges. 

There is also margin that should be explained in this context. Margin is a special type of leverage that involves using existing cash or securities positions as collateral used to increase one's buying power in financial markets. Margin allows you to borrow money from a broker for a fixed interest rate to purchase securities, options, or futures contracts in the anticipation of receiving substantially high returns.

Additionally, before involving in a leveraged position, one needs to check how much leverage is involved in the whole market. For example, in Binance, one can see under “Margin data” how margin debt has grown, margin long-short positions ratio, and isolated margin borrow amount ratio per trading currency pair, for example, BTC/USDT. 

The reason this is so important is that, If long positions are higher compared to short ratios, it is a bullish sentiment and means that most of the traders think that the price will go up. 

However, we also saw previously huge liquidations as a result of a market crash. For example, on May 17, 2021, the market saw over $2.4 billion in crypto liquidations. The entire crypto market took an aggressive 66% downturn within 12 hours and then regained 50% of the losses the following 12-hour period.

Investor and entrepreneur Mark Cuban writes about leveraged markets: “De-Levered Markets get crushed. Doesn’t matter what the asset is. Stocks. Crypto. Debt. Houses. They bring forced liquidations and lower prices. But crypto has the same problem that [high-frequency traders] bring to stocks, front-running is legal, as gas fees introduce latency that can be gamed”.

How Leverage can be Used in Crypto?

In many crypto CEXs, such as Binance, one can borrow up to 100 times their total balance. This amplifies your buying or selling power so you can trade with significantly more capital than what you currently have in your wallet. 

The amount of leverage is described as a ratio, such as 1:5 (5x), 1:10 (10x), or 1:20 (20x). It shows how many times your initial capital is multiplied. For example, imagine you have $100 in your exchange account but want to open a position worth $1,000 in bitcoin (BTC). With a 10x leverage, your $100 will have the same buying power as $1,000. 

However, if the price of Bitcoin in this example goes down, you will receive a margin call, and if the margin is not met, your position can be liquidated. 

In DeFi, on platforms such as AAVE, you can lend and borrow cryptocurrencies and real-world assets (RWAs) without going through a centralized intermediary. When you lend, you earn interest; when you borrow, you pay interest. If you take a loan, you will engage in a leveraged activity. You will be required to provide collateral and get your loan. The contract is executed on a blockchain via a smart contract. If your collateral value decreases, you will be margin called and need to meet the obligation by providing extra collateral.

How can One Use Leverage in MELD?

The initial service MELD will offer will be instant crypto-backed loans. First, a user will deposit their cryptocurrency to MELD as collateral. The protocol will then use the deposited cryptocurrency to create a collateralized debt position (CDP). A smart contract records the terms of the loan and registers it on the blockchain. Upon KYC/AML confirmation, the protocol will execute the loan or a wire transfer directly to your bank account. Users will be able to manage their CDP directly from the MELDapp.

Loans are issued at a Loan to Value (LTV) ratio of 50%. If the collateral value falls to LTV 65% or stays above 50% for more than three days, a margin call happens. The customer must provide added collateral to return the loan to an LTV of 50%. The same happens if the LTV reaches 75%. If the LTV reaches 85%, a liquidation event is triggered where the collateral is converted to USD/EUR stable coins equivalent to the fiat loan plus a 5% fee. Further info can be found in the MELD whitepaper. 

However, it is important to mention that, thanks to the advanced risk model, a user should not experience liquidation of their position if the rebound is within such a brief period as it happened on May 17, 2021.