Leverage is a useful concept in both traditional and decentralised finance, allowing large profits (or losses) to be made on comparatively little initial capital. The potential for considerable returns presented by leveraging a position also comes with significantly higher risks than direct investment.
The term leverage refers to a variety of techniques that amplify the financial outcomes that can result from investing a given amount of capital. This can be achieved through borrowing or by entering into arrangements such as options contracts.
An investor can increase their buying power by borrowing funds, and then use the extra funds to buy an asset that one thinks will increase in value, resulting in higher returns than simply investing in that asset with one’s initial capital.
For example, Investor A buys $1,000 of a stock, the price of which appreciates 5% over the course of a month, resulting in a profit of $50. Investor B borrows against $1,000 at a ratio of 1:10 (or 10% margin), and goes on to buy $10,000 of the same stock. The same 5% increase occurs, generating a profit of $500, and Investor B can then go on to return the borrowed amount, plus interest, having made a much larger return on the initial capital.
Likewise, it’s easy to see how if the change in price were to be a 5% decrease, both investors would make a loss, and Investor B’s losses would be amplified, too. As losses approach the collateral amount, the lender will demand that a borrower either deposit more capital or sell some of their position to repay some of the loan. This may come with penalty fees as well as the standard interest for borrowing in the first place.
The above are simple examples, but in practise investors often construct complicated systems of leverage in which a drop in the price of one asset may cause a domino effect across various different investments. In this way, an investor in a highly leveraged position stands to lose far more than the initial collateral, which would be the maximum loss for a direct investment.
All of the leverage tools that exist in traditional finance also have their counterparts in DeFi: borrowing, options, and even novel concepts such as leveraged tokens.
Given the inherent volatility of DeFi as a new and innovative financial space, leveraging one’s position via borrowing must be done from a position of overcollateralization, whereby the value of the collateral is greater than the borrowed amount. This ensures that the lender is not at risk of losing funds if large price swings in the collateral asset occur, which could result in liquidation.