🏋️Leverage, Collateral and Rebalances
The relationship between leverage and collateral ratios
Last updated
The relationship between leverage and collateral ratios
Last updated
In finance, leverage and collateral ratio are two crucial concepts. Leverage can multiply returns, but also increase risk, whereas collateral ratio helps to manage this risk.
Understanding their relationship is essential for any DeFi user.
Leverage is the use of borrowed funds to amplify potential returns from an investment. It's like using a lever to lift a heavy weight - with a small force (your initial investment), you can lift a large weight (the leveraged investment).
The leverage ratio is the proportion of debt to equity in an investment. If an investment is described as "3x leveraged", it means that for every dollar of investor equity, three dollars are borrowed for investment.
In the context of DeFi, a collateral ratio refers to the ratio of the value of collateral (assets pledged to be seized as a last resort) to the value of borrowed funds. A higher collateral ratio indicates a lower risk for suppliers, as it implies that more assets back the supplied funds in case the borrower defaults.
In the DeFi space, the collateral ratio is usually expressed as a percentage. For instance, a collateral ratio of 150% implies that the value of the collateral is 1.5 times the borrowed amount.
The relationship between leverage and collateral ratio is inverse - if one increases, the other decreases. Understanding their correlation is key to managing risk and potential returns.
When the price of the collateral rises, the collateral ratio increases, and the leverage ratio decreases. On the contrary, when the price of the collateral falls, the collateral ratio decreases, and the leverage ratio increases.
Rather than using standard liquidation approaches, the collateral of Borrowing Strategies undergoes a rebalancing mechanism to enable more flexible position management. When Borrowing Strategies enter a borrowing position, they consolidate their underlying assets, combining collateral (borrowers' assets) with the borrowed liquidity (Liquidity Suppliers' assets). This complete position is wrapped and provided to Liquidity Suppliers' smart contracts.
From the Borrowing Strategies' perspective, this strategy secures an undercollateralized loan while endowing the Liquidity Suppliers' smart contracts with ultimate position management authority. The on-chain transparency of all Integrated Liquidity Market smart contracts enables full trustlessness for both borrowers and suppliers.
Borrowing Strategy positions are overseen through rebalancing, a distinct alternative to traditional overcollateralized positions and liquidations. Rebalancing operates on an ongoing basis, responding to specific parameters and market conditions. Unlike old-fashioned liquidation systems, which entail liquidation thresholds and result in chunky 50-100% liquidations at a time, rebalances can offer more frequent and minor adjustments. Rebalances also are automatic in nature, allowing for potential leverage increases as underlying collateral values rise. If the asset employed in the strategy appreciates and the target leverage hasn't been met, rebalancing automatically adjusts to optimize leverage and ensure efficient collateral utilization.
In essence, rebalances encompass liquidations and more. During extreme market volatility and underlying collateral devaluation, rebalances act akin to liquidations, recalibrating positions until the Liquidity Suppliers' position is settled. Conversely, when market conditions prompt modest shifts or no change at all, rebalances make proportional adjustments (based on target leverage thresholds) or remain unaffected. Rebalances also allow for leverage to increase in the case where underlying collateral value is increasing and target leverage has not been met (standing in stark contrast to traditional Borrowing Platforms where users must manually monitor for these market conditions then manually execute additional borrow transactions).
This nuanced approach illustrates that rebalances offer a comprehensive spectrum of management capabilities. They adapt to varying market dynamics, ensuring efficient utilization of collateral and robust position management within the Integrated Liquidity Markets framework.
Leverage and collateral ratio are two sides of the same coin. Leverage can amplify returns, but it also increases risk. The collateral ratio serves to mitigate this risk by ensuring there's enough collateral to cover potential losses.
By balancing these two factors, DeFi protocols can provide users with opportunities for increased returns while managing risk. However, it's crucial for users to understand these mechanics and their implications before participating in such platforms.
As always, users are strongly advised to do their own research, as the values of collateral and the precise mechanics of leverage can vary between different DeFi platforms and market conditions.
