A Basic Walkthrough of Leverage Creation in DeFi

Correction: In the first distribution of ‘DeFi Digest 14: A Reflection on Liquidity Dynamics Through the Contagion & GHO Stablecoin’, we incorrectly referenced Voyager instead of Celsius as having a 1.2b hole in its balance sheet. The amount lent to 3AC by Voyager was $350m in USDC and 15,250 in BTC, with their current asset-liability mismatch unknown.

In last week’s DeFi Digest, the team discussed liquidity dynamics that were prevalent when Terra collapsed and Celsius unwound its on-chain leverage, which led to the following chart.

Aside from their flawed fully sharecoin-stablecoin tokenomics design, Terra failed to ensure sufficient swap liquidity between the UST and 3pool to accommodate large outflows from Anchor.

This was arguably what triggered the ‘bank run’ in the first place, as order book liquidity was multiples that of on-chain, yet it was transparent liquidity on Curve that set off the panic.

Anecdotally, we have found that many subscribers are unfamiliar with the leverage creation process in DeFi. Thus we would like to dive deeper using an example scenario (with numbers) to illustrate how liquidity is created on a smart contract network level via different dApps.