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.

Figure: Liquidity Flow and Creation (Rehypothecation) in DeFi

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.

The balance sheets displayed here and below reflect the user’s balance sheet on the borrow / lending platform Aave.

Step 1: A user starts with $10,000 in ETH on Ethereum. They deposit all 6.66 $stETH into Lido (assuming $1,500/ETH), in exchange for 6.66 $stETH which yields 3.9% APR^[1].

• stETH represents the staked version of ETH, accruing the value of staking rewards less penalties
• Lido rewards get distributed directly to the user’s wallet in stETH, which can then be sold to realize yields
• The ETH to stETH conversion process is one-way for now, with rumors of the liquidity event to occur after ‘the Merge’ projected in Q3-Q4 ‘22

Step 2: User deposits $10,000 in $stETH on Aave to borrow $6,900 in USDC at 1.56% APY.

• stETH has a max LTV of 69% and a liquidation threshold of 81%
• stETH supply rate is near 0% since this ETH → stETH strategy is employed by many
• Interest on Aave accrues with time and is reflected in borrowing positions live

Step 3: User swaps $6,900 in USDC for SUSHI, and stakes SUSHI in ‘Sushi Bar’ for xSushi, earning a 11.05% APY from 0 from trading fees^[2].

• Fees continuously compounds to xSushi via a Sushi:xSushi conversion rate, similar to that of Compound 
• Stakers stake their originally deposited SUSHI and xSUSHI rewards after they unstake – users will want to periodically unstake xSushi to sell to realize yields

Step 4: User deposits $6,900 $xSushi as collateral on Aave (yielding 0.1%^[3]) and borrows an additional $3,450 of USDC against it.

• xSushi has a max LTV has of 50% and liquidation threshold of 65%

Step 5: User swaps $3,450 in USDC to ETH before depositing in stETH:ETH pool on Curve Finance, yielding 7.01% (2.77% in trading fees and 4.24% in LDO rewards).

• LP rewards are distributed upon withdrawal

Aggregate *Portfolio* Risk and Returns

The above is a simplified illustration of how ‘value creation’ occurs via leverage through a user’s lens. Its main risks (from high to low) are:

• Liquidation Risk: Highlighted in the sensitivity table below
• De-pegging Risk: Assumes that stETH will stay pegged to ETH and that slippage is minimal. xSushi will stay pegged to Sushi since there is no LP for Sushi:xSushi – the fee accrual reflected in xSushi’s appreciation is enforced through code
• Platform Hack Risk: Most of the platforms listed above have been audited and have bounties for whitehat hackers to uncover vulnerabilities. This does not mean, however, that exploits are impossible
• Platform Collateralization Risk: Aave is an overcollateralized borrow / lend platform that deploys multiple circuit breakers (e.g. borrow caps, supply caps, isolation mode, and siloed mode) to mitigate the risk of insolvency of the protocol

The aggregate positions above will yield the user a Net Levered Yield of 12.33% from ~2.0x leverage / 50.86% LTV.

It is worth noting that the levered yields are on a portfolio basis, not the user’s collateral ratio on Aave.

LTV on *Aave* Sensitized Against SUSHI and ETH Prices

We then sensitized Aave LTV against SUSHI and ETH prices, deriving a liquidation tangent between SUSHI: $0 | ETH: $2,085 and SUSHI: $2.82 | ETH: $0, based on $10,000 in stETH and $6,900 in xSushi as collateral.

The Liquidation Threshold is characterized by the yellow line and is calculated as the capital-weighted average of the Liquidation Thresholds of all the collateral assets (stETH & xSUSHI).

Aggregate Liquidation Threshold:
($10,000 * 81% + $6,900 * 65%) / $16,900 = 74.5%

Degen’s note: Given stETH’s current ~3% discount to ETH, degens can opt to swap ETH for stETH in Step 1, earning them an extra 3% at stETH’s liquidity event.

Liquidity Creation to a Smart Contract Network

From a Layer 1/2’s perspective, the value creation process highlights the importance of cornerstone DeFi projects such as Established Borrow/Lending Platform (Aave), DEX with Deep Liquidity (Sushiswap), and Liquid Staking Infrastructure (Lido) to attract and rehypothecate liquidity in their ecosystems.

The user’s positions generate an additional $10,350 more in liquidity, as opposed to the initial deposit of $10k ETH in the Ethereum network. While increased TVL is great and all, Layer 1 networks need to ensure that resilient infrastructure (e.g. LP liquidity, bridge liquidity, and oracles) is in place to accommodate periods of stress in the markets.

Bottom Line

Liquidity creation through leverage is a key concept in DeFi – this manifests in the traditional world through prime brokerages as well. When applied appropriately, leverage can improve the capital efficiency of positional biases at the expense of liquidation risk. Smart contract networks need to build and maintain sufficient liquidity throughout their ecosystems to build lindy.

^[1] The displayed APRs here and the proceeding steps are not reflected in the balance sheets. Instead, they are detailed in ‘Aggregate Portfolio Risk and Returns’ below.

^[2] Sushiswap charges a 0.05% transaction fee on every swap on every chain. 0.045% is distributed as SUSHI to xSUSHI stakers, while 0.005% is distributed to the Sushi Treasury.

^[3] Liquid staking derivatives generally have lower collateral supply yields since users are incentivized by staked yields already – platforms also recognize the discount in value from re-hypothecated assets