Leverage and Collateral Ratio

This page describes the relationship between leverage and collateral ratio

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.

What is Leverage?

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.

Here is an article that goes into more depth on the use of leverage.

What is Collateral Ratio?

In the context of decentralized finance, collateral ratio refers to the ratio of the value of collateral (assets pledged as security) to the value of borrowed funds. A higher collateral ratio indicates a lower risk for lenders, as it implies that more assets back the loan 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.

How are these defined for the Blueberry Vaults?

In the case of the GLP 3x Leveraged Vault and the USDC vault, we define these terms in this way.

$GLP_{USDC}$ is the amount of GLP minted from loaned USDC.

$GLP_{3x}$ is the amount of GLP put into the GLP 3x Leveraged Vault.

$GLP_{combined} = GLP_{USDC} + GLP_{3x}$ is the total amount of GLP, which is the sum of $GLP_{USDC}$

and $GLP_{3x}$.

$leverage=\frac{GLP_{combined}}{GLP_{3x}}=\frac{GLP_{USDC} + GLP_{3x}}{GLP_{3x}}$

Leverage is defined this way since the $GLP_{3x}$ pool has exposure to the entire $GLP_{combined}$ pool.

$collateral\_ratio=\frac{GLP_{combined}}{GLP_{USDC}}=\frac{GLP_{USDC} + GLP_{3x}}{GLP_{USDC}}$

The collateral ratio is defined this way since the entire $GLP_{combined}$ pool backs the $GLP_{USDC}$ pool.

Since these are so closely related, we can define this terms in relation to each other.

$leverage=1+\frac{1}{collateral\_ratio-1}$

and

$collateral\_ratio=1+\frac{1}{leverage-1}$

And here is a chart showing the relationship between the two.

How are Leverage and Collateral Ratio Related?

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.

Consider the Blueberry Leveraged GLP Vault, which targets a leverage ratio of 3x. This corresponds to a collateral ratio of about 150%. The collateral ratio serves as a buffer to manage the risk of price volatility of the collateral.

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.

To ensure the system's stability and limit exposure to risk, if the leverage ratio goes above 4x or 133% collateral ratio, the system automatically rebalances it back down to 3x immediately.

In Summary

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, protocols like the Blueberry GLP Vaults 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.