Speculative Multipliers on DeFi: Quantifying On-Chain Leverage Risks

Abstract

Blockchains and DeFi have consistently shown to attract financial speculators. One avenue to increase the potential upside (and risks) of financial speculation is leverage trading, in which a trader borrows assets to participate in the financial market. While well-known over-collateralized loans, such as MakerDAO, only enable leverage multipliers of $1.67\times$, new under-collateralized lending platforms, such as Alpha Homora (AH), unlock leverage multipliers of up to $8\times$ and attracted over 1.2B $\texttt {USD}$ of locked value at the time of writing.

In this paper, we are the first to formalize a model for under-collateralized DeFi lending platforms. We analytically exposit and empirically evaluate the three main risks of a leverage-engaging borrower: (i) impermanent loss (IL) inherent to Automated Market Makers (AMMs), (ii) arbitrage loss in AMMs, and (iii) collateral liquidation. Based on our analytical and empirical results of AH over a timeframe of 9 months, we find that a borrower may mitigate the IL through a high leverage multiplier (e.g., more than $4\times$) and a margin trading before supplying borrowed assets into AMMs. We interestingly find that the arbitrage and liquidation losses are proportional to the leverage multiplier. In addition, we find that 72.35% of the leverage taking borrowers suffer from a negative APY, when ignoring the governance token incentivization in AH. Finally, when assuming a maximum $\pm 10$% move among two stablecoins, we pave the way for more extreme on-chain leverage multipliers of up to $91.9\times$ by providing appropriate system settings.