Collateral Exposure

Understand LP Exposure

Collateral Exposure Explained

Collateral exposure is the relative risk of collateral being seized, as a function of the rising or falling value of the leverage trading strategy. If the value of the leverage trading position is declining, the collateral is at greater risk of being seized by the lender, because the borrower’s ability to repay the loan is diminishing. In a DeFi setting, the lender’s only recourse is a claim to the value of the collateral. Conversely, as a leverage trading strategy is increasing in value, the collateral exposure is decreasing.

Collateral serves as a borrower’s “skin in the game”. Because DeFi lending agreements are between anonymous participants, skin in the game is often necessary to ensure ethical behavior. Due to the lack of recourse in DeFi (strangers dealing with strangers, after all), it would not make sense for a lender to offer a non-recourse loan to a borrower without assurances that the loan would be paid back. 

What to Know  

Collateral is typically considered equity, or principal capital of the borrower. So as a leverage trading strategy declines in value, a borrower can either sell off some of the leverage position, or post more collateral, in order to stay within LTV limits. Staying within LTV limits will help avoid the collateral being seized. Collateral exposure can have a negative effect on the overall returns of the leverage trading strategy, as the borrower either has to post more collateral (equity capital), or realize losses on the borrowed position by making an untimely sale. 

In DeFi, stablecoins tend to be a widely used form of collateral. Gains and losses are largely quoted in fiat currency terms. Stablecoins, pegged 1:1 with fiat currency and often backed by them, experience virtually no volatility vs fiat. This allows a trader to concern himself solely with the price volatility of the leveraged trading position.

Why it Matters

As lending collateral can often be considered a trader’s equity capital, it’s important to keep an eye on the leveraged trading strategy. If a strategy starts losing money, the collateral becomes more exposed to being seized and the overall trade stopped out. In DeFi, LTV’s are widely published per platform and give traders a good sense of the risks they can take in their levered trading position. For example, a leveraged trading position with stablecoin collateral and 65 LTV will allow the trader to know that they have 35% downside (excluding the borrow rate) in their levered position before the collateral would be seized. If the trader chooses a leverage trading position with a coin that has price volatility higher than 35% in a given term, then there is significant collateral exposure risk during the lending term.

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What is Yearn?

Yearn Finance is a suite of products in Decentralized Finance (DeFi) that provides lending aggregation, yield generation, and insurance on the Ethereum blockchain. The protocol is maintained by various independent developers and is governed by YFI holders.