Innovation or "house of cards"? How does Leveraged Liquidity work in DeFi

In what cases is borrowed liquidity useful, what danger does it pose and how to borrow money to a user who owns bitcoins 

Rapid falls and ups of quotations are typical for the cryptocurrency sector. Partly, high volatility is caused by the participation of a large share of borrowed capital in transactions. Nevertheless, convenient leveraged liquidity is also one of the strengths and features of web3 finance.

Content
Are DeFi loans the foundation of the foundations?
A unique advantage of crypto assets or a dangerous trap?
I have bitcoin, how do I get liquidity and what are the risks?
Are DeFi loans the foundation of the basics?
Almost every blockchain ecosystem has its own loan protocol for decentralized finance, and the largest blockchains even have several. The scheme of operation of such protocols is approximately similar: by freezing their coins in a smart contract, users can release liquidity by obtaining a loan in the desired cryptocurrency or stablecoins, interest is accrued on the deposit and loan, and a bonus for using the platform as tokens for voting on the future development of the protocol. Stablecoin loans are usually issued at impressively low interest rates: from 1% to 2% per annum.

The annual interest rates for depositing coins into the protocol or loans are identical for most large and time-tested platforms, so users can choose a product based solely on the general usability of a particular blockchain and its software solutions. Thus, if a user, for example, often exchanges coins on Solana and plays a certain P2E game on the same blockchain, then it will be more convenient to choose a loan protocol on the same blockchain, if necessary.

Providing coins for loans from other users or making a loan is an extremely convenient and fast process, which accelerates the already rapid movement of liquidity within the cryptocurrency sector.

When the market falls, traders using DeFi loans are forced to hastily close their positions, fearing the liquidation of collateral, thereby further accelerating the decline. With the growth of the market, it is also easy for traders to continue to create a new volume of purchases, since the increase in the value of collateral assets allows you to increase the size of loans, thereby releasing new liquidity.

Leveraged protocols have been repeatedly used in market manipulations to collapse the exchange rate of coins when a large player takes a short position or intentionally "detach" stablecoins from the dollar exchange rate — all described technologies are beyond the reach of regulations or censorship, and there is no KYC practice.

A unique advantage of crypto assets or a dangerous trap?
The practice of borrowing funds against property or other valuables has been known since time immemorial and is widely used today. However, cryptocurrencies stand out among all other types of assets due to the incredible ease of obtaining borrowed liquidity and the complete freedom of its movement.

It is difficult to imagine any other asset with similar properties. For comparison, let's give a popular analogy of bitcoin with gold. Can the owner of 1 gram of gold (~3,500 rubles) use his asset to take 1,000 rubles of borrowed liquidity in two clicks? Such an idea sounds completely unrealistic for precious metals, but it is an everyday "use case" for bitcoin.

Owners of classic stocks on brokerage accounts may object, since most brokerage platforms also provide leverage based on the capital available to the user. This is true, but there are two key differences that fundamentally distinguish web2 and web3.

For web2, the annual interest on loan brokerage funds will be significantly higher, and it will be convenient to use the funds only inside the initial platform. In the case of DeFi, loan funds are instantly credited to the user's wallet and can immediately be used and transferred to third-party wallets and services without any restrictions.

In what cases is leveraged liquidity useful? The most valuable use of DeFi-landing will be for those who want to preserve the growth potential of their assets — historically, the crypto sector is in correction most of the time, and on the contrary, only for a short time at the peaks of its price. It is easy to miss such moments if you sell an asset if you need to obtain dollar liquidity, assuming to buy it again later — rapid growth can occur in a few weeks or even days, leaving users who have left the asset "overboard".

Leveraged liquidity can also be particularly useful for users of developing countries with small deposits who seek, as far as possible, to increase their portfolio of crypto assets step by step. For such a category of users, the use of DeFi protocols allows you not to part with crypto assets in an unprofitable phase of the market.

Of course, such tools carry many dangers for inexperienced users. It is critically important to keep statistics on all loans taken out, as well as to track the "health" (health factor) of open positions, which is based on the ratio of the liquidity taken to the collateral provided. The safest ratio will be no higher than 1/3.

It is recommended to use only the least volatile of the coins, such as ETH or BTC, as collateral. The volatility of the latter has been steadily decreasing this year and, against the background of geopolitical instability, has fallen below many fiat currencies and even the S&P500 index.

I have bitcoin, how do I get liquidity and what are the risks?
The blockchain of the flagship sector does not support smart contracts by default, so for BTC holders in its native network, the first action will be to transfer bitcoin to another network that supports DeFi interactions. You can switch to another network in a decentralized way, using one of the bridges, or using a centralized exchange. In this case, the user will need to bring their BTC to the exchange, sell them, withdraw the amount in the main asset of the destination network (for example, for Matic it will be Matic) and then use any of the DEX to exchange the asset back to the "wrapped" BTC on the new blockchain, leaving a little bit of the asset of the network itself to pay subsequent commissions.

Despite the many advantages and little-studied new ways of using borrowed liquidity, its use remains extremely dangerous and fraught with risks at every stage. Hacks and breaches of smart contracts, failures in the operation of the oracles of loan protocols that can lead to accidental liquidations, excitement and gambling dependence on the feeling of being able to receive "free funds" are just a short list of dangers awaiting users.