Reserve leveraging and looping might just be DeFi’s biggest liquidity threat

DeFi’s liquidity may increasingly become exposed to capital risks at an extensive level due to growing adoption of leveraged strategies by protocols and users to max-farm yield and generally generate revenue.

Sometimes we discuss capital extensivity and it sounds all positive in our heads because what could be more fun than “making money off money” — even though that means creating more debts and other times lots of risk factors pop out and makes it almost instantly less shiny because we get to understand how debt-maxing can easily be a costly mistake for a technology that at core, seeks to make capital hard.

You can create debt atop crypto all you want and max-leverage on user deposits creating artificial values based on derivatives-inflated numbers, but at the end of the day, you can't fake how much of said crypto actually exists — which is the real liquidity that is owed to the markets and that makes your little play in the park of leverage a dangerous endeavor, just ask FTX, or have we forgotten?

Of course, we can both look at this from an individual standpoint where the concept is on the subject of “recursive borrowing and/or looping” and from a protocol standpoint — where we are looking at reserve assets leveraging and generally extra-yield sourcing strategies which often often involves exposure to derivatives — but both cases ultimately result in a shared-risk for the entire ecosystem, even though they generally will appear to look like isolated problems.

I recall when I first talked about how crypto was going to enable fractional reserve banking on another level, the focus was on centralized stablecoins and CBDCs and how they are essentially the same thing. This was July, 2023.

Now looking back on everything said, I've realized I did not completely represent the full extent of DeFi’s role in expanding credit on-chain and the risks associated, but I guess I can also argue that this was partly due to many of what we have today as “products and services” of DeFi not existing then.

E.g: liquid staking and restaking solutions.

That said, what we are dealing with is a case of potential insolvency cascade for multiple DeFi protocols, given how interconnected they've become, especially on EVM-chains.

In part, I came to paying more attention after exploring Ethana, a synthetic stablecoin protocol I recently wrote about.

What really is Reserve leveraging?

The average DeFi protocol tries to earn yield from user deposits and this usually involves gaining exposure to derivatives. Sometimes this is perpetual derivatives while other times, a case of leveraging wrapped tokens derivatives with yield incentives.

Reserve leveraging in this context essentially refers to the action of taking any leveraged positions on reserve assets obtained from user deposits. This is something that is rather becoming too common with recent developments and should serve as an indicator of just how much less liquidity DeFi has given the growing basis of debt in the ecosystem.

To fully understand what is happening and to include user-side actions that trends towards the same capital risks, let's look at it more extensively:

Reserve Leveraging refers to the process of using user deposited assets — often referenced as “reserves” — in DeFi protocols to maximize capital efficiency through recursive borrowing or rehypothecation.

To explore,

—Recursive Borrowing (Looping)

A user deposits an asset such as stETH(staked ETH issued by Lido finance) in DeFi protocol.

Said user goes on to borrow against the deposit, perhaps takes out a loan in ETH. Then proceeds to convert borrowed ETH back into stETH and re-deposits it in the protocol.

This process can be repeated as many times as the curve of debt-to-collateral ratio permits to amplify yield exposure.

—Protocol-Level Reserve Leveraging

Lending protocols often reinvest idle reserves into strategies such as yield farming and recently liquid-staking derivatives(LSDs) to increase returns — Ethana does this.

Some platforms reuse yield-bearing LSDs to generate additional yield from sources like EigenLayer, where stETH can be restaked for additional yields.

As much as this process increases potential revenue, it also increases the potential of systemic risk if positions become too leveraged, which is the case most of the time.

Looking back on all of this, it sort of makes sense why ETH would underperform, there's a lot of debt floating around as TVL when really those supposed liquidity do not exist in any meaningful sense.

Both protocol reserve leveraging and user recursive borrowing leads to market instability and historically speaking, this is never pretty when shits hit the fan.

If we begin to explore potential scenarios of off-chain leveraging being in place for protocols that are governed by fake DAOs or foundations, etc, it could get much worse. The ecosystem is without a doubt, in far more debt than what is represented and it cannot afford the risks, and my speculation is that the bear market after this bull market will be soul-killing, the worst we've seen in history as every person, institution and protocol struggle to manage debt exposure when it's too late.