Undercollateralization: The Key to Leveraging
PembRock leveraged yield farming allows you to earn greater rewards by borrowing up to 3x the amount of crypto that you are currently holding. Sounds great, right? But in an environment where users can be anonymous, how are these loans secured? In this doc, we’ll quickly explain to you how undercollateralized lending is the key to leveraged yield farming like a pro.
Collateral in the world of finance is defined as funds that a borrower puts up in order to secure a loan. It acts as a guarantee to the lender and is forfeited to them in the event that the borrower is unable to repay the loan.
A similar principle works in the world of DeFi, where borrowers put up crypto in order to secure loans that are automated by smart contracts. For this reason, they are quick to obtain.
Aave, Maker, and Compound, the three Ethereum-based platforms that helped to popularize lending and yield farming provide overcollateralized loans. This means that you need to put up more funds than you borrow. To use an example from the NEAR universe, to borrow $150 worth of ETH on Burrow, you would need to put up 200 USN (NEAR’s stablecoin) as collateral.
You may be asking, why not use the funds you have rather than locking them up to get a loan that is smaller in value? There are two big reasons:
- You don’t have to sell the crypto you have in order to get liquidity. You can keep your underlying funds while using a borrowed coin to farm or perform any other transaction in the DeFi ecosystem.
- Those with bad or non-existent credit scores navigating the world of traditional finance can get access to loans at much better rates than they would otherwise be able to.
You might see collateral factor mentioned when consulting lending platforms. This relates to the amount that needs to be put up to obtain a loan, and varies according to the token that is being used as collateral, as well the platform used.
Using our example with ETH & USN above (200 USN to borrow $150 worth of ETH), we see a collateral factor of 75%. If 300 USN was required to borrow the ETH, the collateral factor would be 50%.
One of the big differences between our platform and others in the DeFi space is that we provide undercollateralized loans for farmers. This means that you can obtain loans that are of greater value than the initial funds provided.
For example, a farmer who wants to open a leveraged position can put up 100 NEAR and receive 200 more, bringing their total to 300 NEAR which can be farmed. This means greater utility for the user as well as greater liquidity for products such as Ref Finance within the NEAR ecosystem, the DEX we have integrated with on launch.
PembRock puts in place appropriate liquidation thresholds so that funds provided by lenders will never be in any danger. If a token in the position falls to a point where the farmer is in danger of not being able to cover the loan, their position will be automatically liquidated.
This handy graphic gives you an idea of how the risk of liquidation rises as more funds are leveraged. With PembRock, you can leverage anywhere between 1 and 3x, with auto-reinvesting meaning you benefit from compound interest without having to lift a finger.
In the example where we borrow 200 NEAR against 100 NEAR of collateral, the leverage level is now 3 with a debt ratio of 67%. If the price of NEAR drops by more than 31%, it means your collateral no longer covers the losses you have incurred. For this reason, liquidation protects both the protocol and you from losing all your funds.