Margin

The collateralization ratio is the primary measure of a position's health, calculated as (Value of Collateral / Value of Borrowed Assets) * 100%. It determines liquidation risk and borrowing capacity.

• A minimum collateralization ratio is set by the protocol; falling below it triggers liquidation.
• A higher ratio provides a larger safety buffer against price volatility.
• Protocols often offer better loan terms (e.g., lower fees) for overcollateralized positions.

Liquidation is the forced closure of an undercollateralized position to protect lenders. It occurs when a position's collateralization ratio falls below the protocol's liquidation threshold.

• A liquidation engine automatically auctions the collateral to repay the debt.
• The borrower typically incurs a liquidation penalty (a fee deducted from remaining collateral).
• Liquidators are incentivized with a bounty to execute these transactions swiftly, ensuring system solvency.

This defines how risk is managed across multiple positions.

• Isolated Margin: Risk is contained per position. Each trade has its own, separate collateral pool. Liquidation of one position does not affect others, limiting downside but requiring more capital management.
• Cross Margin: All positions share a single collateral pool. This allows for greater capital efficiency and shared risk buffers but exposes all assets to liquidation if the pooled collateral ratio falls below the threshold.

Leverage is the use of borrowed capital to amplify the size of a trading position, magnifying both potential profits and losses. It is expressed as a ratio (e.g., 5x).

• Maximum leverage is determined by the protocol's minimum collateralization requirements.
• For example, with a 150% minimum ratio, the maximum theoretical leverage is approximately 6.6x (1 / (1 - 1/1.5)).
• Higher leverage increases the liquidation price proximity to the entry price.

In perpetual futures markets, funding rates are periodic payments between long and short traders used to tether the contract's price to the underlying asset's spot price.

• When the funding rate is positive, longs pay shorts (indicating bullish sentiment).
• When negative, shorts pay longs (indicating bearish sentiment).
• These payments occur at regular intervals (e.g., every 8 hours) and are a critical cost/income factor in margin-held perpetual positions.

A dynamic metric, often called a Health Factor, represents a position's proximity to liquidation. It is the inverse of risk.

• Formula: Health Factor = (Collateral Value * Liquidation Threshold) / Total Borrowed Value.
• A health factor of 1.0 is the liquidation threshold.
• Values > 1.0 indicate a safe position; the lower the value, the higher the risk.
• Protocols use this to display risk clearly and may offer warnings as it approaches 1.0.

The primary risk in margin trading is forced liquidation. When the value of the collateral falls below the required maintenance margin ratio, the position is automatically liquidated by a liquidator bot to repay the loan. This process often incurs a liquidation penalty (e.g., 5-15% of the position), resulting in significant loss for the trader. Key factors include:

• Health Factor / Collateral Ratio: A real-time metric determining liquidation proximity.
• Price Volatility: Rapid price swings can trigger cascading liquidations.
• Oracle Accuracy: Reliance on price oracles introduces a single point of failure.

DeFi margin protocols are typically overcollateralized, requiring users to deposit more value than they borrow (e.g., 150% collateralization for ETH). This creates a safety buffer against price declines. Key considerations:

• Collateral Types: Protocols accept specific, often volatile, assets (e.g., ETH, wBTC).
• Liquidation Threshold: The specific collateral value at which liquidation is triggered.
• Haircuts: The discount applied to collateral value to account for its volatility and liquidity.
• Cross-margin vs. Isolated Margin: Cross-margin pools collateral, increasing efficiency but also interconnected risk. Isolated margin confines risk to a specific position.

Margin protocols are complex smart contract systems vulnerable to exploits. Key threats include:

• Logic Flaws: Bugs in liquidation logic, interest rate models, or oracle integrations.
• Oracle Manipulation: If an oracle is compromised or delayed, it can cause incorrect liquidations or allow undercollateralized borrowing.
• Economic Attacks: Flash loan attacks can be used to manipulate collateral prices or drain liquidity pools in a single transaction.
• Admin Key Risk: Many protocols have multi-sig governance or admin functions that could be abused to alter critical parameters.

Successful margin trading depends on market liquidity at critical moments.

• Exit Liquidity: Closing a large position in a thin market can cause high slippage, eroding profits.
• Liquidation Slippage: During a market crash, liquidators may struggle to sell collateral at the oracle price, potentially leading to bad debt for the protocol if the auction fails to cover the loan.
• Borrowing Capacity: Available liquidity to open new margin positions can dry up during high volatility, limiting strategy execution.

Unlike centralized finance (CeFi), DeFi margin has no traditional counterparty, but systemic risks remain.

• Protocol Insolvency: Widespread liquidations can generate bad debt that exceeds the protocol's reserves, potentially impacting all users.
• Composability Risk: Margin positions are often integrated with other DeFi legos (yield farming, perps). A failure in one protocol can cascade.
• Stablecoin Depeg: Using a stablecoin as collateral or debt becomes highly risky if it loses its peg, triggering unexpected liquidations.

Prudent traders employ several strategies to manage margin risk:

• Conservative Leverage: Using lower leverage (2-3x) reduces liquidation sensitivity.
• Continuous Monitoring: Actively tracking health factors and setting up alert systems.
• Diversified Collateral: Avoiding over-concentration in a single volatile asset.
• Understanding Parameters: Knowing the exact liquidation threshold, penalty, and oracle update frequency for the protocol used.
• Using Stop-Loss Orders: While not native to all DeFi protocols, they can be simulated with external tools or smart contracts.

Leverage is the use of borrowed capital (margin) to amplify the potential return of an investment. It is expressed as a ratio (e.g., 5x).

• Mechanism: A trader posts $1,000 in collateral to control a $5,000 position, using 5x leverage.
• Effect: Magnifies both profits and losses relative to the initial capital.
• Risk: High leverage increases the likelihood of a liquidation event if the market moves against the position.

Liquidation is the forced closure of a leveraged position when its value falls below the maintenance margin requirement.

• Trigger: Occurs when the liquidation price is reached, meaning the collateral can no longer secure the loan.
• Process: The protocol automatically sells the position to repay the lender, often with a liquidation penalty.
• Purpose: Protects lenders from losses by ensuring loans remain over-collateralized.

Collateral is the asset deposited by a trader to secure a margin loan and open a leveraged position.

• Function: Acts as security for the borrowed funds; its value determines borrowing capacity and liquidation risk.
• Types: Can be the same as the traded asset (e.g., ETH as collateral to long ETH) or a different, accepted asset.
• Haircut: Protocols often apply a collateral factor (e.g., 75% for ETH) to mitigate volatility risk, meaning $100 of ETH may only secure a $75 loan.

Maintenance Margin is the minimum amount of equity, expressed as a percentage, that must be maintained in a margin account.

• Role: A safety threshold set by the protocol or exchange. If the account's equity falls below this level, a margin call or automatic liquidation is triggered.
• Calculation: Equity / Total Position Value ≥ Maintenance Margin Ratio.
• Example: With a 10% maintenance margin on a $10,000 position, the trader's equity must not fall below $1,000.

These are two primary methods for managing risk in a margin account.

• Isolated Margin: Risk is contained. Collateral is allocated to a single position. Losses are limited to the funds in that isolated account, protecting other assets.
• Cross Margin: Risk is pooled. All available collateral in the account backs all open positions. This provides higher capital efficiency but exposes the entire portfolio to liquidation from a single losing trade.

The Funding Rate is a periodic payment exchanged between long and short traders in perpetual futures markets to peg the contract price to the spot price.

• Mechanism: When the market is bullish (more longs), longs pay shorts. When bearish (more shorts), shorts pay longs.
• Frequency: Typically paid every 8 hours.
• Impact on Margin: These payments are deducted from or added to a trader's margin balance, affecting the profitability and longevity of a leveraged position.