In DeFi, a common way to create leveraged exposure is to borrow against crypto collateral, use the borrowed asset to increase exposure to a chosen asset, and keep enough collateral to meet the lending market’s rules. The added exposure can magnify losses as well as gains, while variable borrowing costs and liquidation thresholds can change the position’s risk while it is open.
What “margin trading” means in DeFi
DeFi lending markets let users supply assets as liquidity and let borrowers lock collateral to borrow another asset. A leveraged position uses that borrowing to increase exposure beyond what the user could buy with their starting funds alone. Because the loan is secured by collateral, the borrower must maintain enough collateral value relative to the debt under the protocol’s rules.
This is different from a leveraged perpetual futures position. Lending-based leverage creates collateralized debt and is governed by a lending market’s liquidation rules. Perpetual futures use derivative contracts and exchange margin rules. The mechanics below concern lending-based leverage, not futures.
How borrowing creates a leveraged long
Suppose a user wants more exposure to an asset than their initial funds would buy. In a simplified lending-based strategy, they deposit collateral, borrow another asset, exchange the borrowed funds for more of the desired exposure, and may deposit that asset as additional collateral. The position now has a larger exposure, but also more debt.
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Some users repeat the borrow, exchange, and redeposit sequence. The Bank of Canada’s 2026 study of Aave V3 calls this recursive leverage. Each loop can increase both exposure and debt, making the position more sensitive to adverse price changes and financing costs. It does not remove the need to repay the loan or satisfy the collateral rules.
What determines whether a position can be liquidated?
Protocols use their own measures and thresholds. In Aave V3, the health factor reflects collateral value, liquidation thresholds, and debt. Oracle prices affect the value assigned to collateral, and interest accruing on debt can increase what is owed. Aave’s documentation says: “When it falls below 1, the position becomes eligible for liquidation and external liquidators can repay part of the debt in exchange for collateral.”
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Aave’s documentation illustrates the calculation with $10,000 of ETH collateral, an 80% liquidation threshold, and $6,000 borrowed in GHO, producing a health factor of 1.333. That is an example from Aave’s documentation, not a universal market setting or a recommended borrowing target. Parameters vary by asset and market.
Morpho documentation describes market-specific loan-to-value (LTV) and liquidation LTV (LLTV) measures, with permissionless liquidation. Its example for a market with an 86% LLTV gives an approximate 5% liquidation incentive. That figure is specific to the documented example; it should not be assumed for other Morpho markets or protocols.
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When a position crosses its liquidation condition, a liquidator can repay some of the debt and receive collateral under the protocol’s terms. The borrower’s collateral falls, and the process can crystallize a loss. A rapid price move may leave little time to respond. The Bank of Canada’s 2026 study reports that Aave V3 liquidations occurred in clustered waves driven primarily by sharp drops in collateral prices; that is the paper’s finding, not a prediction about how every market decline will unfold.
Why the cost and risk can change over time
Borrowing rates are not necessarily fixed for the life of a position. Aave says its interest-rate model responds to liquidity utilization and rises more sharply above a target utilization point. As a result, the cost of keeping a position open can change while it is active. No particular current rate or yield follows from that mechanism.
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Collateral prices can fall while debt grows through interest, weakening the position’s liquidation metrics from both directions. A strategy that looks manageable at entry can therefore become more vulnerable without any additional borrowing.
How to assess a lending market before borrowing
Do not choose a market based on an illustrative threshold or incentive alone. The current documentation establishes how the mechanisms work, but does not provide a comparable live market snapshot or support a ranking of Aave and Morpho by safety or cost. Check the specific market’s terms and conditions, including:
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- Eligible collateral and borrow assets: Confirm which assets can be supplied and borrowed in that market.
- Collateral limits and liquidation method: Understand the market’s LTV or health-factor methodology, liquidation threshold, and liquidation terms.
- Liquidity and utilization: Assess whether borrowing liquidity is available and how utilization may affect borrowing costs.
- Chain and transaction costs: Account for the network where the market operates and the transaction costs of opening, adjusting, or closing a position.
- Protocol, oracle, and smart-contract exposure: Consider the systems that execute the market’s rules and supply its price information.
Ways to manage liquidation risk
Risk management cannot make leveraged borrowing safe or guarantee that a position will avoid liquidation. It can help a borrower understand what could change the position’s status and avoid relying on a single favorable assumption.
- Read the current market’s collateral and liquidation rules rather than carrying over figures from another asset or protocol.
- Consider how a collateral-price decline and debt growth from interest could affect the position’s liquidation metric.
- Account for variable borrowing costs when evaluating how long a position might remain open.
- Understand how the protocol handles liquidation, including how much debt may be repaid and what collateral a liquidator may receive.
- Keep wallet and transaction security separate from position risk: secure signing does not change collateral thresholds or prevent liquidation.
Wallet security is a separate risk
Interacting with a DeFi application generally means using a wallet to sign transactions. Ethereum.org explains that state-changing contract writes require a signed transaction and, in the standard externally owned account flow it describes, gas. A hardware wallet can keep private keys offline, which may be useful for someone who chooses self-custody, but it cannot prevent liquidation, correct a protocol vulnerability, or make an unsafe approval safe.
Ethereum.org also warns that a recovery phrase or private key gives access to accounts, and that unlimited token-spending approvals can let a contract drain tokens. Verify the website and transaction details before signing, and use limited approvals where possible. A hardware device does not replace those checks.
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