Leveraged vaults are whitelisted vaults that execute specific DeFi yield strategies. Users can earn leveraged returns because Notional allows users to borrow up to 10x+ their initial capital and deposit their initial capital + borrowed funds into the vault to earn yield. If the return on the vault yield strategy is greater than the cost the user paid to borrow, leveraged vaults can be very profitable.
Notional can allow users to borrow more than their initial capital because all the capital is placed directly in the vault, and Notional has the ability to liquidate the vault's assets. If the assets in the vault decrease in value relative to the user's debt, the user can be liquidated and Notional can claw back the assets in the vault and use them to repay the user's debt.
Users borrow ETH from Notional and deposit the ETH into this vault. The vault then deposits ETH into the wstETH/ETH pool on Balancer, stakes the LP tokens on Aura, and harvests all incentives.
The user brings 10 ETH to Notional, borrows 50 ETH from Notional at 5% fixed, and deposits 60 ETH into the leveraged vault. The vault strategy earns 8% APY. The user's all-in return is 23% APY. (8% + 5 * (8% - 5%))
This user has 60 ETH in assets vs. a 50 ETH debt. If the value of the assets falls below the liquidation threshold, the user can be liquidated.
The yield comes from the DeFi yield strategy that the vault executes. Some vaults use Notional-specific strategies to generate yield, and other vaults put capital on external protocols and generate yield that way.
Notional-specific example: DAI/USDC cross-currency vault. This vault swaps DAI to USDC, and then lends the USDC on Notional. This vault is profitable if the USDC lend rate is greater than the DAI borrow rate. The user can be liquidated if USDC depegs.
External protocol example: wstETH/ETH Balancer/Aura vault. This vault deposits ETH into the wstETH/ETH pool on Balancer, stakes the LP tokens on Aura, and harvests all incentives. This vault is profitable if the yield from the strategy is greater than the ETH borrow rate on Notional. The user can be liquidated if wstETH/ETH LP tokens decrease in value because stETH depegs.
You have the option of borrowing at any active fixed rate maturity in the borrow currency. You can switch between different maturities at any time without exiting the vault, but you can only borrow from one maturity at a time. So if you want to switch, you need to switch your entire loan at once.
When your fixed rate borrow matures, your vault position will automatically be settled at no penalty and your profits will be available for you to claim. You can then withdraw from the vault or re-enter by borrowing from another fixed rate maturity.
Most leveraged vaults have liquidation risk that comes from exchange rates. Users borrowing DAI in the DAI/USDC cross-currency vault can be liquidated if USDC depegs and the USDC/DAI exchange rate drops too far. Users borrowing ETH in the wstETH/ETH Balancer/Aura vault can be liquidated if stETH depegs and the stETH/ETH exchange rate drops too far.
If you get too close to liquidation, you can exit the vault or top up your position to reduce your liquidation risk at any time.
The Notional UI will show you how much leverage you're taking relative to the max leverage for that vault, and it will also show you the price at which your position will exceed max leverage and you will get liquidated.
Entering and exiting leveraged vault can involve transaction cost. Leveraged vault transaction costs come from two places - Notional lending markets and the vault itself.
On Notional, you pay a transaction fee when you lend or borrow at a fixed rate. This means that you will pay a fee on your loan when you enter and exit the vault. Read more about fixed rate lend/borrow transaction fees here.
Entering and exiting the vault can also include transaction fees. For example, when users enter the wstETH/ETH Balancer/Aura vault, the vault needs to swap some of their ETH into wstETH and then deposit it into the Balancer pool. This swap involves transaction cost. The same cost applies when the user exits the vault.
The Notional UI will show you the transaction fee breakdown before you enter the vault.