A lot of leveraged tokens have appeared over the past six months. Some traders liked the combination of the benefits of margin trading and the absence of the liquidation risks.
This article will focus on how these tokens work and what risks are associated with them.
Currently, there are more than a hundred leveraged tokens traded on numerous exchanges. The ancestor and main issuer of leveraged tokens is the FTX exchange. Their tokens are traded on such exchanges as Poloniex, MXC, Bitmax, Gate, and several others. Until recently, Binance also provided an option of trading FTX leveraged tokens, but at the end of March, CZ tweeted that they received many complaints from users (who did not understand the new financial instrument) and decided to delist these tokens from the platform. But in mid-May, it was announced that Binance was launching their own tokens with leverage. Interestingly, the FTX and Binance tokens have something in common: only tokens from these issuers follow the ERC20 standard. This means that you can transfer them between exchanges (which support these tokens), as well as store them on your ethereum wallet.
Leveraged tokens of other exchanges, such as MXC and Gate, are mere digits on the exchange, they cannot be withdrawn, and they do not exist on any blockchain.
Each leveraged token represents a futures contract position. The price of the token seeks to follow the price of the position which it is based on.
Let’s have a closer look at three main types of tokens: Bull, Bear, and Hedge. Bull corresponds to a long position with 3X leverage; Bear corresponds to a short position with 3X leverage, and Hedge corresponds to a short 1X position. Most issuers have different token names, but the principle of operation is identical.
With a 10% increase in the underlying asset, the Bull token will grow by 30%, Bear will fall by 30%, and Hedge will fall by 10%.
If the underlying asset falls by 10%, the Bull token will fall by 30%, Bear will grow by 30%, and Hedge will increase by 10%.
Everything seems to be simple, but there is a rebalancing mechanism that needs to be taken into consideration as well…
Rebalancing of leveraged tokens occurs on a daily basis. In the case of a negative outcome, this will reduce risk, and with a positive result, rebalancing will reinvest the profits.
In addition, rebalancing occurs if the intraday market movement leads to the growth of the leverage 33% higher than the underlying position. That is, if the market goes down so much that the leverage of the Bull token turns 4X, the token will be rebalanced. This corresponds to a market movement of about 10% for Bull/Bear tokens and 30% for Hedge.
This means that tokens can use leverage of up to 3X without a significant risk of liquidation. To eliminate a token with a 3X leverage, a market movement of 33% or more is required. However, the token will rebalance at a 10% price change, reducing the risk while returning to the target leverage size of 3X.
In other words, if the price of the underlying asset goes in an expected direction, you benefit not only from the 3X leverage but also from rebalancing. If the price goes in the opposite direction, you can get stuck with the token for quite a while. Below is a table showing the change in ETH price and the outcome for the margin traders and the ETHBULL token holders.
As you can see from the table, 3X margin long is more profitable than ETHBULL tokens in cases where the price fluctuates during the rebalancing period. The goal of Binance and their new BTCUP and BTCDOWN tokens is to solve this problem.
The main differences between BTCUP and BTCDOWN tokens from “ordinary” leveraged tokens are:
- Lack of fixed leverage;
- Different approach to rebalancing.
The magic of compound interest.
Let’s assume that the underlying asset grows by 5%. Accordingly, the leveraged token would increase by 15%. The next day, the underlying asset falls by 5%. Therefore, the token would drop by 15%. As a result, we have a total loss of 0.25% in the underlying asset and a loss of 2.25% in the leveraged token.
This situation is called inhibition of volatility. The higher the volatility and the longer the investment time period, the more significant the inhibition of volatility negative effect is.
Assume that the previous example covers a more extended period (365 days) when the prices of the underlying asset remain the same, and the volatility remains within + 5%/- 5%. Let’s look at the effect on the value of both assets.
As you can see from the graph, over time, the fixed leverage token price tends to zero, which means that this tool is not suitable for long-term investments. The floating leverage of Binance tokens is designed to reduce the effect of inhibition of volatility.
New rebalancing mechanism
During the day, leveraged tokens increase or decrease the underlying asset’s impact on achieving the target leverage. As the price of the underlying asset increases, the token increases the number of positions. Conversely, if the price drops, this will lead to a decrease in positions.
Traditional leveraged tokens are rebalanced at a predetermined time (on a daily basis). Being entirely predictable, they are sensitive to front-running deals. Arbitrage traders can predict future transactions and make profits by manipulating the market.
In contrast, Binance leveraged tokens do not undergo rebalancing unless losses are extreme. In fact, these tokens rebalance the position as necessary to maximize profits during growth and minimize losses during the fall, which helps avoid liquidation. This means that “common” market fluctuations will not lead to rebalancing, and the token price will continue to correlate with the underlying asset.
Leveraged tokens can be a good tool for short-term speculation, but their price tends to zero in the long run. On the other hand, if you correctly predict the price movement of the underlying asset, the leveraged tokens’ return can be significantly higher due to the rebalancing mechanism.