Things One Needs To Know About Decentralized Leveraged Tokens

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Coinmonks

9 min readOct 21, 2021

There are several models of Decentralized Leveraged Tokens live on the market, including Set Protocol, Tracer and Phoenix Finance. Each of them applies a very different approach to the tokenization of the leveraged position.

Several months earlier, Iposted my ideas on the decentralized solution on the Decentralized leveraged tokens, and Phoenix Finance put these theories into practice weeks ago. The protocol is now live on Polygon, BSC, and Wanchain, with a united interface. For those who want to learn more about this model, please check the details here.

What Are Leveraged Tokens?

Leveraged tokens are derivatives giving holders stable leveraged exposure to cryptoassets. Token holders do not need to worry about actively managing a leveraged position, borrowing or liquidation.

Fixed leverages or leverage ranges are maintained by the rebalancing mechanism.

For example, the ETHBULL 3x leveraged token on Phoenix Finance — also known as 3x Long ETH token — is an ERC-20 token, with exposure corresponding to three times the return of ETH. For ETH goes up 1% in a day, ETHBULL 3x leveraged token will rise by 3%.

Differences Between Leveraged Tokens And Other Leveraged Instruments

The biggest difference between leveraged tokens and margin trading/perpetuals is that leveraged tokens rebalance both periodically when reaching a certain threshold in order to maintain specific leverage.

While differently, products like margin trading and perpetuals are constantly changing their leverages as to the price fluctuations, even if traders set the predetermined leverage when taking on a position.

You can check this article for more details about leverage in different DeFi products.

Things to Know Before Trading Phoenix Leveraged Tokens

An Extremely Easy to Use Leveraged Product

Phoenix tokenizes decentralized leveraged products into the ERC-20 form. These tokens are fungible and interchangeable.

A user can take a fixed 3x leveraged exposure to a certain underlying asset by simply buying and holding the tokens. The leveraged exposure is automatically granted. Actively managing a leveraged position is not a concern. If one wants to close it, all they need to do is to sell the tokens.

Furthermore, the leveraged tokens will rebalance themselves to make the leverage in a stable manner. Users are not required to work on margins, liquidation, collateral, or funding rates. They are all embedded in the tokens’ contracts. This provides an extremely friendly way for users who intend to hold a constant and stable leverage exposure to a certain cryptoasset.

Currently, the Phoenix protocol is accessible through a joint interface that supports multiple blockchains.

A Product to Trade Rather Than Hold

After being created by FTX exchange, though holding a constant position, leveraged tokens are usually regarded as a kind of product to trade rather than hold for a long time. They provide additional options for traders to gain more exposure and profit in a short term.

The main argument lies in the rebalancing mechanism, which keeps the leverage at a stable state. As introduced here, without rebalancing leverages, like in the margin trading, the actual leverage level will shift as to the underliers’ price movements. To keep the leverage stable, at every rebalancing occasion, each leveraged token reinvests profits, if making any, and sells off part of its position to deleverage to mitigate risks, if taking a loss. It works differently from margin trading or perpetual. Leveraged token holders may get confused when the financials perform differently from their expectations.

For long-term leveraged token holders, one is actually fighting against the possible disadvantages from the leverage rebalancing. Like when you are getting profits, the rebalancing will ‘inflate’ the real leverage by reinvesting, compared with margin trading, though the real intention is to stabilize it. If the market is moving unfavourably afterwards, you will be more financially damaged due to the ‘inflated’ risks. Well, of course, you may earn more in times of favourable market movements.

In short, leveraged tokens are easy and powerful instruments for short-term trading, but please pay more attention to the rebalancing’s interference when holding them for longer periods. And the longer periods one holds the tokens, the more unpredictable it will seem to be, due to the disturbance of multiple rebalances.

Please view the “Financial performance” section below to find out more on this topic.

A product with 100% collateral

Unlike synthetic assets, whose performances are mirroring those who are holding these underlying kinds, Phoenix decentralized leveraged tokens make sure that these tokens are 100% collateralized, by actually holding those positions. In other words, Phoenix decentralized leveraged tokens are asset-backed tokens.

This means that when Phoenix decentralized leveraged tokens are created, a series of transactions including borrowing and trading is executed. Lending pools are established to power the tokens’ leverages, and decentralized exchanges collaborate for transactions when buying, selling and rebalancing. These mechanisms make sure that the net value of the Phoenix leveraged tokens is always backed by real assets and debts.

In turn, this assures minimal counterparty risks when making transactions and financial insurance in tracking the leveraged performance.

Leveraged tokens rely on the underlying token’s liquidity on Dexes

Though leveraged tokens are tokenized into ERC20 forms, the Phoenix protocol does not intentionally establish liquidity pools on Dexes. In other words, the transactions don’t rely on the leveraged tokens’ liquidity.

When purchasing Phoenix leveraged tokens and taking leverages, the same amount of the leveraged tokens are minted, and when the Phoenix leveraged tokens are sold, they are redeemed for the designated assets. On both occasions, a series of transactions will be triggered, based on the underlying tokens’ liquidity.

For example, suppose there is no transaction cost or price slippage, and Alex buys 1 unit of ETHBULL (3x) token with USDC, when its net value is $100.

After receiving $100 USDC, the contract is triggered to borrow 200 USDC from the pool. Then, the 300 USDC will be traded for ETH from decentralized exchanges. At the same time, the contract will create 1 unit of ETHBULL (3x) token. Therefore, the liquidity of the leveraged tokens depends on the underlying token’s pool (ETH/USDC in this case) on the designated decentralized exchange.

This mechanism fully utilizes the existing liquidity on DEXes, without needing to create other leveraged token pairs.

Financial performance

Since the leverage needs to be restored at the time of rebalancing, higher volatility may cause unexpected difficulties for traders. Especially in occasions of multiple rebalances, the effects are compounded in re-leverages and de-leverages. The mathematical outcomes can be unexpected to common understandings.

In favorable trending markets with lower volatility, the performance for longer periods is more likely to exceed the return of margin trading, as the gains are compounded in rebalancing. However, in volatile markets, the same mechanism may harm the token’s long-term performance.

Let’s take a closer look at the leveraged tokens’ financial performances with examples. (Assume a daily rebalancing to 3x leverages)

Assume that 3 users make $100 investment in ETH, ETH Bull 3x and ETH Bear 3x respectively at day 1. ETH price changes as follows in the next 30 days.

These three portfolios have different financial performances. The calculation can be seen on Sheet 1 here.

We may notice that:

The volatility of ETH has been magnified by the leveraged tokens.
If we look closer at the daily performance, the leveraged tokens’ performance is more or less the same as the 3x leveraged expectations.
In the first 9 days, when ETH price is making a steady upward movement, the ETH bull token has an 82% gain, outperforming the +23% ETH price rise by actually more than 3 times. Meanwhile, ETH Bear 3x suffers a 49% loss, less than the 3 times the ETH rise. This is due to the de-leveraging mechanism — the gain is magnified by compounding and the loss is protected by deleveraging.
In volatile times between day 9 and day 20, the price of ETH rises from 3688 to 3699. However, both ETH bull and bear tokens fall in value, as proof of the idea that volatility is the enemy of leveraged tokens.
In the last 10 days, when the ETH price is making a steady downward movement, the ETH bear token is rising in value with leverage, while the ETH bull token value drops dramatically.
If we take the 30 days’ performance as a whole, ETH price drops by 5%. But the ETH bull token drops by 26% and the ETH bear token drops by 2%.

In other words, the long-term performance of the leveraged tokens may be more unpredictable due to the rebalancing mechanism.

Therefore, investors of leveraged tokens over longer periods are encouraged to actively monitor their investments and to consider a strategy that mitigates the effects of rebalancing.

Let’s take another look by including the 3x margin trading in the comparison.

As shown on Sheet 2 here:

Both the leveraged tokens and margin trading have a clear effect of magnifying volatility by taking 3x leverages.
Leveraged bull tokens perform better than longing ETH in margin trading in the first 9 days in the trending market.
Leveraged bear tokens lose less than shorting ETH in margin trading in the first 9 days in the trending market.
From Day 20 to Day 30, leveraged bull tokens drop more dramatically than having a 3x ETH long margin, due to the higher leverages compounded from the previous gains.
From Day 20 to Day 30, leveraged bear tokens recover less than having a 3x ETH short margin, due to having less leverages by deleveraging in the previous rebalancing.
On Day 18, traders having a 3x ETH short margin are suffering from an 82% value drop. If the price continued to rise, they would be at great risk of getting liquidated. On the contrary, leveraged bear token holders are losing 57% in net value, and they would not get liquidated, even if the ETH continued to rise.
Margin trading is easier to predict as it always holds a 3x leveraged position against Day 1. Leveraged tokens are more difficult to predict as they always hold a 3x leveraged position against the previous day. In other words, the real-time leverage is adjusted periodically (daily in our example).

To mitigate the risks of unpredictability in rebalancing, Phoenix protocol applies a range for triggering the scheduled rebalancing. If the real leverage lies within 2.5 to 3.5, the rebalancing will not be activated, in order to lower the effect of auto-compounding.

Other risks

There may be other risks involved in the Leveraged Token Protocol. It is highly recommended to check on the potential risks in these docs before making any transactions.

Conclusion

This article serves as an introduction of several main features in the design of leveraged token model live on the Phoenix Finance Platform, some of which may be different from the traditional leveraged tools. Please DYOR before making any transactions or investments with Phoenix leveraged tokens.

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