What Are Leveraged Tokens?
Leveraged tokens are cryptocurrencies that allow traders to gain leveraged exposure to an underlying cryptocurrency without putting up any collateral.
Leveraged tokens are used by traders with the aim of multiplying gains from token price movement. These tokens are used to leverage long and short positions and for hedging against market volatility.
How do Leveraged Tokens Work?
Leveraged tokens are designed to multiply the percentage price movement of the underlying cryptocurrency.
For example, a 2X long leveraged token for ethereum (ETH) will produce two times the percentage change of ETH’s price movement.
If the price of ETH increases by 10%, the 2X long leveraged token for ETH will increase by 20%.
However, if the price of ETH falls by 10%, the 2X long leveraged token for ETH will decrease by 20%.
The risk-reward ratio of leveraged tokens is very high due to its volatility. Traders are advised to proceed cautiously when using leveraged tokens, as the risk of heavy losses is significant.
Leveraged tokens Explained
Leveraged tokens were popularized by centralized crypto exchanges such as Binance and FTX.
There are mainly two types of leveraged tokens:
1. Constant leverage
These are conventional leveraged tokens that maintain constant leverage to the underlying asset. For example, leveraged tokens at a constant leverage of 2X will always multiply the daily percentage change by 2.
2. Variable target leverage
Variable target leveraged tokens are issued by Binance – the world’s largest crypto exchange by volume.
These tokens are designed to maintain a variable leverage range between 1.25X and 4X.
According to Binance, the variable target leverage maximizes profitability on the upswing and minimizes losses on downswings.
- High volatility
Leveraged tokens are considered among the riskiest instruments in the crypto market due to their high volatility. The amplification of the daily price movements of the underlying asset is the main reason for their high volatility.
- Volatility Decay
Leveraged tokens are vulnerable to volatility decay, which refers to the divergence in the returns between the underlying cryptocurrency and the leveraged token.
Here is an example of volatility decay. Let’s say you have a 2X long leveraged ETH token that delivers two times the daily return of the ETH token.
Let’s assume that both ETH and 2X long leveraged ETH tokens are trading at $1000.
On day one, if the ETH price rises by 10% to $1100, the 2X ETH leveraged token will increase by 20% to $1200.
On day two, if the ETH price drops by 20% to $880. The 2X ETH leveraged token will fall by 40% to $720.
In this time period, holding ETH would result in a loss of -12%, while holding 2x leveraged ETH tokens would result in a loss of -28%.
As the volatility trims your investment, leveraged tokens are only used for short-term trading.
- Extra Charges
Centralized crypto exchanges like Binance charge extra fees to trade leverage tokens.
Binance charges trading, subscription, redemption, management, and funding fees to trade leveraged tokens.
- Rebalancing Mechanisms
Leveraged tokens are governed by algorithms that increase or decrease their position in the underlying asset to meet their target leverage. Leveraged tokens are vulnerable to these rebalancing algorithms that may fail to work efficiently during highly volatile markets.
In 2021, a CoinDesk article cited crypto traders complaining that Binance’s leveraged tokens “didn’t deliver as promised” during the Terra-induced market crash of May 2021.
Advantages of Leveraged Tokens
Leveraged tokens are popular as it does not require the trader to pledge collateral and constantly manage their margins. The lack of collateral deposit also means traders do not have to worry about liquidation risk.
- Magnified profits
When leveraged tokens are used well, traders can multiply their profits using leveraged tokens compared to simply holding the underlying asset. Using leverage also allows the trader to gain exposure to a higher value of trade with their available funds.
- Shorting and hedging
Leveraged tokens can be used to profit from token price drops and crypto market crashes. These tokens are also used to protect investor portfolios against price drops. Binance Leveraged tokens like BTCDOWN and ETHDOWN generate between 1.25X to 4X leveraged gains when the price of BTC and ETH declines, respectively.
How Do Leveraged Tokens Work on DeFi?
You can also find decentralized finance (DeFi) leveraged tokens on web3. Let’s look at Index Coop’s ETH 2x FLI leverage token as our example.
Index Coop issues and maintains the ETH 2x FLI leverage token by leveraging the power of other DeFi applications such as Uniswap and Compound. To mint the ETH 2x FLI leverage token on Index Coop, you will have to deposit ETH.
The ETH is deposited on a DeFi lending protocol called Compound to borrow USDC. The USDC is then used to buy more ETH on Uniswap. The newly purchased ETH is deposited back into Compound to earn interest.
You can also buy the ETH 2x FLI leverage token directly on Uniswap instead of minting it on Index Coop.
Popular Leveraged Tokens
Here are some popular leveraged tokens issued by centralized exchanges and DeFi protocols
- BTCDOWN and ETHDOWN
BTCDOWN and ETHDOWN are short-leveraged tokens issued by Binance that aim to provide leverage up to 4X for bitcoin and ether.
- BTCUP and ETHUP
BTCUP and ETHUP are long-leveraged tokens issued by Binance that aim to provide leverage up to 4X for bitcoin and ether.
- BTC 2x Flexible Leverage Index and ETH 2x Flexible Leverage Index
These leveraged tokens issued by DeFi protocol Index Coop target long 2x exposure to BTC and ETH. The tokens held a combined market cap of over $14 at the time of writing.
Leveraged tokens are crypto innovations that improve on their traditional counterparts, like margin trading, by simplifying the process.
It should be noted that leveraged tokens are highly risky instruments that are not recommended for market newcomers.
Always do your research before investing, and never trade with money that you cannot afford to lose.