All You Need to Know About Leveraged Tokens

The cryptocurrency market has grown rapidly over the past few years, making discussions about it more mainstream. Some people are well-versed in it after making an initial investment, while others are just beginning to consider the possibility.

The demand for crypto products that can be leveraged has increased on the foreign exchange and stock markets. Leveraged tokens are a form of cryptocurrency that has recently become very popular. They are a type of hybrid investment product that has become popular recently.

Profits (or losses) are magnified when you trade using leveraged tokens. Read on if you're interested in investing in leveraged tokens and also want to learn more about them.

Overview

A leveraged token is a financial product that aims to track the price changes of an underlying asset while also leveraging the returns of that asset through the use of derivative instruments (for instance, with 3x leverage).

Currently, there are more than a hundred leveraged tokens traded on numerous exchanges. The ancestor and main issuer of leveraged tokens was the FTX exchange, which no longer exists. Their tokens are traded on such exchanges as Poloniex, MXC, Bitmax, Gate, and several others.

For some time, Binance also provided an option of trading leveraged tokens, but they received many complaints from users and decided to delist these tokens from the platform.

However, in mid-May, it was announced that Binance was launching its leveraged tokens. Interestingly, the Binance 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Leveraged tokens of other exchanges, such as MXC and Gate, are mere digits on the exchange, they cannot be withdrawn, and they do not exist on any blockchain.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 on which it is based.

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%, the 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%, the Bear will grow by 30%, and the 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 daily. 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 Hedges.

This means that tokens can use the 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, a 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 approaches 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 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.

Spot Vs. Leveraged Tokens Vs. Derivatives

You can get the best return while keeping risk within reasonable limits by choosing the best product based on how the market is doing and how much risk you are willing to take.

Spot

Spot facilitates the instantaneous purchase and sale of cryptocurrency by using fiat currency. In other words, it's the practice of exchanging US dollars for Bitcoin and Ethereum.

Derivatives

Investors can make money with derivatives trading products by buying and selling contracts based on their forecasts of how prices will move in the future.

Leveraged Tokens

A leveraged token is a fund that tracks the profits and price changes of cryptocurrencies and magnifies them. For instance, if the price of BTCUSDT increases by 10%, a trader who purchases BTC3L (long BTC with 3x leverage) will earn a 30% profit.

Benefits of Leveraged Tokens

Leveraged tokens are useful for three main reasons:

Risk Management

Leveraged tokens automatically reinvest profits back into underlying profits. This implies that if the trader’s leveraged token position makes money, the tokens will automatically open 3x leveraged positions in the underlying asset.

Also, leveraged tokens automatically reduce risk in case there’s a loss.

Managing Margin

Leveraged tokens can be purchased on the spot market in the same way that regular ERC-20 tokens can. Just spend $10,000 on ETHBULL, and you'll have a 3x leveraged long coin without having to worry about collateral, margin, or liquidation prices.

ERC20 Tokens

Since leveraged tokens are ERC20 tokens, they can be withdrawn from your account. This allows you to keep track of your leveraged tokens in your custody while also transferring them to exchanges that list the tokens.

Top Leveraged Tokens

The value of a leveraged token is pegged to the fluctuations in the market value of a basket of perpetual contract positions. Thus, traders' leverage is influenced by fluctuations in the market for perpetual contracts. Some of the most popular leveraged tokens include BTCUP, TRXUP, and BTCDOWN.

Among the notable derivative products that can be traded on Binance's spot market are leveraged tokens. Leveraged tokens can have both fixed and variable leverage, and they are rebalanced every day at 00:02:00 UTC or whenever the spot market price changes by 10%.

However, while leveraged tokens present the opportunity for greater returns, they are also vulnerable to volatility decay. They also tend to have higher management fees, which is a problem.

There is a daily management fee of 0.01% for Binance leveraged tokens. 

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 (daily). 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. 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 Rebalance to Maintain a Target Leverage

Each leveraged token aims to provide an amount of leverage, such as 3x the underlying asset. The token will rebalance itself automatically to keep the leverage constant. It will reinvest any earnings if it turns a profit. It will also sell some of its positions if losses are incurred.

It is common practice for leveraged tokens to rebalance once per day. During times of high volatility, the token's supporting exchange may be set up with triggers that force all token holdings to be rebalanced right away.

Leveraged tokens on the Binance exchange function slightly differently than they do on other exchanges. Instead of aiming for a certain leverage level, they aim for a range. Some Binance-leveraged tokens, for instance, aim for leverage in the range of 1.25x the asset price to 4x the asset price. 

Leveraged Tokens are Popular for Their Simplicity

The risks associated with margin trading can be substantial, necessitating vigilant oversight on the part of the investor. Conversely, leveraged tokens are a no-hassle alternative.

Margin (money borrowed from a brokerage or cryptocurrency exchange) and collateral are not a concern. Due to rebalancing, the possibility of liquidation is extremely low. It is highly unlikely that the token will be completely wiped out because, even if its value drops, it will sell off some of its positions.

Leveraged Tokens are Prone to Volatility Decay

Volatility decay is one of the dangers of leveraged tokens, which is when volatility negatively affects an investment.

For instance, consider the purchase of $200 worth of ETH. If the price of ETH increases by 10% the following day, the value of your investment will increase to $220. If the price falls by 10% the next day, your investment will reduce to $198.

Imagine instead that you had invested that money into a token backed by Ethereum (ETH) that would have multiplied your earnings from ETH by three. That's a 30% increase, or $260, two days after you make your purchase. Nonetheless, the next day, the coin's value would drop by 30%, resulting in a loss of $78.

In a nutshell, if you invest in leveraged tokens, your portfolio will be more likely to lose a lot of money because of falling volatility and profits.

Many Crypto Exchanges Don't Sell Leveraged Tokens

Purchasing leveraged tokens can be a lengthy process, especially for those living in the United States. You can only buy them on a few cryptocurrency exchanges, and some of those don't even accept cash deposits.

So, to buy leveraged tokens, investors deposit funds into an alternate cryptocurrency exchange and then move those funds to the one suitable for leveraged tokens.

There are Extra Fees

There is a risk of volatility decay when holding leveraged tokens. Another issue is that there are typically extra management charges. As stated earlier, the administration costs of the two widely used leveraged tokens are: 

Binance Leveraged Tokens

These have daily management fees of 0.01%.

Leveraged Tokens are Short-Term Investments for Professional Traders

Leveraged tokens are a bad long-term investment due to volatility decay and management fees. Since cryptocurrency is hard to predict, holding leveraged tokens comes with a high risk of losing money.

You should only invest in these if you have strong convictions about the future price movement of the underlying cryptocurrency. If you think the token's value will go up in the future, buying a leveraged token can help you make a lot more money.

Due to the inherent danger, leveraged tokens aren't suitable for newbies. It's possible to suffer a major setback in a short period.

Additional thoughts

Leveraged tokens are an easy entry into leveraged trading for seasoned crypto traders or investors with a high tolerance for risk. If you want to invest in leveraged trading but don't want to go all in just yet, leveraged tokens can be a good option for you.

On the other hand, trading with leveraged tokens may not be the best choice if you are new to crypto trading or lack extensive experience. While learning more about leveraged trading and leveraged tokens, you may also want to try out other trading strategies, such as spot trading or day trading.

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.

Conclusion (Updated for 2023)

Conclusion: Leveraged Tokens in 2023

As we delve into the world of leveraged tokens in 2023, it's evident that these financial instruments have undergone significant developments and adaptations since their emergence. This article has provided a comprehensive overview of leveraged tokens, touching on various aspects such as their operation, types, benefits, drawbacks, and the evolving landscape in 2023.

Leveraged tokens are ERC20 assets that offer investors a unique opportunity to gain leveraged exposure to the cryptocurrency markets without the complexities of managing traditional leveraged positions. In a constantly evolving financial landscape, they have become an increasingly popular choice for seasoned traders and investors looking to maximize their gains and hedge their risks.

The key takeaway from this article is that leveraged tokens are not a one-size-fits-all solution. They come with their set of advantages and disadvantages, making them suitable for certain types of traders and investors.

One of the most crucial aspects to understand about leveraged tokens is their operation. These tokens aim to magnify the price changes of an underlying asset, whether it's a bullish, bearish, or hedging position. Rebalancing is a fundamental mechanism that helps these tokens maintain their target leverage, and it plays a crucial role in managing risk and optimizing returns.

In 2023, the landscape of leveraged tokens has evolved significantly. While they were initially pioneered by exchanges like FTX and delisted by others like Binance due to user complaints, Binance has now re-entered the market with ERC20-based leveraged tokens, providing more flexibility for traders.

BTCUP and BTCDOWN tokens introduced by Binance have added a new dimension to leveraged tokens by offering a range of leverage rather than fixed leverage. This innovation is designed to combat the issue of volatility decay, a challenge that traditional leveraged tokens often face. By allowing leverage within a range, these tokens seek to mitigate the impact of fluctuations in the underlying asset's price.

When evaluating leveraged tokens in 2023, it's essential to consider them within the context of other investment options. In comparison to spot trading and derivatives, leveraged tokens offer simplicity and ease of use. They eliminate the need for collateral, margin management, and the risk of liquidation. However, they are not immune to volatility decay, which can erode returns over time.

Another crucial aspect of leveraged tokens is their availability and fees. As of 2023, purchasing leveraged tokens can be a more cumbersome process, particularly for residents of the United States. Investors often need to navigate multiple cryptocurrency exchanges to access these assets. Moreover, there are management fees associated with most leveraged tokens, which can impact the overall return on investment.

Leveraged tokens are not suitable for long-term investments due to volatility decay and management fees. They are better suited for short-term speculation, where traders have strong convictions about the price movements of underlying cryptocurrencies. However, it's important to emphasize that leveraged tokens are not beginner-friendly, and inexperienced traders may incur substantial losses in a short time.

In conclusion, leveraged tokens in 2023 offer a valuable tool for experienced crypto traders and investors with a high risk tolerance. They provide an avenue for gaining leveraged exposure to cryptocurrency markets while avoiding the complexities of traditional leveraged positions. However, they come with inherent risks, including volatility decay and management fees, which make them less suitable for long-term investments.

As you navigate the world of crypto trading, it's essential to understand your risk tolerance, investment goals, and level of experience. Leveraged tokens can be a valuable addition to your trading toolkit, but they should be used judiciously and in conjunction with a well-thought-out investment strategy. In the ever-evolving world of cryptocurrencies, staying informed and adapting to new developments will be key to making the most of leveraged tokens and other innovative financial instruments.