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FLI tokens create leverage by depositing collateral into a decentralized lending protocol (like Compound) and taking out debt that is then swapped for more of the collateral, thereby increasing exposure to the underlying collateral asset.
Every 24 hours, based on price changes of the underlying asset, the smart contracts managing the FLI tokens will buy or sell additional quantities of the underlying asset to rebalance towards the Target Leverage Ratio.
Below are three key considerations of FLI products :
Read on for our beginner's guide to using Flexible Leverage Index Tokens.
1. Price Impact
Crypto can be a volatile asset class. With markets in constant flux, the leverage ratio can change rapidly in a short period of time.
When there is a dramatic swing either up or down, the ratio will reflect that. As one would expect, if ETH price falls the leverage ratio will rise, and if ETH price rises then the leverage ratio will fall.
When rebalancing back to the Target Leverage Ratio of 2x, the token needs to either increase or decrease leverage, respectively.
Allowing for a flexible leverage ratio means that the product will not snap back to 2x leverage immediately, but can temporarily rest somewhere in between (like 1.8x or 2.2x).
This means when we are swapping the collateral asset (ETH or BTC) for the borrowed stablecoin (USDC) we don’t have to swap as much, meaning there is less NAV decay due to DEX price impact.
The same concept applies for leveraging up as well when we swap borrowed stablecoins for the collateral asset.
2. Gas Costs
Every time a rebalance occurs, a fee is paid to transact on the Ethereum network — better known as gas. Maintaining a strict 2x leverage ratio would require constant rebalancing, which would rapidly rack up gas costs.
With a flexible leverage ratio, we can tolerate deviations from the target of 2x and rebalance at less frequent intervals.
3. Volatility Drift
Lastly, the FLI tokens are still affected by volatility drift, but to a greatly reduced degree due to the flexible leverage ratio.
Volatility drift takes place when rebalancing and can be thought of as locking in prices at that point in time. As this continues to happen NAV decay starts taking effect.
To help combat this, the FLI tokens have a set recentering speed which determines the rate at which the leverage ratio returns back to it’s Target Leverage Ratio.
With a current set speed of 5%, that means a rebalance transaction will be 5% of the full amount it would take to rebalance back to a strict 2x target. Since the token gradually rebalances back to the target ratio, this leads to smaller price impact, and over time, less NAV decay.
On top of that, in a dynamic market, there can be rapid growth and rapid decline in prices.
As prices continuously climb the Current Leverage Ratio on the FLI products will gradually fall under 2x leading to less than 2x returns. This in turn temporarily benefits the tokens if there is a reversal in the market and prices fall since exposure will be less than 2x for a short period of time.
To better understand this, let’s look at an example of volatility drift, but with a fixed leverage ratio to keep things simple.
Let’s start with an equal investment of $100 into a regular asset and $100 into a fixed 2x leverage of the same asset. Then say the price of the asset goes up by 5% on day one and another 5% on day two.
As mentioned earlier, there is not an immediate rebalance of the FLI Token so as the price of the collateral asset rises, the leverage ratio falls, meaning we can make the assumption that the leverage ratio will be slightly less than 2x after day 2.
Then on day three, the price drops 10% and we can see the results of our investments in the table above.
In this example, holding the regular asset lost out marginally, while the fixed 2x leverage investment lost out more.
Since the FLI tokens have flexible leverage we can expect its losses would be somewhere in the middle, giving marginally better protection than a fixed 2x leverage product.
Please keep in mind this example is more for illustrative purposes, and it is unlikely the markets will perfectly match this scenario.
To better understand some of the risks associated with the FLI tokens look no further than Understanding the Risks of Owning FLI Tokens.
Disclaimer: The Content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.