Leverage tokens work by utilizing on-chain lending protocols, like Aave or Compound, and automatically adding/removing collateral to maintain a leverage position.
For the purpose of this article, we will look at how the ETH 2x FLI leverage token works.
The ETH2x-FLI aims to stay at a leverage ratio between 1.7 - 2.3x. This flexible rebalancing nature minimizes the number of rebalances, and thereby gas costs, to maintain a leveraged position. It currently uses Compound as its lending protocol.
Minting and Redeeming
To understand how the leverage token works, first we will look at how it levers up and delevers.
The token starts off by supplying cETH as collateral to Compound to be able to borrow back USDC. In order to get the leverage, the protocol trades USDC for ETH using onchain liquidity on a DEX like Uniswap. Finally, we put the ETH back into Compound to earn interest by wrapping it into cETH.
Delivering works in a similar way, but in the opposite direction. It starts by removing ETH from Compound by unwrapping cETH into ETH. Next, because it borrowed USDC, that is the asset it has to pay back, so it swaps the ETH into USDC using a DEX again. Finally it takes the USDC and pays back the original loan on Compound.
When somebody mints a new FLI token, the protocol takes their ETH and levers it to the current leverage ratio (between 1.7 - 2.3) using the mechanisms described above. When you min, as opposed to buying the token directly from a DEX, you are going to get some USDC back along with the FLI token as that is part of the debt you are taking on. The flow is illustrated in the diagram below:
If you are buying directly from a DEX, don’t worry about this.
When somebody redeems a new FLI token, the same thing happens in reverse. The user pays back their FLI and USDC, the protocol pays back the debt on Compound, burns the FLI token, and returns the original cETH to the user.
Naturally, as ETH’s price fluctuates, the leverage ratio of the ETH deposited and the USDC borrowed changes. In order to keep the leverage in line, a network of bots monitor the leverage condition and rebalance (using the levering and delivering processes described above) to take back the leverage ratio to 2x. The protocol does not immediately rebalance back to 2x, but goes back to 2x at a defined speed from where it is presently (between 1.7x - 2.3x).
In the extreme case where the leverage ratio breaks out past the defined bounds of 1.7x - 2.3x, the protocol has a Ripcord function that engages in an emergency rebalance to bring it back within the bounds. Whichever bot calls the Ripcord function to execute the rebalance gets a reward.
What Happens To Any Liquidity Mining Rewards?
Any rewards are consumed and returned to the user whenever possible. In the example above, the protocol will receive COMP rewards for its collateral and debt positions. The protocol automatically claims the rewards, turns it back into ETH and deposits it back into the leverage position to be given back to the user when they redeem.
When Do Leverage Tokens Work Best?
Leverage tokens work best in trending markets as you are able to keep your leverage and perform poorly in choppy markets. In choppy markets, leverage tokens are constantly levering up and delevering which eats into performance.