Using leverage naturally comes with its own set of risks. In this article, we will dive into the risks of using leverage tokens with the Flexible Leverage methodology.
The main risks we will cover are:
Smart contract risk.
The Flexible Leverage Indices aim to target a specific leverage ratio, but have a tolerance bound within which they stay in. When you go to the product page of a FLI product, you can see the difference between the target leverage ratio and the real current leverage ratio.
Over longer periods of time, the difference between the real leverage and the target leverage may create different results than how the product would be expected to perform with a constant leverage ratio.
Furthermore, all leveraged ETFs suffer from something known as volatility decay which is why they tend to perform poorly in choppy markets. You can read more about volatility decay here.
To understand how this works and why we chose to have a tolerance risk, you can check out this article here.
While we have deep safeguards put in place to ensure against a liquidation, we do use Compound to create our leveraged positions. With Compound, if our collateralization ratio ever goes above a certain threshold, we will get liquidated.
In the case of extreme flash crashes with incredibly congested on-chain traffic, there is a chance that we get liquidated before we are able to execute our safeguards. These events are extremely rare and far between, but the risk nevertheless remains.
Smart Contract Risk
As with products utilizing smart contracts, there are some inherent risks. Our protocol and leverage specific smart contracts have gone through deep auditing by some of the industry’s best auditing firms. However, exotic attack vectors may pop up and they may be damaging.
Audit reports and a general overview of the inherent risks of using TokenSets and Set Protocol can be found here.