The first thing to understand about leveraged investing is this: It loses money faster.
A new decentralized finance (DeFi) product should drive this point home, for better or for worse. The brainchild of Index Coop, which aims to do for DeFi what S&P and Dow Jones did for stocks, it allows an investor to easily take a leveraged position on ether (ETH) with just one transaction.
The cooperative is releasing its first product using its Flexible Leverage Index (FLI), a token called ETH2x-FLI. It will target a value that goes up twice as fast as the second-largest cryptocurrency (and down the same way).
Leverage has been a killer use case for decentralized finance, starting all the way back with the money market Compound. But rarely has making such big bets required so little work.
“There really isn’t anything like this in terms of getting DeFi leverage in a single token,” an Index Coop member who goes by the handle Lemonade Alpha told CoinDesk in a phone call.
The ETH price has climbed from $400 in late November to touching $2,000 in recent days. For users who believe it has further to go, FLI would be a way to double down on such gains.
Previously, to go extra long on ETH, a user would have to do the following: Deposit a bunch of ETH into Compound. Borrow a bunch of USDC, a stablecoin engineered to hold its value to the U.S. dollar, and swap all that for more ETH.
To go even further, he could deposit the fresh ETH and do the same loop again. We saw lots of that during the wildest parts of 2020’s “DeFi summer.”
Not only does that take much manual effort and require lots of transactions, it also puts the user in the position of stewarding the loan to make sure it doesn’t fall below collateral requirements (if it needs more, that’s more transactions).
With ETH2x-FLI, a user can get roughly the same exposure with a single transaction, said Lemonade. The leveraged position is simply tokenized and traded like any other ERC-20 token running on top of the Ethereum blockchain.
As a result, an investor’s downside risk is easy to quantify: He can’t lose more than the price he bought at – but he can lose it faster.
“A lot of people, when they think about leverage, they think about this BitMEX kind of casino, 25 times margin position,” Lemonade said. “We think about this as completely opposite.”
ETH2x-FLI targets two times leverage, which means the holder should get twice the gains when ETH goes up and twice the losses when it goes down, but not always.
“Sometimes the leverage itself is going to be [diminished] because the token is trying to be a safeguard for you,” Lemonade said.
With FLI, robots have your back.
On the back end, ETH2x-FLI has done all the same transactions laid out in the examples above, which means there’s a bunch of collateral backing a bunch of loans. If the loans become undercollateralized the collateral gets slashed, and that hurts all holders of ETH2x-FLI. So it bears repeating that 2X is a target.
FLI uses an algorithm to protect the collateral. When necessary, the algorithm will increase its collateral position, which will decrease the leverage. By leaving flexibility around the amount of leverage, FLI can manage risk.
It’s very expensive in DeFi for a loan to fall below its collateral requirement, which can happen quickly when a collateral asset is volatile (like ETH). When that happens, the collateral will be sold off to close the loan. The borrower will get his collateral returned but only after a hefty liquidation fee has been taken out.
Obviously if this happened to FLI it would hit a lot of users, which is why it’s built for flexibility in terms of its collateralization buffer.
Though liquidations won’t be able to hit too many users at first. FLI is intended to put a limit on its assets under management initially to $5 million. As the system proves to be safe, it can raise the cap.
Buying ETH2x-FLI on the open market won’t be the only way to get it. Users can mint it directly, but that’s probably going to be more appropriate for advanced users with deeper pockets. It works best when there’s a dislocation between the market price of the token and the price Index at which Coop will mint, Lemonade Alpha explained.
More to come
Index Coop won’t stop with ETH, but it expects this product to be its flagship leveraged offering.
“The FLI is a general index structure. It can be adapted for other tokens outside of ETH,” Lemonade Alpha explained.
There’s no immediate plans around which ones or when. INDEX token holders will decide what else to make and when.Index Coop previously created the DeFi Pulse Index (DPI), which uses the Set Protocol under the hood just as FLI does. DPI packages together the top governance tokens in DeFi into one token.