IIP: 186
Title: Launch A Leverage Suite on Arbitrum
Status: Proposed
Author(s): @MrMadila
Reviewer(s): @anthonyb.eth, @allan.g
Created: 9th Apr 2024
1 Abstract
The Index Coop core team proposes that the DAO launch a suite of automated leverage tokens on Arbitrum main-net. These automated leverage tokens will be built on Index Protocol and utilise Aave V3 to achieve specific target leverage ratios.
The target ratios and collateral assets are as follows:
- iETH1x (inverse 1x)
- iBTC1x (inverse 1x)
- ETH2x
- BTC2x
- ETH3x
- BTC3x
This proposal seeks $INDEX holder approval to launch these products.
Note: while these products share some similarities to the newly launched BTC2x and ETH2x tokens on main-net they will not be identical. Bridging the L1 products to Arbitrum L2 will not translate into holding these new tokens. If you are unsure which product is which or correct for you please reach out in the community discord.
2 Market information
2.1 Target customer segments & user stories
User stories:
- As a token holder, I want leveraged exposure to ETH or BTC
- As a token holder, I want the convenience of automated liquidation protection on inverse and leveraged positions.
- As a token holder, I want access to leverage with lower overall costs compared to perps.
- As a token holder, I want persistent leverage instead of decreasing leverage as prices rise or increasing leverage as prices fall.
2.2 Market research
The primary motivation for launching a suite of leverage products on Arbitrum is to enable users to maintain automated leverage exposure using Index Coop products on a chain with substantially lower gas costs and that is popular with traders.
This is seen in the popularity, TVL, volume and number of users seen on Perp DEXs such as GMX.
GMX quick Stats*:
- Followers on X 233k
- TVL: $536m
- Volume (1m cumulative): $190b
- Users: 5k (1w total)
Index Coop has developed new smart contract infrastructure on Index Protocol that enables leverage strategies on Aave V3. This new infrastructure enables automated leverage tokens as well as leverage staking strategies. For this reason, the new Leverage Suite tokens will be built on Index Protocol using Aave V3 for collateralised debt position management.
Leverage tokens on L1 have been some of the Index Coop’s most popular and successful products. With more and more users using L2s and the rise in leverage trading we believe such products can offer something different from the range of leverage solutions already available.
On Ethereum mainnet over 4,000 unique addresses currently hold ETH2x. For BTC2x, there are currently ~800 unique. These holders represent a significant share of Index Coop’s user base and contribute meaningfully to TVL and recurring revenue. New and existing user activity has also increased in recent months. The new suite on Arbitrum will allow users to transact at much lower gas costs.
2.3 Differentiation
The following products or services offer similar value propositions to users:
Feature Comparisons:
Here we can see the largest perpetual platforms do not offer liquidation protection, persistent leverage, or coverage of rebalancing costs. Many leverage automation solutions on the market today require users to open a smart wallet (abstracted account) in order to effectively manage users positions on their behalf which creates a barrier to entry. Again Index Coop differs, users are not required to complete additional steps/txns. Just the usual token approvals to issue and redeem.
2.4 Marketing support / distribution / partnerships
At launch, the Leverage Suite Products will be available to unrestricted persons and not for restricted persons as defined here via:
- Index Coop App for trading
Additional partners may be onboarded before and after launch. Self-issuance support will be enabled through the Index Coop App and also made available through the Self-issuance SDK for external integrations.
2.5 Marketing risks and weaknesses
- Users and liquidity are fragmented across L2s
- Users are familiar with Perp DEXs
3 Financials
3.1 Fees
The Leverage Suite tokens will have fees as follows:
| Product | Annual Streaming Fee | Issuance / Redemption Fee |
|---|---|---|
| iETH1x | 3.65% | 0.10% |
| iBTC1x | 3.65% | 0.10% |
| ETH2x | 3.65% | 0.10% |
| BTC2x | 3.65% | 0.10% |
| ETH3x | 5.48% | 0.10% |
| BTC3x | 5.48% | 0.10% |
Higher fees are charged on the higher leverage products as users would be paying comparatively higher funding rates on perps where funding rates scale with leverage.
Note: lower fees do not apply to the 1x inverse tokens as they are technically the same leverage ratio as a 2x long token (users can think of an iETH1x token as being 2x long USDC against ETH, or a USDC2x token with ETH as the debt asset).
3.2 Fee splits
Index Coop will earn 100% of the revenue from these new leverage tokens, but may enter into revenue-sharing agreements with third parties when appropriate and compliant; Index Coop will also cover 100% of the gas costs associated with rebalancing.
3.3 Product Costs
The cost to IC to launch and maintain these products is negligible in terms of capital outlay and ongoing expenses due to extremely low gas costs. The protocol is already deployed to Arbitrum including the internal smart contract infrastructure.
4 Specification
4.1 Product design
4.1.1 Range-Bound Methodology
The Index Coop Leverage Suite will utilise a range-bound methodology.
For users familiar with the legacy FLI products please read here for the differences in range-bound vs Flexible Leverage Methodologies.
In a range-bound leverage methodology, rebalancing only occurs when the current leverage ratio is less than the minimum leverage ratio or greater than the maximum leverage ratio.
When a rebalance is triggered leverage ratios are brought back within the min and max params. If the recentering speed is set to 0% then a product set to ~1.74x - 2.3x would re-lever to exactly ~1.74 or de-lever to 2.3x. In order to prevent excessive minor rebalances occurring when the leverage ratios are resting just on the boundaries a recentering speed >0% is applied. This means a product with the above params would re-lever to ~1.91x or 2.07x.
4.2 Token Parameter Settings
4.3 Backtest Results
The following backtests are to demonstrate the behaviour of automated leverage positions with the parameters in the previous section. Three different time spans across three different market scenarios have been chosen to illustrate the effects of holding periods, volatility and performance.
Please note that the products are labelled XXX followed by their target leverage ratios. Labels marked -1,2,3xXXX denote a literal multiplication of the target asset RIO to illustrate product performance vs what an inexperienced user might expect taking the leverage ratios at face value.
Data used includes swap fees from rebalancing, estimated average cost of carry and streaming fees.
Short term uptrend
Summary:
Mild outperformance of the -1 and 2x products. Strong outperformance of the ETH3x, this is due to the compounding effect of re-levering into the steady bullish uptrend.
Short term flat trend
Summary:
Mild effects of vol decay leading to mild underperformance of the inverse and 2x strategies and more material underperformance as expected from the 3x.
Short term downtrend
Summary:
Mild outperformance. Deleverage effect more pronounced on the 3x long product. Liquidation protection also observed as a non automated 3x position would have been liquidated at -100% without a user taking action.
Medium term uptrend
Summary:
Limited volatility uptrend. Deleveraging effect observed in the inverse product leading to outperformance. Low volatility leading to closer tracking of illustrative “benchmarks”.
Medium term flat trend
Summary:
Mixed volatility sideways trend. Sharp upswing in the middle of the period exposes the limitations of leverage even with automation as the target leverage ratio lags the move leading to tracking error vs the benchmark. Effect is compounded with higher leverage ratios hence the 3x version under performing the 2x despite BTC being slightly up overall.
Medium term downtrend
Summary:
Steady downtrend. Inverse position showing strong outperformance due to leveraging back into the trend. Long positions down significantly as expected but again liquidation protection displayed as unmanaged long positions would have been liquidated.
Long term uptrend
Summary:
Eventual outperformance of long trades towards the end of the period but users should note the ~4 months of significant drag roughly between Nov 23 - March 24.
Whilst the outperformance is clearly impressive the next charts will demonstrate the risks of using leverage products over long time periods when the trend does not go in the users favour.
Long term flat trend
Summary:
Arguably the most important example and chart to take note of and understand. Rebalancing leveraged positions suffer from something known as volatility drift.
A simple generalisation to describe this is that the leverage ratio has an inverse relationship to the direction of the price movement. For instance as the price of wBTC increases the LR of a long position falls. In order to increase the leverage ratio back to target a rebalance is required. More USDC is borrowed against the increased value of the wBTC collateral and used to buy more wBTC. The opposite happens when the price of wBTC falls. As you can see the position is buying wBTC as prices are rising and selling as prices are falling. In short, buying high and selling low. Volatility in the underlying asset increases the probability of the product reaching the Min and Max LR boundaries resulting in more rebalances and possibly in greater sizes. And so the more volatility the more value is lost. Fortunately the relative % of the value being rebalanced is low vs the total value of the product. But over time this adds up and compounds. This can lead to extreme underperformance if left unchecked.
In the example we can see that BTC experienced a volatile year with 25% drawdowns followed by 50% upswings with dips in between. Whilst BTC finished the period up ~25% the 2x product has the same ROI rather than ~50%. However the 3x really shows the power of volatility decay in action. Instead of a 75% ROI it ends the period slightly negative. Something inexperienced users would likely find counterintuitive. It is therefore imperative users understand volatility drift and regularly check their positions. The automation features are designed to offer users convenience NOT for long term passive exposure.
Long term downtrend
Summary:
Significant and choppy downtrend. The inverse position performed well but there were instances of underperformance. Whilst the long positions were not liquidated the 2x ROI = -95% whilst the 3x = -99.67%
To put this into perspective a 3x user would need a following 30,200% ROI just to breakeven. This would require BTC achieving a 100x in price before even taking into account any volatility drift.
4.4 Governance
The methodology as detailed above must be voted on and approved by $INDEX token holders before launch. Any material changes to the methodology will be communicated externally and are also subject to an $INDEX token vote.
4.5 On-chain liquidity analysis of underlying tokens
The underlying assets – WETH, WBTC, and USDC – are all extremely liquid.
5 Product liquidity
Users will be able to directly issue and redeem leverage tokens via a dedicated Leverage Suite app site; there will be no dependency on secondary market liquidity for leverage tokens.
6 ‌Methodologist Background
Leverage, trade and risk params have been proposed by the Index Coop core product team.
7 Disclaimers
You shall not purchase or otherwise acquire our restricted token products if you are: a citizen, resident (tax or otherwise), and/or green card holder, incorporated in, owned or controlled by a person or entity in, located in, or have a registered office or principal place of business in the U.S. (defined as a U.S. person), or if you are a person in any jurisdiction in which such offer, sale, and/or purchase of any of our token products is unlawful, prohibited, or unauthorised (together with U.S. persons, a “Restricted Person”). The term “Restricted Person” includes, but is not limited to, any natural person residing in, or any firm, company, partnership, trust, corporation, entity, government, state or agency of a state, or any other incorporated or unincorporated body or association, association or partnership (whether or not having separate legal personality) that is established and/or lawfully existing under the laws of, a jurisdiction in which such offer, sale, and/or purchase of any of our token products is unlawful, prohibited, or unauthorised).
None of our token products have been or will be registered under the U.S. Securities Act of 1933, as amended, or with any securities regulatory authority of any state or other jurisdiction of the U.S. Our restricted tokens may not be offered, sold, or delivered within the U.S. to, or for the account or benefit of, Restricted Persons. Our restricted tokens that may be offered on secondary markets and other platforms are not for distribution to any Restricted Person. No offers, sales, resales, or deliveries of any of our token products may be made in or from any jurisdiction (including the U.S.), except in circumstances that will result in compliance with any applicable laws and regulations and that will not impose any obligations on Index Coop. Persons who obtain our token products are required to inform themselves about and adhere to any such restrictions. Index Coop reserves the right to impose further restrictions at its sole discretion, which will be communicated through its terms of service or on its website. All website users, including U.S. Persons, must read our Terms of Service and List of Restricted Tokens. U.S. person(s) must comply with our Terms of Service and not use restricted Index Coop tokens.
*Index Coop does not provide tax advice. Nothing contained in this document should be construed as tax advice, and you should consult with your own tax advisor before making any financial decisions.
8.1 Copyright
‌Copyright and related rights waived via CC0 2.