The Best Way to Get Leverage in Crypto?
Today we're covering Protocol FX, an ETH, BTC and now alt coin based spot leveraged protocol on Ethereum.
Introduction
In todays market and when the bull market comes in its full force (if it does of course!), many are expecting blue chip assets like ETH to at the very least reach and perhaps surpass its previous all time high price. Last cycle, that stood at just under $5000.
Given the significant upgrades ETH has brought out from last cycle including proof of stake, the rise of Eigen Layer and restaking, ETH L2s with real success and the now live ETH ETF - can it go higher?
Okay, if not for ETH, perhaps BTC right!
One of the ways investors like to get increased exposure to a variety of assets is via leverage, however, leverage itself has a number of different risks depending on the exact strategy deployed. Many have cons that make it difficult to hold long term and other elements that need to be taken into consideration before positioning in these instruments.
The Power of Leverage
Personally, I can think of 3 distinct ways an investor would get leverage on their ETH, which each having both pros and cons that I think are worth noting.
Leverage via perpetual futures
Leverage via call options
Leverage via looping money markets
How to get leverage via perpetual futures?
Perhaps one of the most common methodologies we have around today in the DeFi space, partially due to its popularity, its simplicity, and of course the vast number of protocols to use perpetual instruments on. Perps are the trading derivative that let you either long or short with a slider to decide how much leverage you would like to take. These instruments track the underlying assets price and have what is known as funding rates to enable prices to be as close to the underlying asset as possible.
These are great because they are simple (green or red button), there is no time dependency, you can choose the leverage you want, hedging is possible, and there is a wide market of alts to choose from too (depending on which protocol you use). Protocols like Hyperliquid, dYdX, GMX, IntentX, Jupiter, Vertex, Drift and many others are some of the leading apps within the perpetual space. Perps are not all happy and sunny though, unfortunately, there are some cons that make other options at times more attractive and these are:
The Funding Rates - the on going fees paid by either longs or shorts to keep the perp instrument price in line with the underlying.
Liquidation risk - the risk of capital loss if price falls or rise above a certain price after which your position is liquidated and at times results in complete loss of capital.
Spread risks - the price differences between buyers and sellers that result in worse trading execution / slippage.
High fees - the fees associated with opening and closing positions.
How to get leverage via call/put options?
Options are one of the most interesting instruments when it comes to adding a tool to your trading or investing arsenal. For those new, options are contracts exchanged by buyers and sellers that give the buyer the right but not the obligation to exercise a trade at a certain pre-determined price at a date in future.
An example is an ETH call option expiring on the 1st of December 2024, with a strike price of $4000. The buyer pays a premium to the seller, lets say $50 and is able to have the exposure of 1 whole ETH with this capital. If ETH goes to $4500, the buyer can exercise this option and make multiple x’s on their original investment. On the other hand, if the price of ETH ends up being $2000, they can choose not to exercise and at max, their downside is the $50 they spent.
One of the reasons options are interesting is because unlike perps which are fairly straight forward, with options, you have the choice to build very different strategies with very different pay offs. These include being long or short on volatility, hedging strategies, and more. Even if you think prices will remain flat, there is an option strategy for you to use. Of course today we’re talking about leverage and with this call options (or put options) can give you significant leverage on your capital plus there are no funding rates or liquidations. Like perpetuals however, there are downsides, there include:
Time weighting dependency - options have a time component to them and can therefore expire worthless.
The current option market on chain doesn’t have enough TVL to support significant option trading nor is there support for a wide range of alt coins.
The difficulty in pricing implied volatility for assets on chain.
How to get leverage via money markets?
Money markets or lending/borrowing protocol have risen to popularity being on the biggest sectors of DeFi. Pioneered by the likes of AAVE, leverage is possible here by unlocking ‘extra’ capital you can do whatever you like with! It works by lending your asset and then borrowing stable coins against this collateral which now gives you the capital to use at your wish. The looping strategy involves buying more of the asset with this, lending it out again, borrowing more stables, buying more of the asset and repeating the cycle X number of times determining your leverage.
The concerns here remain around a few specific things:
Liquidation - if you over leverage yourself and borrow at a high utilisation, the collateral ratio will be as such that small price changes could end up liquidating your collateral.
Interest rates - these at time are dynamic and at high utilisation can be double digits which certainly add up over time.
Smart contract risk - money markets, especially newer protocols have traditionally been higher risk than many other protocol types.
High utilisation risk - if there is high utilisation, at times it may not be possible to remove your collateral.
Protocol FX
As you can see, the 3 main instruments we have today to get leverage have their cons. Thankfully, today I’ll be talking about a way to get ETH leverage without paying interest or funding rates, without significant liquidation risk and without any time dependencies, these are called x assets by Protocol FX. To understand how x assets and it’s built in leverage works, you briefly need to understand Protocol FX and how it works.
Protocol FX have 2 derivatives for every assets they support, a stable asset (often referred to as the f asset), and the x asset (the asset that captures the leverage). Users can deposit assets like stETH or wBTC into a smart contract which can then split this and mint both the stable asset (f asset) and the volatile asset (the x asset). As the price of the underlying asset changes, the volatility similarly gets split across these two new assets and because one of them is a stable asset, the extra volatility can flow into the x asset giving it ‘leverage’.
We’ll take stETH as an example for the below:
The total value of stETH deposited = the total value of fxUSD + the total value of xstETH.
As a user the choice can be made to mint either of the assets, the stable coin being collateralised and therefore the excess volatility can be transferred to the x asset.
This means when the price of ETH goes up, the x asset goes up ever more (depending on what the leverage factor is) and when the price of ETH falls, xETH falls at a significantly higher rate. No funding rates, no liquidations, no borrow rate. Just pure spot!
Here is my referral code to get started (by using this you help support me but no worries if you don’t want to!) - Try FX Protocol here!
How does it compare to holding spot ETH?
Lets take a look at 2 possible positions:
Position 1 - buying $10,000 worth of ETH
Position 2 - buying $10,000 worth of xstETH
If ETH goes up 100%, then your holdings are worth double, at $20,000.
As xstETH currently offers 1.7x leverage, your balance will be $27,000. An additional 70% gained on the original investment
Obviously, the same things occurs on the downside too where your losses will get magnified based on the leveraged amount.
How to get access to leveraged tokens?
Head to the app → Click here to take you there
Minting directly from the protocol
Buying on the open market (ETH/Arbitrum - DEX)
Given that ETH GWEI has been as low as 1 GWEI recently, using the ETH L1 chain has been pretty convenient!
For those that prefer L2s, they’re also an option. Arbitrum is a great place to get yourself from Protocol FX exposure with xETH which currently has liquidity sitting on Curve.
Simply go to any aggregator and you can buy xETH on Arbitrum directly there. We do need to see a little more liquidity but hopefully this can grow over time.
Composability
The most interesting elements on top of this come from being able to take an asset like xETH and use it across DeFi for other strategies. One of these includes Timeswap where you can lend it out or borrow against it - the later of which gives you the option to leverage up or even short.
What are the risks?
The risks here come from a few areas
Blockchain risk - risks of using assets on chain and on L2 chains
Smart contract risk - the risk of smart contracts being exploited and backing being drained
Lack of demand for the sister product fETH → xETH wouldn’t get much leverage. This at the worst case scenario would make xETH = ETH in terms of 1x leverage.
A massive price drop in the underlying assets in which the stability pool is unable to rebalance the protocol, the price of xETH can fall to zero
Conclusion
In general, if you can tolerate these risks, levered spot tokens provides a wonderful opportunity to not have to hold an asset as spot without paying a borrow fee, without paying funding rates and without having to worry about liquidations whilst still having a levered exposure to the asset.
It’s one of my favourites for now (this can always change as crypto is so reflexive) but hope to have shared something new with you and something you can potentially benefit from!
What do you guys think? Let me know!
The contents of this issue do not constitute towards any financial or investment advice, rather this newsletter consists of posts containing just my own personal thoughts and experiences and I am not a financial advisor.
ETH is being cannibalized by L2s. My confidence level in it soaring far above its previous ATH has tanked. I don’t want levered ETH. Solana or SUI, however… I’d like to see more articles on leverage in those ecosystems. Cheers