DeFi, in particular, has benefited tremendously from composability, and Flexible Leverage Index tokens (FLI) are an excellent case study for understanding composability and its implications for financial innovation.
First, let’s define composability. Composability is an innate feature of Ethereum applications that allows them to be used as building blocks for other applications. In other words, if an application is deployed to the blockchain, other projects or protocols can generally plug into that application and leverage its functionality. For this reason, these decentralized applications are often referred to as legos because they can be pieced together to enable new functionality and create new use cases.
To make things less abstract, let’s take a look at FLI tokens. FLI tokens create 2x exposure to the underlying assets with the use of leverage, or debt. In order to create a leveraged position, you must be able to:
Building a money market from scratch is no small task. Sourcing liquidity, establishing security, and managing reserve factors are only a few of the many hurdles to clear, and ensuring technical and financial scalability is an entirely different set of problems.
Thankfully though, there are money market protocols on Ethereum like Compound and Aave that offer permissionless borrowing and lending capabilities. So instead of starting from scratch or relying on multiple intermediaries, the smart contracts that manage FLI products can simply plug into Compound or Aave, post collateral, and borrow the assets needed to generate leverage.
In the case of ETH2x-FLI, the smart contracts deposit ETH as collateral to Compound and borrow USDC; BTC2x-FLI posts wBTC as collateral and also borrows USDC.
After borrowing the appropriate assets, borrowed assets must be exchanged for the asset to which you want leveraged exposure to (i.e. ETH or wBTC). If you were to start a market like this from scratch, you would need to find willing participants, source enough liquidity, and develop some sort of order matching mechanism, which would prove to be an entire project in and of itself.
Again though, existing on-chain innovation in the form of Decentralized Exchanges (DEXs) enables FLI smart contracts to quickly and efficiently exchange assets in a plug-and-play fashion. DEXs like Uniswap and Sushiswap provide deep liquidity, heightened security, and self-custody for the smart contracts that manage FLI products and they play a critical role in generating leveraged exposure.
In the case of ETH2x-FLI, borrowed USDC is swapped for ETH on Uniswap, thus creating additional exposure to ETH on top of the existing position. This same process is executed in reverse whenever the product needs to be deleveraged in order to pay down the borrowed balance in Compound: ETH is swapped for USDC and that USDC is paid back to Compound.
Plugging into these different DeFi protocols instead of starting from scratch yields tremendous efficiency gains for FLI products because engineering resources can focus on improving debt management automation or iterating on rebalancing algorithms, rather than developing and managing a series of side projects. More broadly, these building blocks allow new projects and protocols to go to market more quickly and integrate advanced functionality at a more rapid rate than before. The result is an open, interoperable ecosystem with compounding innovation, and composability is at its core.
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