Understanding Leverage Tokens vs Perps

The Index Coop Arbitrum Leverage Suite provides users with quick, simple, and convenient access to automated leverage for BTC and ETH with liquidation protection. These tokens are all fully collateralized at all times using Aave V3 to create collateralized debt positions underneath.

This article will examine:

• Differences between how Perps and Leverage Tokens function
• Understanding Funding Rates and Cost of Carry
• Pros and Cons of Leverage Tokens vs Perps
• Detailed Parameters

Perps and Leverage Tokens

What are Perps?

Perpetual futures, sometimes referred to as perpetual swaps or “perps”, are a type of derivative contract that allows traders to speculate on the future price of an asset. Traditionally, futures contracts have an expiration date; however perpetual futures do not, hence the name.

Perps have been popular across centralised exchanges for some time, but more recently thanks to the cheaper transaction fees on L2s or alternative L1s, decentralised perp exchanges have been made possible and even successful.

To open a perp position, users must deposit collateral to their account; this is sometimes referred to as margin. Perps traders do not have to use the underlying assets as collateral if they choose not to. Stablecoins are often a popular choice. As a simple example, User A can deposit USDC to a perp dex and take a $1,000 10x long BTC position, meanwhile User B can also deposit USDC and take an equal-sized short position. If BTC increases by 5%, User A will be up 50% and User B down 50%. Neither the exchange nor the users have touched BTC. It is simply users betting on the price of BTC using another asset as collateral.

If users do not keep enough collateral or margin on account, their positions can be liquidated if the market moves against them. This is when the exchange automatically closes the position before a loss larger than the user's collateral can occur.

Perps can offer very high levels of leverage and can potentially be more liquid than spot markets (especially on Layer 2s). Traders do not have to own or deliver the underlying asset/s.

What about Leverage Tokens?

How Leverage Tokens work can be found in the previous intro article. As a quick recap, Leverage Tokens are fully collateralised by the underlying assets. For instance, the ETH3x product supplies WETH to Aave v3, borrows USDC, and swaps the USDC for more WETH. This is then deposited back to Aave again as collateral to borrow more USDC. This process is repeated or looped until the desired amount of leverage is achieved. This creates a dollar-denominated debt position that can only be repaid by withdrawing some of the deposited WETH. If the price of ETH falls the value of the collateral has fallen relative to the debt and so the net value of the position is less.

As you can see this is very different from a perp where the underlying asset is not required.

Funding Rates and Cost of Carry

Perp traders pay a funding rate which helps to keep the price of the contracts close to that of the underlying. When significant numbers and/or sizes of trades are made in the same direction the funding rate increases (if too many longs) or decreases (if too many shorts) to incentivise traders to take the other side and keep the market balanced and prices in-line. Funding rates are paid periodically between longs and shorts. How funding rates are calculated depends on each exchange.

A simple example on how funding rates are applied in practice:

• User A opens a $10,000 1x long BTC position
• If the funding rate is 0.01% per epoch (ex. every 8 hours) they will pay $1 to the short traders
• So a user with a $10,000 1x short BTC position will receive $1
• Everything remaining equal if they did this every day for 1 year the long would pay a total of $1,095 to the short trader
• If a user opens a 2x position they will pay 2x the funding rate and so on.

Leverage Tokens on the other hand do not pay funding rates. However, as they are depositing collateral and borrowing assets from a lending protocol both positions are liable to interest rates. The net of which can be referred to as the “Cost of Carry”.

A simple example for ETH2x and Inverse ETH1x:

• ETH2x
  • $1,000 of WETH is supplied to Aave earning 2%
  • A total of $1,000 USDC is borrowed at 5%
  • This is then swapped for WETH and re-deposited leaving;
  • $2,000 of ETH earning 2% and $1,000 of USDC debt paying 5%
  • Net Cost of Carry = -1%
• iETH1x
  • $1,000 of USDC is supplied to Aave earning 5%
  • A total of $1,000 of WETH is borrowed at 2%
  • This is swapped for USDC and re-deposited leaving;
  • $2,000 of USDC earning 5% and $1,000 WETH debt paying 2%
  • NET Cost of Carry = +1%

On Aave V3 the interest rates are determined by the supply and demand of lenders and borrowers. This is known as Utilisation. As more assets are borrowed from a market or “Utilised” the interest rate gradually increases. Above a certain threshold however (usually around 90%), the rate dramatically increases with subsequent demand. This is known as the kink rate and is designed to drastically reduce borrowing demand so that the pool remains functional and a certain level of deposits can still be withdrawn from the pool.

Summary: Why are Funding Rates and Cost of Carry Important?

Simply put, perp funding rates can reach eye-wateringly high levels during periods of elevated demand for leverage. These rates are typically much higher than the cost of carry on Aave. 

This is shown in the chart below. Where the approximate net cost of carry of an ETH2x leverage token from Index Coop (including the 3.65% streaming fee) is much lower than the funding rates paid on an equivalent 2x perp position across some of the largest and most popular perp exchanges.

While there are instances where the funding rate becomes negative on certain platforms, leading to longs being paid rather than charged, the overall trend remains clear. As observed in the table below, for the most recent 90 days ETH2x would have been significantly cheaper than an equivalent perp position.

Even with the cost of carry more often being lower than funding rates, it can still be volatile. On top of the usual risk management, these are examples of why it is important for all leverage users to regularly monitor their token holdings and understand the mechanics and details of the platforms and products they use. Perp platforms do not typically display funding rates prominently or on an annualised basis making them difficult or unintuitive to understand and/or compare. Index Coop is fully committed to transparency and clarity for all users. Cost of carry will always be clearly displayed on Index Coop’s leverage trading interface; historical data will also be available in Dune.

Where to access the Leverage Suite

The Leverage Suite is available via: app.indexcoop.com/leverage, but not to Restricted Persons (including U.S. Persons).

Users of the Leverage Suite and Index Coop website must do so in accordance with Index Coop’s Terms of Service while also noting the list of Tokens Restricted From Restricted Persons. The Index Coop application site at app.indexcoop.com uses a range of technologies to ensure agreement and compliance with the Terms of Service.

Important risk notice

Index Coop is committed to full and fair disclosure and it is important for users to understand that the Leverage Suite - of inverse and leverage tokens on Arbitrum - is a collection of high risk token products. Crypto assets themselves are risky and volatile compared to traditional assets people are more familiar with and the products in the Leverage Suite add further risk and volatility to the user. Simply put, users of crypto assets should be aware that this volatility means they could lose a lot of their money quickly - and users of the Leverage Suite bear this risk to an even greater degree. Users should be absolutely sure that the Leverage Suite tokens are suitable tools to help them achieve their financial goals and if they are not sure, they should seek financial advice to help understand these tokens better.

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