The rebalancing mechanism for leveraged tokens is more suitable for one-sided markets. This method enables the user to multiply trading earnings through the compound effect. However, they may also lead to significant fund losses amid a two-sided market shakeout.

Compound Effect and Fund Losses

Leveraged tokens utilize the rebalancing mechanism to amplify the daily change (rather than annualized PnL) of the underlying asset. Rebalancing is essentially a process where traders buy low and sell high. When the underlying asset price goes up, the real leverage level of the corresponding positions of leveraged tokens will be lower than the target leverage. Thus, fund operators need to long contracts at a higher price to increase the leverage level. The rebalancing works in reverse when the price goes down.

Owing to the mechanism, daily rebalancing would generate compound effect on a one-sided market, while the underlying asset price would swing back to its original level amid large market fluctuations. This would result in a decline in the account net value of leveraged token holders causing fund losses. 

Take AscendEX’s BTC3L as an example to explain how compound effect and fund losses occur.

1.     The compound effect in a one-sided market

1)     The market moves up in one direction

BTC3L:

The BTC price rose 10% from 100 USDT to 110 USDT on day 2. At this point, BTC3L’s net value is 100*（1+10%*3）=130 USDT.

The BTC price rose 9.09% from 110 USDT to 120 USDT on day 3. At this point, BTC3L’s net value is（1+9.09%*3）=165.451 USDT.

In the two-day market rally, BTC3L’s overall gain is（165.451-100）/100*100%=65.451%>60%. 

As such, when the market moves up, leveraged tokens generate higher returns than perpetual contracts of the same leverage with more advantages.

2.     The market moves down in one direction

BTC3L:

The BTC price tumbled 10% from 100 USDT to 90 USDT on day 2. At this point, BTC3L’s net value is 100*（1-10%*3）=70 USDT.

The BTC price dropped 11.11% from 90 USDT to 80 USDT on day 3. At this point, BTC3L’s net value is 70*（1-11.11%*3）=46.669 USDT；

In the two-day market decline, BTC3L’s overall loss is（（100-46.669）/100*100%=53.331%< 60%.

As such, when the market moves down, leveraged tokens post smaller losses than perpetual contracts of the same leverage with more advantages. 

Please note: To facilitate calculation and understanding, the above cases take no account of such trading costs as transaction fees and funding rates that occur in actual transactions.

2.     Fund Losses amid Two-Sided Market Shakeouts

1)     The market declines shortly after a rally

BTC3L:

The BTC price rose 10% from 100 USDT to 110 USDT on day 2. At this point, BTC3L’s net value is 100*（1+10%*3）=130 USDT.

The BTC price fell 9.09% from 110 USDT to 100 USDT on day 3. At this point, BTC3L’s net value is 130*（1-9.09%*3）=94.549 USDT.

In the two-day market shakeout, BTC3L’s overall change is（94.549-100）/100*100%=-5.451%.

2)     The market rallies shortly after a decline

BTC3L:

The BTC price declined 10% from 100 USDT to 90 USDT on day 2. At this point, BTC3L’s net value is 100*（1-10%*3）=70 USDT.

The BTC price rose 11.11% from 90 USDT to 100 USDT on day 3. At this point, BTC3L’s net value is 70*（1+11.11%*3）=93.333 USDT.

In the two-day market shakeout, BTC3L’s overall change is （93.333-100）/100*100%=-6.667%. 

Although the BTC price returned to its original level amid two-way market shakeouts, losses have been incurred for the net value of leveraged tokens. Therefore, leveraged tokens should only be taken as a short-term hedge tool, but rather a long-term investment.

Risk Disclosure: As an emerging financial derivative, theoretically, there is no liquidation risks for a leveraged token. However, with incorrect trend predictions, there will be a risk that the net asset value of a leveraged token approaches 0 amid extreme market conditions. Please fully understand the rules before engaging in leveraged token trading and be cautious to reduce potential risks.