Need to Know Intel

FLI investors can experience exceptional performance while the market is on an upward trajectory. However, investors need to understand the four performance and four technical risks inherent in flexible leverage index (FLI) products

Flexible Leverage Index products are ERC-20 tokens created by the Index Coop to give double (2x) exposure to Bitcoin, Ethereum, Matic and other popular crypto tokens. These products are appealing because they allow investors to gain exposure to leveraged returns while greatly reducing the risk and complexity normally associated with leveraged trading. In this post we provide information on the following risks inherent to owning FLI products.

• Difference in Performance

• Predictability

• Value Loss

• Liquidation

• Secondary Markets

• Smart Contract

• Dependency

• USDC Centralization

Performance Risks

1. FLI Tokens perform differently than a simple leveraged position

The returns from using a FLI token will not be as predictable as using a simple leveraged position to execute the same trade. Using a simple leveraged position, a trader deposits collateral on an exchange and takes a position that will return a simple multiple of the return on the underlying asset. For example, if a trader takes a 2x position on BTC, they can expect to see their returns exactly double BTC’s return. If BTC returns 10% they can expect a return of exactly 20% on their investment.

FLI products use a different mechanism and traders cannot expect to see their leveraged returns track the returns of the underlying asset as closely. Using a BTC2x-FLI token, investors can expect to see a similar return to a simple leveraged position, especially over shorter time-frames. Using our example above, a BTC return of 10% over a week will likely return close to 20% on BTC2x-FLI, however due to the flexible leverage ratio and daily rebalancing, it is unlikely to return exactly 20%.

2. FLI Tokens will perform less predictably during choppy markets

FLI tokens can be expected to perform predictably in positive market moves, and the return on a FLI token should track the 2x target during steady upward price movement with reasonable accuracy. All leveraged assets will perform less predictably in choppy or sideways markets. FLI tokens employ a flexible leverage ratio that helps to stabilize performance during these periods, but some divergence will occur. Traders should expect returns on FLI to deviate from the 2x target during these periods, and higher levels of volatility should produce a greater divergence. This is an example of a phenomenon called volatility drift, and is a characteristic of all leveraged assets and tokens.

3. FLI Tokens can lose significant value during a major market correction

FLI Tokens are designed to protect the user from the risk of liquidation during a large price correction. If the price of the underlying asset (ETH or BTC) falls very quickly, the rebalancing mechanism will begin to aggressively reduce leverage in order to stay within safe operating bounds.

While liquidation is very unlikely, FLI investors should note that their investment can still realise significant losses during a large price drop. For example, between May 15th to 23rd 2021, the price of ETH fell by 48%. During the same period an investment in ETH2x-FLI lost 72% of its value.

4. There is risk of liquidation in the event of a complete market crash

While a position held in FLI tokens cannot be liquidated, there is the risk that the underlying position in ETH or BTC can be. FLI tokens represent a managed leveraged position on Compound, and keeper bots automatically reduce leverage when prices decline in order to maintain a safe collateralization ratio. In the event of an extreme market crash, such as an instantaneous 75% drop, keeper bots may be unable to act fast enough to maintain required levels of collateral and the position could be liquidated.

Technical Risks

1. The price of FLI tokens may deviate from NAV on secondary markets

If the demand for FLI tokens exceeds supply on secondary markets, the price may exceed the NAV (Net Asset Value). In this situation traders are paying more for the token than what it is intrinsically worth, causing the price to rise. This can lead to a temporary price premium on a FLI token. Arbitrage bots have been deployed to respond to and minimize these deviations from NAV by minting new tokens. In May of 2021, due to high demand, the Supply Cap of mintable tokens was reached, and a premium on ETH2x-FLI developed that could not be rebalanced by arbitrage bots. Significant steps have been taken to prevent this from happening again including the delegation of parameter changes to specific community members in order to reduce governance risk and to expedite these processes in the future.

2. Smart Contract Risk

Smart contracts are essential building blocks in achieving the automation and reliability of FLI tokens, and any protocol in the DeFi ecosystem. They offer a high level of security and transparency when designed correctly. However all systems are prone to bugs and errors, and smart contracts offer lucrative opportunities for attackers if they can be hacked or exploited.

All FLI tokens are deployed on Set Protocol’s asset management platform. All of FLI’s underlying modules on Set Protocol have been fully audited. You can find more information here. The smart contracts for both ETH2x-FLI and BTC2x-FLI can be read online.

3. Dependency Risks

FLI tokens are dependent on a number of other decentralized protocols and are exposed to the risk of one of those protocols failing or being incapable of meeting the dependencies FLI requires to function safely. Primarily, FLI tokens are dependent on Compound, as well as decentralized exchanges like Uniswap and Sushiswap. As lending platforms and liquidity providers, these protocols are essential to manage and rebalance the underlying position in ETH or BTC. In the event where sufficient liquidity was not available, FLI tokens would be unable to manage the leverage ratio. Similarly, FLI relies on Chainlink’s oracle as a source of price information. If Chainlink failed to update that data FLI would be at risk as keeper bots may not be able to respond to price fluctuations.

4. USDC Centralization Risk

USDC is a completely centralized token that is controlled by Circle and Coinbase, and as such is subject to government regulation. In the event of regulatory intervention, USDC has a blacklist mechanism that can be toggled on to prevent transactions on an address. If regulators decided to enforce a USDC blacklist of Compound or FLI specifically, all of the USDC locked in the contract would become worthless.