The Index Coop’s leverage tokens, like our new  ETH2x and BTC2x tokens, have long been among our most popular products because they offer a simple way for users to access persistent targeted leverage on assets like Ethereum and Bitcoin. 

Typically, users use perpetual futures markets or create a spot leverage position manually or with the assistance of a tool like Contango if they want to access leveraged return. Both of these options require a sophisticated understanding of DeFi and financial markets. With the Index Coop’s leverage tokens, amplifying the price increases of ETH and BTC is as simple as buying any other ERC20 token. 

However, leverage tokens like ETH2x and BTC2x come with their own set of complexities and risks that are worth understanding. In particular, volatility drift can adversely affect their performance. 

Because of volatility drift, the long-term performance of leverage tokens doesn’t always match the expected multiple implied by the leverage ratio, especially in highly volatile markets. This can be confusing for users. 

With that in mind, this article will explain the causes and effects of volatility drift. 

We’ll cover the following topics:

1. Understanding the three causes of volatility drift 

2. How rebalancing to maintain the leverage ratio contributes to volatility drift 

3. How range-bound rebalancing mitigates volatility drift

4. How rebalancing costs contribute to volatility drift 

5. How borrowing costs contribute to volatility drift

Understanding the three causes of volatility drift

Volatility drift refers to how the value of a leverage position can decrease over time, failing to deliver the expected multiple implied by the leverage ratio, especially in highly volatile markets. There are three main causes of volatility drift. 

1. First, all products that target a persistent leverage ratio will suffer from compounding.

2. Second, each rebalance that occurs has a cost in price impact and trading fees. 

3. Third, borrowing funds on a lending protocol incurs a borrowing cost.

Let’s take a deeper look at all three causes of volatility drift.

‍How rebalancing to maintain the leverage ratio creates volatility drift 

You may know that when an asset goes down by 10% on day 1 and then up 10% on day 2, it does not return to its original price.

For example, say the price of ETH is $2,000 at day 0. If it declines 10% on day 1, the price will be $1,800. If it increases 10% on day 2, it will be $1,980. 

The same principle applies to leverage products, except that it is more exaggerated. 

Let’s take an example of a user who purchases $1,000 of ETH2x when the price of ETH is $2,000 and a current leverage ratio of 2.0. They will have $2,000 in ETH collateral and $1,000 in USDC debt for a NAV of $1,000. Now, let’s say the price of ETH increases by 10% to $2,200.

Example of the ETH’s price increasing by 10%

‍Now, imagine the product was rebalanced back to a leverage ratio of 2.0. To achieve this, ETH2x will borrow $200 USDC, sell it for $200 ETH, and add that as part of the collateral. Notice how the leverage ratio is pushed back to 2.0, but the NAV does not change. 

Example of a rebalance back to a leverage ratio of 2.0

It’s important to note that in this step, the price of the collateral and debt assets has not changed, but the amount of collateral and debt has changed. The index merely re-levering by borrowing more USDC and selling it for ETH. In the final step, let’s imagine the price of the collateral asset, ETH, going back to its original value. Here’s where you can see volatility drift in action. The price of the collateral (ETH) is back at $2,000, but the NAV of the position has declined from $1,000 → $981.81. This is due to the “snap-back” rebalancing to the leverage ratio of 2.0. 

Example of the ETH price returning to its original price of $2,000

‍How range-bound rebalancing mitigates volatility drift

As we saw in the previous section, rebalancing to maintain the leverage ratio can cause significant volatility drift. To help mitigate this problem, Index Coop leverage products use a range-bound rebalancing methodology. 

This approach establishes a lower and upper bound of leverage, maintaining a target leverage ratio within these bounds. The products only rebalance towards the target when the leverage ratio exceeds this range. 

This helps prevent the aggressive “snap” back to the leverage ratio we saw in the previous section. 

In the case of ETH2x, the bounds are set at approximately 1.7 - 2.3, so in the above scenario, where the price of ETH increased from $2,000 to $2,200 and back to $2,000, ETH2X would not have rebalanced. Instead, it would have returned to its original NAV.

Over time, though, the price of ETH will move, and the leverage ratio will exceed its bounds. Index Coop’s products have small rebalances that nudge the leverage ratio back within the bound. Over a long period, these small rebalances have had a similar effect on the NAV of products, as shown above. Any time there is rebalancing, there will be volatility drift.

Index Coop’s products target a specific leverage ratio, which fluctuates as the price of the underlying asset changes. The ratio has upper and lower bounds. 

Let’s take an example of a user who purchases $1,000 of ETH2x when the price of ETH is $2,000 and a current leverage ratio of 2.0. They will have $2,000 in ETH collateral and $1,000 in USDC debt for a NAV of $1,000. Now, let’s say the price of ETH increases by 10% to $2,200.

Example of the ETH’s price increasing by 10%

When the leverage ratio goes outside the upper or lower bounds, the product is rebalanced. In the example above, you can see that the leverage ratio decreases as the price of the collateral asset increases. Similarly, the leverage ratio increases as the price of the collateral decreases. 

Range-bound rebalancing allows a leverage ratio to remain persistent around the target leverage. To minimize volatility drift, these products use what is known as recentering speed. When a product’s leverage ratio exceeds its bounds, it rebalances but doesn’t snap back to the target leverage ratio in one sudden move. Instead, it is gently nudged back towards the target.

How rebalancing costs contribute to volatility drift 

The cost of rebalancing is another contributing factor to volatility drift. Three costs go into a rebalance: 

• Swap fees

• Price impact

• And gas fees. 

You're familiar with these costs if you’ve ever traded on a DEX. 

In Index Coop’s leverage products, the gas fees are paid for by the DAO, but the price impact and swap fees are paid by the product (i.e., the holders of the product). Fortunately, price impact and swap fees are minimal since the leverage products are only available for the most liquid assets in DeFi, but these costs can still add up over time. The more rebalance volume the product has, the more swap fees and price impact will occur. 

Index Coop dampens the price impact by checking the liquidity of DEX pools and setting strict maximum trade sizes. Ultimately, that costs Index Coop more money, but it is extremely important for the performance of these products.

How borrowing costs create volatility drift

The final major cost that impacts volatility drift is the net cost of borrowing assets from Aave. In onchain lending protocols like Aave, you supply collateral and borrow debt. When supplying assets, the user earns the variable supply rate; when borrowing assets, the user pays the variable borrow rate. Let’s say that the supply rate for ETH is 4%, and the borrowing rate for USDC is 6%.

In this case, the cost of carry is advantageous. The user would be earning 2% per year from holding the position! However, this isn’t always the case, and the cost of carry can change. It’s important to note that the cost of carry, in the long run, is significantly less than the typical funding rates on perpetual exchanges.