Leveraged tokens are derivatives that provide holders with stable leveraged exposure to crypto assets. Holders of such tokens do not need to worry about actively managing leveraged positions, borrowing, or liquidation. Once this model is replicated on-chain, it becomes possible to decentralize leveraged tokens—a product originally born off-chain. In this article, we refer to such products as decentralized leveraged tokens.
We analyze three decentralized leveraged token models currently available in the market: Set Protocol, Tracer, and Phoenix Finance, and compare the structural differences in their approaches.
Set Protocol
Overview
Set Protocol (also known as TokenSets) is a DeFi asset management platform currently operating on Ethereum and Polygon. Through this DeFi protocol, asset managers can create their own crypto asset exposure strategies, which Set Protocol packages into ERC20 tokens. Others can simply buy and hold these Set tokens to track or replicate the same exposure as the underlying strategy.
Set Protocol’s leveraged token model is called FLI (Flexible Leveraged Index). It functions like a tokenized index, tracking 2x leveraged exposure to the underlying asset. Currently, Set Protocol offers BTC 2x and ETH 2x FLI on Ethereum, meaning holders of these FLI tokens can maintain approximately 2x leveraged long positions on BTC and ETH.
How It Works
As mentioned, the active products on TokenSets are leveraged tokens representing 2x leveraged long positions on underlying assets, often referred to as "bull tokens." Set Protocol collaborates with Compound, one of the top DeFi lending protocols, to borrow assets for minting these tokens and to rebalance target leverage, ensuring the mechanism runs smoothly.
FLI tokens can be minted or purchased on the secondary market. When FLI tokens are minted, they are created via smart contracts. When purchased, they are traded on Uniswap.
Let’s take ETH 2x FLI as an example to understand the creation process.
ETH 2x FLI aims to maintain leverage between 1.7x and 2.3x. This target range is designed to reduce rebalancing frequency (which can be costly on Ethereum) and minimize "surprise" scenarios in financial performance due to continuous leverage rebalancing.
To mint ETH 2x FLI, users deposit ETH. To provide leveraged exposure, the protocol first deposits the ETH into a lending protocol like Compound, converting it to cETH. Using the deposited ETH as collateral, the protocol borrows USDC and uses it to purchase additional ETH on a DEX like Uniswap. This ETH is again deposited into Compound, and the borrowing and purchasing process is repeated to double the portfolio’s ETH exposure.
When redeeming ETH 2x FLI tokens, the reverse process occurs.
This minting and redemption process may be complex for less experienced traders and can involve high gas costs, especially on Ethereum.
To improve the user experience, the protocol created an ETH 2x FLI/ETH liquidity pool on Uniswap. Users can buy and sell ETH 2x FLI on Uniswap with standard gas fees, just like any other ERC20 token. Price slippage and market depth depend on the liquidity in this pool.
The same method applies to BTC 2x FLI.
Other protocols, such as Fodl, also use similar borrowing mechanisms to achieve leverage, though they are not pure leveraged token products.
Market Size
Set Protocol launched ETH 2x FLI in March 2021, followed by BTC 2x FLI in May. According to TokenSets data from October 18, 2021, the market capitalization of these FLI tokens was growing rapidly, with a total value of nearly $190 million.
Tracer
Overview
Tracer is a decentralized protocol for derivatives. Their current live product, called Perpetual Pools, launched on Arbitrum in September 2021. It is a decentralized model for creating leveraged tokens that do not expire or get liquidated.
Tracer’s pool model creates leveraged long and short tokens, representing respective leveraged exposures that can be traded on secondary markets. Long and short tokens are counter-parties; one’s profit is the other’s loss.
How It Works
Unlike Set Protocol, which creates leverage by integrating lending protocols, Tracer uses liquidity/collateral pools to mint leveraged long and short tokens. Each collateral pool has two opposing positions: long and short. Both sides are backed by collateral assets, and long and short tokens are issued in pairs. When the price changes, the collateral supporting both sides is redistributed based on a built-in algorithm, leading to price changes in the leveraged tokens.
For example, if the underlying asset’s price increases, long tokens gain collateral from the short token pool. If the price decreases, short tokens gain from the long token pool. The amount of collateral transferred is calculated using an embedded "power lever" model to avoid liquidation.
All value transfers and relative leverage are "updated" hourly (similar to scheduled rebalancing in other leveraged token models). This mechanism triggers transfers and mints/burns tokens according to the algorithm.
Note that a perpetual pool does not always hold equal collateral on both sides. This imbalance can result in varying leverage levels. The side with less collateral may have higher "profit leverage" and lower "loss leverage," similar to the funding rate mechanism in perpetual contracts.
Thus, real-time leverage in Tracer’s model depends on pool imbalance. Even after rebalancing, long and short tokens do not guarantee fixed leverage levels and may not move symmetrically.
Market Size
Tracer’s Perpetual Pools are still in early stages, having launched in September 2021. As of November, their total value locked (TVL) was around $40 million.
Phoenix Finance
Overview
Phoenix Finance is a DeFi protocol specialized in crypto financial derivatives. It currently offers two products: decentralized options and a leveraged token model, operating on Polygon, Binance Smart Chain (BSC), and Wanchain.
Phoenix Finance’s leveraged token model is highly flexible, supporting not only BTC and ETH but also a growing list of other tokens like Matic, Quick, AAVE, AXS, BNB, ADA, CAKE, WAN, XRP, and WASP across three chains, each offering 3x leverage.
How It Works
Like Set Protocol, leveraged tokens are supported by borrowing mechanisms. However, Phoenix Finance created its own lending pools to enable leverage. Stablecoin pools support "bull tokens," while pools of underlying assets support "bear tokens." Users can contribute assets to these lending pools, earn passive yield, and receive farming rewards. Loan APY depends on pool utilization.
According to their documentation, Phoenix Finance does not currently integrate with external lending protocols for two main reasons:
- Protocols like Aave or Compound have their own collateral ratio requirements, which limit maximum achievable leverage. For example, a 60% loan-to-value cap allows a maximum leverage of 1/(1-60%)=2.5x. Higher leverage is not possible under these constraints.
- During extreme market conditions, lending protocols may face liquidity issues. If lending liquidity is exhausted, all deposited assets may become locked (as seen in Aave in late October 2021). This could prevent rebalancing and lead to failed leverage maintenance or even liquidation.
When users buy leveraged tokens on Phoenix Finance, the tokens are minted via smart contracts, triggering a series of transactions. The protocol automatically borrows assets from its lending pools and integrates with DEXs to swap for target tokens. For example, a 3x ETH bull token on Polygon would borrow USDC and swap it for ETH on Quickswap. Slippage depends on the depth of the relevant DEX pool.
When selling leveraged tokens, they are redeemed, and reverse transactions are executed.
The borrowed assets supporting the protocol’s leverage are collateralized by the total assets of the leveraged tokens and the trades themselves. This is not under-collateralized and allows flexibility to support any target leverage level—though higher leverage implies higher risk.
Market Size
Phoenix Finance’s leveraged tokens are still nascent with relatively low liquidity. However, their flexibility offers significant growth potential in the future.
Frequently Asked Questions
What are decentralized leveraged tokens?
Decentralized leveraged tokens are on-chain derivatives that provide automated leveraged exposure to crypto assets without requiring active management, borrowing, or facing liquidation risks. They are typically issued as ERC20 or similar standard tokens.
How do leveraged tokens maintain their target leverage?
Most models use periodic rebalancing mechanisms. For example, Set Protocol rebalances within a range to minimize costs, Tracer updates hourly using a pool-based algorithm, and Phoenix Finance uses custom lending pools and DEX integrations to adjust leverage as needed.
Can leveraged tokens deviate from their target leverage?
Yes, especially during high volatility or low liquidity. Protocols usually define a range (e.g., 1.7x–2.3x for Set Protocol) to reduce frequent rebalancing. Tracer’s leverage can vary based on pool imbalance.
What are the risks of using leveraged tokens?
Risks include protocol failure, smart contract vulnerabilities, liquidity issues during market extremes, and potential divergence from expected leverage due to rebalancing costs or market conditions. It’s important to understand the specific model and its limitations.
Where can I trade decentralized leveraged tokens?
Tokens from Set Protocol and Phoenix Finance are available on DEXs like Uniswap and chain-specific exchanges. Tracer’s tokens are traded on Arbitrum-based platforms. Always check liquidity and slippage before trading.
How do I choose the right leveraged token product?
Consider factors like supported assets, leverage level, chain compatibility, fees, and protocol security. Each model has trade-offs between flexibility, complexity, and decentralization. 👉 Compare real-time performance metrics to make informed decisions.
Conclusion
As we approach the end of 2021, decentralized leveraged tokens remain an emerging but promising tool for traders seeking stable leveraged exposure. Each model—Set Protocol, Tracer, and Phoenix Finance—offers unique mechanisms and advantages, with varying degrees of flexibility, complexity, and risk.
The space is still young, and continued development and adoption will likely bring improvements and new innovations. Whether you’re a trader, developer, or DeFi enthusiast, keeping an eye on these protocols can provide valuable insights into the future of on-chain leverage.