Insight: All about on-chain leverage

Disclaimer: This analysis is part of a grant from f(x) Protocol. The content of this article remains independent and f(x) Protocol has had no control over the published content.

Introduction and Context

Credit has become an essential element of our societies, underpinning the financing of companies and states, with interest rates directly impacting economic parameters such as unemployment and inflation. In finance, credit is equally important, often referred to as “leverage.”

Leverage is a form of credit that involves borrowing money to open positions in the markets with more capital than one actually holds. Like a physical lever, financial leverage amplifies potential gains in the markets but also magnifies potential losses.

Various financial products enable the use of leverage, most of which rely on a margin system: the trader deposits financial collateral against which they borrow a larger sum to gain market exposure. The collateral protects the borrowed assets. If the total loss on the position approaches the deposit amount, the trader risks liquidation, resulting in a total loss of their capital and automatic repayment of the loan.

Thus, leverage carries more risk than other forms of trading but offers potentially higher returns.

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Types of Leverage

When it comes to using leverage in the markets, the current financial ecosystem offers many possibilities. This phenomenon is even more pronounced in the crypto market, where decentralized finance (DeFi) allows developers to create novel mechanisms. In this chapter, we will detail the main centralized and decentralized solutions for using leverage in the crypto market.

Futures Contracts

A futures contract binds a buyer and a seller to exchange an asset at a predetermined date. At the contract's maturity, the seller agrees to deliver the asset to the buyer or provide a cash settlement equal to the difference between the initial and final prices.

If the asset price increases during the contract, the seller incurs a loss, compensating the buyer for the price difference. Conversely, if the asset price decreases, the seller profits by keeping the difference between the initial and final prices.

As these contracts are usually cash-settled, the required capital contribution is often a fraction of the contract's total value. This allows traders to purchase more contracts than they could with a spot position, where owning the underlying asset is necessary.

Centralized Perpetual Contracts

Futures contracts originate from traditional finance, where trading occurs only on weekdays during working hours. Crypto markets, however, are open 24/7. To adapt, the exchange BitMEX introduced the innovative concept of perpetual contracts in 2016, which have since become the most active markets in crypto.

A perpetual contract functions similarly to a futures contract, except it has no expiration date. Like futures, perpetual contracts allow leverage without the inconvenience of contract rollovers. This enables indefinite leveraged exposure to the crypto market.

Since perpetual contracts lack a maturity date, their price can deviate significantly from the underlying asset's price. To address this, a funding rate mechanism was introduced. This is a fee exchanged between buyers and sellers to align the perpetual contract price with the underlying asset price. If the perpetual price exceeds the asset price, buyers pay the funding rate to sellers, and vice versa. The greater the price deviation, the higher the funding rate, which is typically settled every eight hours.

Options

An option is a contract granting the right to buy or sell an asset at a predetermined price and date. Unlike futures, exercising an option is optional; the buyer is not obligated to execute the option if the underlying asset's price is unfavorable.

Key parameters of an option include:

• Direction: A "call" option gives the right to buy an asset (speculating on price increases), while a "put" option gives the right to sell an asset (speculating on price decreases).
• Strike Price: The price at which the option holder can buy or sell the asset.
• Premium: The cost paid by the buyer to the seller for the option, which is non-refundable. For a call option, the buyer becomes profitable if the asset price exceeds the strike price plus the premium.

The premium amount depends on several factors, including time to expiration and asset volatility, but is generally lower than the asset's value. This allows for leveraged market exposure without liquidation risk, though the premium is a fixed, unrecoverable cost for the buyer.

Options are more complex than futures and perpetual contracts due to their multiple parameters, making them less popular among retail traders.

Margin Trading

Margin trading involves speculating on markets by borrowing funds to buy assets directly. Borrowing occurs after an initial deposit called margin, and funds are held in an account managed by a broker, who can liquidate positions if losses exceed the margin deposit. Margin trading incurs borrowing fees, which vary based on market demand.

One advantage of margin trading is the use of cross-margin, which shares collateral across multiple positions to maintain them beyond their individual liquidation levels.

Leveraged Tokens

Leveraged tokens are another innovation in the crypto sector. They represent tokenized margin positions created by an exchange, providing easy access to leveraged products without liquidation risk or collateral management.

However, leveraged tokens have two major drawbacks:

1. Daily Rebalancing: Leveraged tokens adjust their margin daily to maintain a constant leverage ratio. This can cause losses during sideways market conditions, where price swings reduce the token's value.
2. Rebalancing Fees: Frequent rebalancing incurs fees that can significantly erode performance over time.

Leveraged tokens are a simple way to access leverage but are generally unsuitable for long-term holding due to these inefficiencies.

Decentralized Perpetual Contracts

The popularity of perpetual contracts on centralized exchanges has driven their adoption on the blockchain. Blockchain programmability has enabled various models, with two major ones emerging:

1. Order Book Perpetuals (e.g., HyperLiquid): Similar to centralized perpetuals, these contracts aggregate buy and sell orders in an order book, matching buyers with sellers. Each long position is offset by a short position, with gains and losses settling between the counterparties. A funding rate aligns the perpetual price with the spot price.

   HyperLiquid features a unique Hyperliquidity Provider vault, using depositors' liquidity to place orders automatically, ensuring market liquidity through automated market making.

2. Liquidity Pool Perpetuals (e.g., GMX): These contracts use liquidity pools as counterparties. When a trader opens a position, they deposit collateral, and a portion of the pool's tokens is allocated to cover potential losses. The pool earns from traders' losses and borrowing fees.

   This model is more decentralized than order book models but carries higher counterparty risk if traders win frequently. Despite its risks, the liquidity pool model has demonstrated resilience over its three years of existence.

Lending

Decentralized lending protocols like Aave or Morpho offer decentralized borrowing. Users deposit crypto collateral, securing loans of lower value, which can be used for DeFi or trading.

Like other leveraged methods, lending carries liquidation risk if the collateral value nears the borrowed amount. Liquidators can repay the loan to claim the remaining collateral. Borrowers also pay interest rates, which vary with supply and demand and accumulate linearly.

Unlike other leveraged methods, lending can serve purposes beyond trading but is less intuitive and has fewer features, making it less popular with traders. For example, to leverage ETH, a trader deposits ETH, borrows stablecoins, converts them to ETH, and must monitor collateral levels to avoid liquidation.

Collateralized Debt Positions (CDP)

CDP protocols like Sky (formerly MakerDAO) or Liquity are integral to lending systems. Unlike traditional lending, CDPs issue stablecoins backed solely by deposited collateral.

Borrowing through CDPs accrues linear interest added to the repayment amount. Though CDPs primarily issue stablecoins, they can also be used for leverage. For example, borrowing stablecoins to reinvest in the collateral asset creates a leveraged position. This method offers a decentralized approach to leverage but requires careful collateral management.

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Where does yield come from ?

The unique structures of leveraged products generate yields for counterparties, which can be leveraged strategically. Let’s break down these sources of yield:

Perpetual Contract Funding Rates

Both centralized and decentralized perpetual contracts use a funding rate to align the perpetual contract price with the underlying asset. When the perpetual price exceeds the underlying price, long positions pay the funding rate to shorts, and vice versa. Since demand often favors longs, shorts typically receive the funding rate.

This enables the delta-neutral strategy, which involves buying the asset on the spot market while shorting it via a perpetual contract. This creates a stable-value position that generally earns yields from funding rates. Protocols like Ethena automate this strategy with their stablecoin USDe.

However, delta-neutral strategies have variable returns, ranging from a few percent annually to double digits. During bear markets, negative funding rates can nullify the strategy.

Option Premiums

Options offer leveraged exposure without liquidation risk, with the premium as the maximum loss. The option seller collects this premium, facing potential losses if the asset surpasses the strike price.

A popular strategy for sellers is the covered call, where the seller holds the underlying asset while selling a call option. This allows the seller to earn the premium while hedging potential losses if the asset price rises. However, a significant drop in the asset’s value can result in losses. Currently, few crypto protocols automate this niche strategy.

Liquidity Pool Perpetuals (e.g., GMX)

Liquidity pool-based perpetuals, such as GMX, act as counterparties to traders. The pool collects trading fees and profits from trader losses, distributing these earnings to liquidity providers.

Returns from these pools vary, typically ranging from 10% to 50% annually, depending on market activity.

Lending and CDPs

Both lending protocols and CDPs allow users to earn yields from interest on borrowed assets. In lending protocols, interest rates are distributed to liquidity providers. CDP interest rates fund stability modules or reserves.

Lending yields vary significantly based on market conditions, with rates ranging from less than 1% to 15% annually. CDPs generally offer more stable yields, typically between 7% and 15% annually.

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Comparison of Different Leverage Types

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f(x) Protocol v2

As discussed earlier, blockchain programmability empowers developers to create innovative mechanisms not possible in traditional finance. f(x) Protocol v2, recently launched, exemplifies this new generation of protocols that enable leveraged trading on-chain while providing a stablecoin and attractive yield opportunities.

When a trader opens a leveraged position on ETH using f(x) Protocol (currently the only supported asset), they deposit stETH as collateral. To cover the full leveraged position, the protocol borrows additional stETH via a flash loan and adds it to the collateral.

For example, with 5x leverage on a 1 stETH position, the trader deposits 1 stETH, and the protocol borrows 4 stETH via a flash loan. With this 1 stETH deposit, the trader gains exposure to the volatility of 5 stETH. The protocol then mints an equivalent amount of fxUSD, the platform’s native stablecoin, fully collateralized by stETH. fxUSD serves as the counterparty for the trader, absorbing all gains and losses from the collateral’s volatility.

The trader is only responsible for opening and closing fees, gaining leveraged exposure to ETH without recurring costs and with limited liquidation risk. The protocol minimizes liquidation risk by rebalancing positions nearing liquidation (with applicable fees), ensuring maximum market exposure during downtrends to capture recovery gains.

No funding fees apply as long as fxUSD maintains its 1 USD peg. If fxUSD trades below 1 USD, a borrowing fee equivalent to Aave's rate is temporarily applied and distributed to the Stability Pool.

fxUSD holders can stake their stablecoins in the Stability Pool, composed of fxUSD and USDC, which stabilizes the protocol through market arbitrage to maintain the fxUSD peg (Learn more about fxUSD peg protection mechanisms).

The Stability Pool offers an estimated 20–25% annual yield, with minimal counterparty risk compared to DEX perpetual platforms like dYdX or Hyperliquid. Yield sources include:

• Returns from stETH collateral
• Opening and closing fees from leveraged positions
• Minor emissions from the FXN governance token

→ For further details on f(x) Protocol, read our dedicated report:

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Conclusion

Leverage in financial markets, especially in the crypto ecosystem, offers both opportunities and risks. From perpetual contracts and options to margin trading and decentralized systems, each leverage method has unique advantages and drawbacks. Liquidation risk remains a common challenge across most methods.

The blockchain's openness and programmability have driven innovative leveraged products such as perpetual contracts, lending, and CDPs—adapting traditional financial instruments to meet the demands of the crypto market. We are likely at the beginning of this evolution. The versatility of blockchains will continue to foster financial innovations, reshaping speculation tools and opportunities.