【Analysis】What's behind the suspicious sharp drop of leveraged tokens on Binance?

Last week, the cryptocurrency market experienced a shocking day, with over $800 billion evaporating within a day. The intense price fluctuations led to many exchanges struggling to cope with their backend systems. At the same time, as funds fled, it also caused a surge in trading volume on the blockchain, significantly extending the confirmation time for transactions. The side effects of these sharp declines resulted in liquidity issues for leveraged tokens, inadvertently sparking misunderstandings among most people about leveraged tokens. If you are not familiar with what leveraged tokens are, it is recommended to read: "Investigation" I don't understand contract trading, is it feasible to play with "leveraged tokens"?

Are Leveraged Tokens Seriously Flawed?

The extreme volatility in the cryptocurrency market last week led to chaos. A user tweeted to Zhao Changpeng, the founder of Binance, claiming that "Binance's leveraged tokens' 'price discovery mechanism' has failed."

https://twitter.com/LamboMoonBoy1/status/1238912407252189191

He pointed out that while the price of ETH dropped from 145 to 140, the price of ETHBULL plummeted from 450 to 150, causing him to lose $9,000 in assets. Some people criticized leveraged tokens as a scam tool, accusing exchanges and issuers of profiting dishonestly through leveraged tokens.

According to screenshots shared by netizens, the upper image shows the spot market price of ETH, and the lower image shows the market price of leveraged token ETHBULL. From the images, we can see that the price of Ethereum dropped from around $143 to $128 and then rebounded to $140, with a maximum drop of only about 10%. However, the price of Binance's ETHBULL, which is supposed to have 3x leverage, plunged by 72% during the same period and remained below $200, failing to recover along with the spot price. Is it really a product issue or is the exchange manipulating investors' funds?

We will address the netizens' questions one by one:

1. Why did the price drop of Binance's ETHBULL exceed 3 times the drop of ETH spot?
2. Why did ETH spot return to the original level, but the price of ETHBULL did not follow suit?

Why Did the Price Drop Exceed 3 Times the Drop of ETH Spot?

Regarding the first question, we need to understand how leveraged tokens are correlated with the spot market. Simply put, the price of leveraged tokens is controlled by the issuer, FTX. When the price of leveraged tokens does not reflect three times the volatility of the spot price, the issuer will mint more tokens or buy back tokens from the market to maintain the 3x price fluctuation of the spot market.

With this basic concept in mind, let's compare the Ethereum spot market price (green), FTX's ETHBULL (blue), and Binance's ETHBULL (orange) within a certain time frame. It is clear that Binance's ETHBULL deviated from the market trend during the highlighted period. Obviously, due to certain reasons, the issuer failed to control the price of Binance's ETHBULL, leading to the price disconnect from the overall market.

According to the issuer, FTX's founder Sam Bankman-Fried explained:

"The price of BULL tokens on Binance did not follow the market reaction mainly because Binance's BULL token inventory was insufficient. Coupled with congestion on the Ethereum network, it took a long time to transfer the tokens to Binance."

7) Some of the BULL tokens had lagged price action on Binance because sellers ran out of inventory and it took a long time to get tokens over because of network congestion.

— SBF (@SBF_FTX) March 12, 2020

The user's question to Zhao Changpeng thus has a reasonable explanation. In simple terms, the sudden drop in price of Binance's ETHBULL was not unfounded but due to a temporary disconnect in Binance's price, which should have plummeted in the first place. The reason for this disconnection is that due to network delays and insufficient inventory, the issuer could not timely suppress the price of ETHBULL on Binance, leading to the delayed plunge. FTX, being the issuer with sufficient token inventory, could maintain a consistent 3x fluctuation with the spot market.

Spot Market Reverted, but ETHBULL's Price Did Not Follow?

Another question is why ETH spot returned to the original level, but ETHBULL's price did not follow suit. Let's use a more obvious example to illustrate.

The above image shows the price chart of ETH BEAR. On March 12th, when the price of Ethereum dropped from $194 to $86, the price of ETHBEAR rose from $24 to $89, an increase of about 270%. However, the token fell back to the original level the next day. Wasn't it supposed to have 3x leverage? Why did Ethereum spot barely move while ETHBEAR suddenly plunged?

In fact, this scenario is normal. Many people mistakenly equate leveraged tokens with the static leverage concept of futures contracts, but in reality, leveraged tokens operate with dynamic leverage, which is fundamentally different from static leverage in futures contracts. The most significant difference lies in the fact that the price fluctuation of leveraged tokens is anchored to "three times the intraday spot price fluctuation" rather than "3 times the spot price fluctuation." According to the FTX Leveraged Tokens guide, without considering the "triggering of the rebalancing mechanism when the intraday volatility exceeds 10%," leveraged tokens will "rebalance" every day at 00:02:00 UTC, meaning the token's price movement for the entire day will be based on this point.

For example:

Day 1

• ETH spot price: Assume the spot price drops from $100 to $50. (A 50% drop)
• ETHBEAR price: Rises from $30 to $75. Due to 3x leverage, it increases by 150%.

Day 2 post 00:02:00 UTC, ETH spot price becomes the base at $50, and ETHBEAR price at $75.

• ETH spot price: Assume the spot price rises from $50 to $60. (A 20% increase)
• ETHBEAR price: Falls from $75 to $30. Due to 3x leverage, it drops by 60%.

In the above example, the price fluctuations of ETHBEAR still maintain about 3 times the fluctuation of the spot market, but while the ETH spot price is lower than the initial price, the ETHBEAR price returns to the original level. This is not a flaw but a necessary mechanism to prevent leveraged tokens from going to zero and to maintain 3x leverage with the spot market.

Understanding this concept, comparing the initial example with the ETH spot price, we can see that the price movement post 08:02:00 UTC indeed maintains a fluctuation of about 3 times the spot market.

Liquidity Risk: Investors Need to Be More Aware

After addressing the above two questions, besides the need for market makers/issuers to improve liquidity, the exchanges themselves are not suspected of cheating, proving they did not have intentions to exploit user assets (at least not in this incident). However, this event highlights that many people do not understand the principles of leveraged tokens and the appropriate investment strategies, mistakenly viewing leveraged tokens as long-term hedging tools. The common adage "read the prospectus before investing" holds true; conducting thorough research before purchasing any investment product can prevent unnecessary losses like the one experienced by this user.

Related Reads:

• 'March 12th' - Crypto's Black Thursday and the Records Broken
• "Investigation: I Don't Understand Contract Trading, Is It Feasible to Trade Leveraged Tokens?"

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