Pro-cyclical Dynamics and Spillover Effects of Variable Leveraged Tokens

25 Pages Posted: 1 Aug 2024

See all articles by Carol Alexander

Carol Alexander

University of Sussex Business School; Exponential Science Foundation

Date Written: March 01, 2023

Abstract

Leveraged exchange-traded products are commonplace investment vehicles whose trading is controlled by market regulators and industry associations that give investment managers guidance on responsibilities to their clients. Variable leveraged tokens are similar to leveraged exchange-traded products except that (i) the underlying is a single contract not a basket; and (ii) regular daily resets are not made-they only occur when the leverage is outside a specified range. These are popular products on the 'self-regulated' Binance crypto derivatives exchanges but traders have little, if any, guidance on the scale of the losses that could be incurred. Highly leveraged positions are allowed and, because there are no margin calls, a collateral account could be wiped out entirely during the middle of the night on a platform which never stops trading. We analyse the dynamics of variable leveraged tokens and prove that the rebalancing trades made by market makers are highly pro-cyclical and they exacerbate losses by augmenting price jumps. Moreover, counter-intuitive behaviour is possible in highly volatile markets whereby the prices of up and down tokens move in the same direction. Our theoretical results are supported using simulations and a case study of some tokens traded on 19 May 2021.

Suggested Citation

Alexander, Carol, Pro-cyclical Dynamics and Spillover Effects of Variable Leveraged Tokens (March 01, 2023). Available at SSRN: https://ssrn.com/abstract=4885174

Carol Alexander (Contact Author)

University of Sussex Business School ( email )

Falmer, Brighton BN1 9SL
United Kingdom

HOME PAGE: http://www.coalexander.com

Exponential Science Foundation ( email )

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