What Is Level Finance?
Level Finance has introduced a more sophisticated risk management system for decentralized perpetual exchanges. This fully on-chain perp dex has gained attention primarily for the fees paid out to liquidity providers, and the recent deployment on Arbitrum marked the beginning of Level Finance’s omni-chain journey.
Key Takeaways
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Level Finance is a decentralized perp DEX that has become a mainstay with the BNB Chain ecosystem and recently migrated to Arbitrum.
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A core focus of Level Finance is real yield and paying out rewards to liquidity providers and stakeholders.
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Level Finance introduces more sophisticated risk management to on-chain trading via Tranches.
DeFi applications have become increasingly sophisticated in recent years and progressively mirror TradFi services more closely but have the tremendous advantage of being wholly transparent and self-custodial.
One of the fastest areas of progress has been risk management, whether in the form of more stringent LTV (Loan-to-Value) ratios, fewer supported assets, or, as this article explores, Level Finance’s introduction of Tranches. Tranches have separated the general community liquidity pool into different tiers of risk, introducing a more refined counterparty risk stratagem. This allows investors to provide liquidity in Tranches that more closely align with their risk appetite.
This article presupposes a relatively robust understanding of perp DEXs, and users who want to get up to speed and prime themselves before diving into Level Finance can read: Decentralized Derivatives.
On-Chain Perpetual Futures: The Current Macro
Two of the most remarkable narratives driving growth in DeFi and acting as capital sinks have been the rise of perp DEXs and liquid staking derivative protocols. Why? Because they service a proven market demand.
Perp DEXs have grown astronomically in popularity and benefit from several tailwinds simultaneously. The FTX collapse marked a significant attitude change amongst crypto investors who are now opting for self-custody, and the raw quantity of ETH held on centralized exchanges has been declining since.
Source: https://pro.nansen.ai/
Market maturity naturally leads to more trading activity, and derivative markets always develop on top of established markets. These typically become larger than the underlying market primarily due to ease of use and exposure, without any of the complications ownership entails.
And more recently, the antagonistic nature of the SEC has reintroduced fear and uncertainty for users of centralized exchanges. Users holding their assets on CEXs take on significant counterparty risk. For this reason, many crypto participants have simply opted for self-custody of their assets, taking security and safekeeping into their own hands. Not to mention the millions of retail traders forbidden to access crypto derivative products through CEXs, such as residents of the United Kingdom.
Factor in the natural volatility of crypto, the skew towards younger investors/ investors with greater risk tolerance, and all of these factors have created the perfect storm for the explosion of perp DEXs.
The Issue of Risk Management With Perp DEXs
GMX was the first perp DEX that broke into the mainstream consciousness and laid the foundation for the journey towards more leverage trading taking place on-chain. On GMX, GLP stakers act as the counterparty to all trades, and GLP comprises of an index of assets. This community-owned liquidity gives the protocol functionality.
Permissionless protocols require the community to act as the counterparty. When users trade on centralized exchanges, it acts as the ‘house,’ and users trade against the exchange. In DeFi, the community must become the ‘house.’
GLP was a fantastic method to bootstrap liquidity but had several issues. Important to note this section explicitly refers to GMX V1, and GMX V2 will address many of these shortcomings, including the introduction of isolated pools. They are outlined solely to grant a better understanding of Level’s innovations.
Source: https://stats.gmx.io/arbitrum
With a singular liquidity provider token, all LPs are treated the same. Every holder gets exposed to long-tail risk- which in crypto is a relatively frequent occurrence. In technical terms, long-tail risk is a hidden risk. It is introduced when the possibility that an asset moves more than three standard deviations from the mean is more significant than a normal distribution implies. Simply put, a rare event such as a Black Swan can cause substantial losses.
The success of perp DEXs depends on the failure of traders. As the above data displays, it is an excellent time to be an LP when traders get liquidated and face heavy losses. The inverse is also true.
Although there is nothing inherently wrong with the blanket treatment of LPs, evolution is the name of the game. Minor optimizations improve user experience, and all of these upgrades contribute to the greater crypto flywheel, driving the adoption and utility of this new and exciting asset class.
Level Finance’s Risk Management Approach: Tranches
The Level Finance team has built the protocol around the concept of risk management. The above example of GMX was also given to outline another unique factor of Level. The code base has been built from scratch, and instead of taking the popular route of forking GMX, deploying it to another chain, and changing the tradable assets, the Level team has built it from the ground up.
The most significant introduction from the Level Finance team is Tranches. This design framework, referred to as RMLP (Risk Management & LP Seniority), changes how liquidity providers interact with the protocol.
Tranches come from TradFi, most commonly associated with MSBs (Mortgage-Backed Securities) and other debt instruments such as bonds. A Tranche is a segment of a larger pool of securities that have been divided according to risk or other characteristics to make it more appealing/ marketable to a specific investor group.
On Level Finance, LPs choose which Tranche they would like to provide liquidity to. This separates risk exposure and tackles one of the chronic issues faced by all perp DEXs, namely long-tail risk, by isolating this risk to LPs with a higher risk tolerance.
Source: https://docs.level.finance/risk-management-for-liquidity-providers
Level features three distinct Tranches, which unlock greater flexibility for liquidity providers. The graphic below gives a precise breakdown of the counterparty risk assigned to each Tranche.
Source: https://docs.level.finance/risk-management-for-liquidity-providers
The concept is incredibly simple: users who take on more risk earn a greater percentage of platform revenue. The Junior Tranche eats the bulk of losses, helping insulate the Senior Tranche. In return, the protocol directs more fees toward those contributing to the Junior Tranche.
This increased customization for liquidity has been one of the key factors driving Level’s success and has increased liquidity provision amongst more diverse groups. The Senior Tranche naturally attracts more risk-averse market participants, and with liquidity being the deciding factor in whether a perp DEX dies or thrives, anything a protocol can do to encourage liquidity provision provides an exceptional boon.
The perp DEX liquidity flywheel works as follows: greater liquidity means less price impact, leadingto more trades, more trades increase trading fees, higher trading fees encourage more liquidity provision, and the flywheel completes itself.
On Arbitrum, each Tranche contains BTC, ETH, USDT, and USDC, with the Junior Tranche additionally containing ARB. On BNB Chain, each Tranche contains BTC, ETH, BNB, and USDT.
This streamlined index provides another upside compared to the GLP model. A classic disadvantage for an index of assets will be that a LP exposes themselves to crypto assets they may not want to be exposed to. In Level’s scenario, streamlined exposure mitigates this classic drawback.
Level Finance Overview
Source: https://docs.level.finance/miscellaneous/brand-assets
Level Finance is a decentralized perp DEX focusing on transparency, a self-custodial approach, ease of use, improved risk management, and ownership. The streamlined attitude found in the LLP (Level Liquidity Provider) index emerges throughout the entire protocol. Users can engage in spot and leveraged trading with both Market and Limit orders available. Tradable assets on the BNB Chain include BTC, ETH, and BNB, and on Arbitrum, include BTC, ETH, and ARB.
Level Finance Interface
Source: https://app.level.finance/trade/btc/long
Source: https://app.level.finance/trade/btc/long
The Level Finance interface presents a familiar TradingView chart, a trading dashboard where users can select their order type and trade direction (long or short). Users will also find the borrow fee – applicable to leveraged positions, variable based on the asset’s utilization – and the current available liquidity for their desired asset. Supported collateral mirrors the assets in the LLP.
Level focuses on ecosystem blue chip assets, especially BTC and ETH, which, as well as being the most liquid assets, drive the majority of trading volume. In an AMA, Level announced it would add more trading pairs in the future but only expected marginal growth as a result.
Level Finance utilizes Chainlink Oracles for its price feeds and employs Chainlink and Pynth Services for liquidations. Users can also find a full breakdown of Level’s AUM (Assets Under Management) on the Analytics page.
A nice feature on Level is the LLP Tracker allowing users to see the profitability of any wallet providing liquidity. It details fees received, PnL vs. Trader, and the change in valuation of the underlying assets. The below graphic shows the performance of one of Level’s most significant liquidity contributors.
Source: https://llp.level.finance/0x8bff27e9fa1c28934554e6b5239fb52776573619
In conclusion, Level Finance has been built as a public good/ service facilitating permissionless leveraged trading where the community is both the service user and counterparty. The defining characteristic of Level is the single-minded focus on doing the basics well.
Level Finance: Real Yield and Fee Generation
At the time of writing, in the past thirty days, Level has generated $4.31 million in fees, and this incredible fee generation has put Level Finance on the map. The below chart ranks every crypto entity regarding fee generation, including blockchains, and Level ranks 13th overall. The only perp DEX generating more fees than Level is GMX.
Source: https://defillama.com/fees
The figure becomes more impressive when factoring in Level’s market cap and TVL (Total Value Locked) relative to its earnings. Currently, Level Finance ranks 10th in TVL but 2nd in fees. This fee generation has understandably drawn attention, especially when paired with the protocol’s approach to revenue distribution for stakeholders.
Source: https://defillama.com/protocols/Derivatives
Level has executed more than $20 billion in total trading volume since its inception and rapidly established itself as a leading perp DEX on the BNB Chain. The expansion to Arbitrum has brought in $466 million in trading volume to date, and the omni-chain voyage has just started.
Source: https://app.level.finance/analytics
Level is also one of the very few protocols that can boast that accrued fees eclipse its market cap. On-chain data objectively shows that Level excels when it comes to generating revenue.
Source: https://app.level.finance/analytics
How Does Level Generate Revenue?
The protocol’s primary sources of income come from position fees, liquidations and associated fees, borrowing fees, swap fees, and minting and burning fees for LLPs.
Traders pay 0.1% to open and close a leveraged trade – the industry standard – and the minting and burning fees associated with LLPs incentivize ideal ratios of assets, with the fee reduced for underweight assets and increased for overweight assets. Level generally applies the standard business model of perp DEXs but differentiates itself through its revenue-sharing strategy.
Level Finance: Stakeholders and Revenue Sharing
Source: https://docs.level.finance/protocol-revenue
The revenue generated by Level gets split amongst the different actors within the ecosystem. LLPs receive 45%, LVL stakers get 10%, the DAO Treasury receives 30%, LGO stakers get 10%, and 5% is reserved for development, aka team. Overall, 95% of platform fees go to users. Hence the classification of Level Finance as a public service/ good.
LVL & LGO Tokenomics
Setting aside LLP, which the article has covered, the core tokens within the Level Finance ecosystem are LVL and LGO. LVL is the utility token used to incentivize liquidity provision, and LGO is the governance token that makes holders shareholders in Level.
A highly simplified breakdown of the tokenomics: LLP for users who want yield, LVL for users who want exposure to Level’s growth, and LGO for users who desire ownership.
Source: https://docs.level.finance/tokenomics/lvl-utility-token
LVL’s tokenomics have recently seen significant changes due to a governance proposal. The proposal included burning 180,842 LVL tokens accrued by an LP position on TraderJoe and implementing a continuous burn of LVL. The treasury will burn LVL from the treasury reserve at a 1:1 ratio for every $1 of trading fees accumulated.
The current circulating supply of LVL is 7,329,185, and the max total supply of LVL is ostensibly 50,000,000. Still, given the dynamic approach to emissions and burn proposals submitted to the DAO, the max total supply will likely end up lower. Team tokens will be vested over four years, with the first unlock occurring on December 26th, 2023.
As well as bootstrapping and incentivizing liquidity, LVL is used for strategic investments with one very important investor to be discussed later. The primary use cases for LVL outside of exposure are yield and governance staking, which come with a 0.4% staking fee that the protocol burns.
Governance staking earns LGO tokens giving holders power over the treasury and decision-making process, and yield staking earns Senior LLP, which can be redeemed for any of the underlying assets.
Source: https://docs.level.finance/tokenomics/lgo-governance-token
The maximum total supply of LGO is 1,000. LGO can only be acquired through periodic auctions that burn LVL or via staking LVL.
LGO holders represent the stakeholders of Level and the ultimate arbiters in the protocol’s fate; they vote on core protocol parameters. These holders additionally manage the treasury and have the option to redeem from the treasury via burning LGO tokens.
LVL underwent a fair launch with no private sales or seed rounds, and there was no pre-allocation of LGO, meaning everyone has free access to governance. One caveat to governance is that a percentage of team tokens (locked and unlocked) can be staked to earn LGO. However, in the early stages of a protocol, this is more often than not a net benefit giving the team the reins and further decentralizing the protocol when everything is established. The general path towards successful decentralization follows three steps: build a killer product, foster and develop an engaged community, and finally, hand the keys over.
Concluding, the overall tokenomics of Level are robust, have inbuilt deflationary measures tied to protocol earnings, and distribution is incredibly fair.
The Referral Contract Exploit
An exploit targeted our Referral Controller Contract.
– 214k LVL tokens drained to exploiters address.
– Attacker swapped LVL to 3,345 BNB
– Exploit was isolated from other contracts.
– Fix to be deployed in 12 Hrs.
– LP’s and DAO treasury UNAFFECTED.More details to follow.
— LEVEL Finance #RealYield (@Level__Finance) May 1, 2023
Level Finance suffered an exploit in May that caused the TVL and the price of LVL to drop. The DAO and Liquidity Pools were unaffected, but the user managed to steal more than $1,000,000 in LVL from repeatedly claiming referral rewards.
Level shut down the referral program, stopped the exploit, patched the bug, and carried on. Level’s new referral link introduced a neat upgrade with omnichain functionality allowing users to earn fees from their referrals regardless if they trade on Arbitrum or BNB Chain.
Future Catalysts
Level benefits from all the standard catalysts that pertain to perp DEXs as market sentiment improves, most notably increased trading volume. The protocol also benefits from the strengthening trend toward on-chain market activity. Additionally, Level has announced the release of utility-based NFTs for community members.
But the real driver of future growth will come from Level’s partnership. Level’s economic model demonstrably works, as does its fee distribution model. This permissionless trading hub is already profitable and executing exceptional volume. The next step is absorbing market share and achieving a more significant percentage of the total trading volume.
In June, Level announced it had successfully closed a $20 million strategic investment from a TradFi firm. The terms are favorable for LVL holders given that investments will occur in tranches opening the possibility for smaller investors to front run and will have a one-year lockup and vesting period.
Still, Level has one more ace up its sleeve: Arthur Hayes. Arthur Hayes invested in Level Finance in February this year, as documented by this medium post. Arthur bought 47,000 LVL for 10 BTC. His average buy price was $4.70, and his holdings are subject to a six-month lock-up followed by a linear six-month vesting period.
For those who do not know, Arthur Hayes co-founded the popular exchange BitMex, has a passion for leveraged trading, and is a crypto perma-bull. He was an early investor in GMX.
But why does Arthur’s investment constitute a catalyst? Mr. Hayes loves to pump his bags, and with his unlock starting in August, he will likely promote Level to his large Twitter audience (nearly 400,000 users). Hayes is also a respected figure in crypto, and his involvement bodes as a net positive.
Conjecture
Slightly more interesting is Level’s acquisition of a strategic investor in January at a far lower cost basis. That investor bought 1,000,000 LVL for $100,000, meaning a price of $0.1. The associated lock-up period is twelve months.
This is worth investigating because of how Level describes the investor:
‘‘The investor, who wishes to remain anonymous, is a seasoned exchanger operator with an outstanding reputation as well as deep industry know-how. In addition to the capital injection, they will also support and advise the team on future developments, partnerships and the project’s roadmap going forward.’’
It certainly sounds like Hayes, and if it is him, his cost-basis for LVL is significantly lower than the publicly reported $4.70.
Level Finance’s Future
Level has attracted institutional investors, paid out staggering amounts of real yield to users, and expanded to Arbitrum. It has already become an established player on the BNB Chain and continues to accrue trading volume on Arbitrum.
Source: https://app.level.finance/liquidity/mezzanine-tranche/buy
The DAO has consistently voted to trim LVL emissions, and the breakdown of yield paid out stacks heavily in favor of fees as opposed to incentives meaning it is sustainable, which is great for liquidity providers and LVL holders who do not get heavily diluted. The end goal for Level Finance? To integrate cross-chain swaps and become an omnichain trading hub.
Level Finance’s focus on doing the basics well has yielded great results. In the several months from its launch on December 26th, 2022, to now, it has already executed $20 billion in trading volume. The path forwards will be much of the same, attract more liquidity, payout yield to holders, and continue increasing its share of the total trading volume.