This month’s plunge in cryptocurrency markets led to steep losses in certain “leveraged tokens” issued by the crypto exchange giant Binance. That might sound like stating the obvious, but for some traders it was a nasty surprise because these particular tokens were designed to profit when prices fall. 

Traders and investors who thought they scored big but ended up losers have flooded social media (and CoinDesk’s email inbox) with complaints that they were poorly served. Some claimed the tokens didn’t deliver as promised, or even went as far as to speculate that Binance had manipulated the tokens for its own benefit. “I’m not going to stop pressing this issue,” read one Reddit post.  

Binance confirms that some traders lost money on the DOWN tokens, which are designed to profit when the underlying cryptocurrencies – such as ether (ETH) or bitcoin (BTC) – fall in price. A glance at the Binance tokens’ tickers – ETHDOWN, BTCDOWN – shows how they’re positioned in the market.

The exchange attributes the losses to an algorithmically driven rebalancing mechanism that it says worked as designed during the market meltdown. It added that the risks of the process were disclosed in advance.

In loosely regulated, anything-goes cryptocurrency markets, the traders may have little recourse, with no obvious investor-protection regulator as there is, for example, in the U.S. stock market. Yet, the episode has turned into a customer-relations debacle, and even Binance acknowledges it’s fielding a surge in complaints.

“Due to last week’s market volatility, we are experiencing higher than usual volumes of queries, so we also seek our users’ understanding and patience,” an exchange representative told CoinDesk.

The matter has turned so acrimonious Binance now says that “following last week’s extreme market conditions, we have reviewed and taken steps to improve the redemption process,” such as making it clear the leveraged tokens cannot be bought or redeemed during rebalancing.

The most widely cited losses took place during the market crash on May 19, when prices for bitcoin dropped nearly to $30,000, after trading above $43,500 earlier in the day. 

Many Binance users saw an opportunity to capitalize on the massive sell-off and rushed to buy the inverse leveraged tokens. Demand spiked for BTCDOWN and ETHDOWN.

But instead of going up as the market tanked, the tokens’ prices declined in some instances, some buyers said, adding the supply of the tokens appeared to increase dramatically. Some traders provided CoinDesk with screenshots they said supported their claims, and many argued on Twitter, Reddit and Discord that Binance should be held responsible.

What happened, according to the Binance representative, is that as the tokens’ value went up, a large number of them were redeemed in a short period of time. The capital allocated as backing for the tokens declined sharply. 

From there it gets quite complicated, but that imbalance kicked in the algorithm, leading to a series of steps including injecting futures positions into the capital base, which in turn increased the leverage in the structures to a level higher than the targeted range. That triggered additional steps that eventually caused the prices to erode.

“This is why, despite best efforts, there is no way to reduce the leverage until the subscription and redemption of the tokens are suspended,” the representative said. 

In some ways it was a twist of fate because in March 2020 Binance CEO Changpeng “CZ” Zhao criticized competitor FTX for its leveraged tokens, arguing that users did not understand them well enough.

“The main reason for delisting is we find many users don’t understand them,” Zhao said at the time, in a since-deleted tweet. “Even with pop-ups warning users each time, people still don’t read it.”

He said Binance had delisted the FTX tokens, even though they were popular, and it was “bad for business.” 

“Protecting users comes first,” Zhao wrote. 

Binance went on to launch its own leveraged tokens in May 2020, saying the decision came “after careful consideration of user requests and evaluation of existing leverage products.” 

The DOWN tokens are designed for users who want leveraged exposure to the prices of cryptocurrencies without the risks of liquidations, according to Binance’s official website. Each token tracks an underlying position, either bullish or bearish, in a perpetual contract with a variable leverage range.

New tokens are issued based on market demand. 

In contrast with existing leveraged tokens like FTX’s, which are built atop the Ethereum blockchain, the Binance tokens are centrally provided. That means users are putting their trust in the exchange and don’t benefit from the data transparency and smart contracts of blockchain technology.

After last week’s incident, some posters on social media accused Binance of increasing the supply of some of its leveraged tokens out of thin air. Such claims are unfounded, according to the exchange.

“We only mint tokens based on user demand,” the Binance representative said. “We don’t control supply; that is entirely demand-driven.”

The Binance leveraged tokens also differ from competitors’ in that they rely on a target range of variable leverage rather than a constant leverage ratio; for the BTCDOWN token, it ranges from 1.25 times to four times.

“The target leverage isn’t constant, and it isn’t publicly visible,” according to a primer titled “A Beginners Guide to Binance Leveraged Tokens,” which appears to have been posted or updated on Binance’s website two days ago. “Why is that? The main goal is to prevent front-running. If these tokens rebalance at predefined intervals, there could be ways for other traders to take advantage of this known event.” 

In October, a few months after Binance listed its own leveraged tokens, the exchange published a blog post stating leveraged tokens are often “the most misunderstood” product in the crypto market.

“Many traders get confused when a token’s performance does not add up with its respective index,” the post read.

According to the “Beginner’s Guide,” the occasional rebalancing of Binance’s leveraged tokens is supposed to address the performance “drag” that comes from holding them for a long time.

They “only rebalance during times of extremely high volatility and aren’t forced to periodically rebalance otherwise,” according to the guide.  

Binance provided the example below of how the rebalancing algorithm works. Tl;dr: There’s a lot more to it than betting on price-go-up or price-go-down in already-risky spot cryptocurrency markets.

It would be easier to demonstrate using hypothetical numbers. Let's assume a DOWN token, with a capital fund size of $100 million and a total underlying futures positions of $180 million. The real leverage ratio is therefore 1.8x.

When the DOWNUSDT perpetual futures prices goes down by 5%, the value of the underlying futures positions will increase by $9 million to $189 million. The DOWN tokens gained $9 million and the available capital is now $109 million. The real leverage ratio is now 1.73x.

Now assume the price of DOWNUSDT perpetual futures goes down by another 120%. The futures position will increase by $226.8 million to $415.8 million, and the available capital gained $226.8 million to $335.8 million. The real leverage ratio decreases to 1.238x.

Since the real leverage ratio is out of the target leverage range of 1.25 - 4x, rebalancing is triggered, and the algorithm adds futures positions to increase the real leverage ratio, to within the target leverage range. For instance, if the algorithm decides to rebalance from 1.238x to 1.7x, it adds an additional $155.06 million worth of futures positions, increasing the total futures positions to $570.86 million which is 1.7x of the capital fund size.

As the algorithm builds up more futures positions, the price of DOWNUSDT perpetual futures is lowered because of the large quantity of short positions held. Now suppose a large amount of DOWN tokens are redeemed by users, reducing the capital from $335.8 million to $130 million. This means the leverage is 4.39x. 

As the leverage is out of range now, the algorithm has to clear the short futures positions at an unfavorable price by buying long positions during a volatile and illiquid market, which causes erosion to the NAV. This may seem counterintuitive initially, but reducing futures positions may further increase the leverage during extreme market conditions.

This is why despite best efforts there is no way to reduce the leverage until the subscription and redemption of the tokens are suspended.

UPDATE (May 27 13:42 UTC): Adds details on Binance’s product versus FTX and Binance response to criticism.