Textbook use case of DeFi: A look at DeFi index funds

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Original title: “The Bull Case for Decentralized Index Funds”

Original source: bankless

Regan Bozman (author of the original) holds BTC, ETH, DPI, INDEX, SNX and CVP. At the same time Regan Bozman is also an investor in Set Labs and an active Index Coop community member. This article does not constitute legal or financial advice.

These fund products may be one of the driving factors for our adoption of DeFi – the way we cross the gap. Blackrock currently manages more than 7 trillion assets and a market value of 100 billion US dollars. A large part of the growth has occurred in the past 10 years.

A few years ago, building a blockchain-based financial system might be a cypherpunk dream, but today’s Ethereum-based financial products are very solid because they trade billions of dollars every day. Popular DeFi applications include MakerDAO’s Dai, a stablecoin that tracks the U.S. dollar, and Uniswap, a decentralized trading platform where anyone can easily exchange any Ethereum-based tokens.

Due to attracting a large amount of human capital, DeFi has become the most invested asset class in the encryption system. As the number of high-quality teams launching compelling DeFi tokens increases, it has also become very difficult to keep up. In this context, some decentralized index funds have emerged, allowing investors to make passive and diversified investments in the DeFi market. In order to understand the different ways to build a decentralized index, let us look at the four most important indexes: sDEFI, DEFI++, PIPT and DPI.

Synthetic fixed weight: sDeFi

In November 2019, Synthetix launched an ERC20 token that can track a basket of DeFi tokens. Sidefi is a synthetic asset – it does not hold any base tokens, but uses an oracle to feed prices to track their value. The index is composed of nine markers and pre-defined weights (based on Twitter polls and community feedback). The community uses Synthetix’s governance system to vote on weight rebalancing and index composition quarterly.

sDeFi is built on the Synthetix protocol, which allows users to create and trade synthetic assets (called synths). These derivatives are essentially derivatives that track the price of a particular asset. Users create synthesizers by depositing collateral (in the form of SNX) and then manufacturing synthesizers based on the collateral. Synthetix uses an oracle to feed prices to determine the value of synths.

benefit

So far, sDeFi has proven its resilience. It is the oldest DeFi index and has withstood the test of a large-scale crash such as the crypto price crash in March 2020.

sDeFi is built on a solid infrastructure. Synthetix is ​​one of the most respected teams in the DeFi industry, and their agreement has processed more than $1.5 billion in transaction volume.

In addition, the rebalancing cost is zero because the index does not trade assets, but only changes the price of the oracle.

Disadvantage

As of this writing, the scale of asset management is less than US$2 million.

The Synthetix-based system and its oracles (providing price information) are subject to a lot of counterparty risks.

Liquidity is limited, and most synthetic assets do not receive a large amount of trading volume outside of the Synthesizer’s own trading system.

Because it is synthetic, it is impossible to redeem the underlying asset.

Fixed weight index: DEFI + + & PIPT

PieDAO was launched in March 2020 with a focus on building infrastructure to facilitate the creation of tokenized indexes.

Their flagship indexes DEFI + +, DEFI + l, DEFI + s track various DEFI token baskets (here collectively referred to as DEFI + +). PieDAO’s index actually holds the underlying tokens-similar to physical ETFs-and has a constant weight, because the weight of each underlying asset is predetermined, and the fund is constantly rebalanced as the price changes. The PieDAO community votes on the index update (discussed in its governance forum).

Constant-weight funds are not particularly common because they require continuous trading to maintain weight and are expensive to execute. However, the introduction of automated market makers makes constant rebalancing cost-effective. PieDAO’s index products are built on the balancer, and introduce some novel governance and security features.

Powerpool launched their PowerIndex (PIPT) this month, which has many similarities with DEFI + +. PowerIndex is also built on Balancer to accumulate voting rights in DeFi governance tokens. A noteworthy difference is that PowerIndex includes CVP, Powerpool’s own token, which has the same weight as the larger DeFi token. Although some people are skeptical, others believe that including CVP will align PowerPool with the index’s base token.

benefit

Both of these indices generate revenue through transaction fees, because traders can trade with the relevant Balancer pool.

As market value-weighted funds tend to be concentrated, fixed-weight funds are likely to diversify risks more evenly.

The redeemability of the underlying assets.

Disadvantage

Counterparty risk in the basic balance system (which has been exploited before).

The risk of gratuitous loss.

Fixing weights is a bit arbitrary, because you rely on methodologists to choose the right weights.

Market Regulation Weight Index: Index Coop’s DPI

Set and DeFi Pulse launched the DeFi Pulse Index (DPI) in mid-September. The index is weighted by market value, which means that the weight of each asset tracks its market value. The index saves the underlying assets and uses Set Protocol as its infrastructure. In early October, Set launched Index Coop, a decentralized community organization that will create and manage encrypted indexes.

DPI quickly surpassed other indexes in terms of assets under management, and is currently almost 4 times that of other indexes. Part of the reason is almost certainly due to liquid mining activities, namely index cooperation encouraging people to buy DPI. However, DPI may also gain more gravity, because the participation of DeFi Pulse increases its credibility.

Index Coop introduced the concept of an “exponential methodologist”. He proposed an index and was responsible for monthly rebalancing. Although the community has a say, this structure requires that each index has a specific person (or entity) (and they also get a portion of the cost from the index). This obviously helped attract DeFi Pulse and attracted other reliable companies such as CoinShares to Index Coop.

benefit

Market value weight eliminates people’s judgment and is almost certainly more effective than relying on community voting to allocate asset weight.

The redeemability of the underlying assets.

Methodologists can increase the credibility of an index.

Disadvantage

Due to the massive participation of the Set team, (currently) the degree of decentralization is lower than other indicators.

Market value-weighted indexes can promote concentration risk.

Worth highlighting disadvantages

Many of the above advantages stem from the relatively low regulatory burden these indices currently face. The US SEC’s guidance indicates that reliance on third parties is a key factor in determining whether something is a security. Since decentralized indexes are automatically executed and do not depend on the central government, they may not be securities. However, this is highly uncertain and it is of course possible for the government to treat these tokens as investment products.

It is also possible that the current rise around the decentralization index is only a flash in the pan. It is currently uncertain whether institutions are willing to purchase unregulated assets managed by the community. If institutional buyers are not interested, the upper limit of the dispersion index in the market is quite low.

Finally, DeFi tokens are still highly correlated – whether the index can significantly diversify risk is still unclear.

to sum up

The decentralization index is a textbook use case for DeFi. They can use smart contracts and permissionless financial tools to provide a better user experience, more liquidity and lower costs.

I believe that they may be one of the first DeFi products to bridge the gap and attract mainstream audiences. Given that the market size of ETFs is indeed astronomical, I expect innovation here will continue to develop rapidly in the future.

The author notes that in the stock market, ETFs are to diversify risks, while in the cryptocurrency market, homogeneity is extremely serious, and the price correlation of various tokens is very high. When choosing a decentralized ETF index, users need to understand the underlying principles in detail to avoid unnecessary losses due to other users’ first-mover advantages and poor information.