Overview of New Trend DeFi Index Funds

Original Title: "The Bull Case for Decentralized Index Funds"

Original Source: bankless

These fund products may be one of the driving factors for our adoption of DeFi—our way of bridging the gap. Blackrock currently manages over $7 trillion in assets, with a market capitalization reaching $100 billion, a significant portion of which has grown in the past decade.

A few years ago, building a blockchain-based financial system might have been a cypherpunk dream, but today, Ethereum-based financial products are very solid, as they trade billions of dollars daily. Popular DeFi applications include MakerDAO's Dai, a stablecoin pegged to the dollar, and Uniswap, a decentralized trading platform where anyone can easily swap any Ethereum-based tokens.

With a large influx of human capital, DeFi has become the most invested asset class in the crypto ecosystem. 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, diversified investments in the DeFi market. To understand the different approaches to building decentralized indexes, let’s look at four of the most important indexes: sDEFI, DEFI++, PIPT, and DPI.

Synthetic Fixed Weight: sDeFi

In November 2019, Synthetix launched an ERC20 token that could track a basket of DeFi tokens. sDeFi is a synthetic asset—it does not hold any underlying tokens but uses oracles to feed prices to track their value. The index consists of nine tokens with predefined weights (based on Twitter polls and community feedback). The community votes on rebalancing weights and index composition quarterly through Synthetix's governance system.

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

Benefits

So far, sDeFi has proven its resilience. It is the longest-standing DeFi index and has withstood major crashes, such as the crypto price collapse in March 2020.

sDeFi is built on a solid infrastructure. Synthetix is one of the most respected teams in the DeFi industry, and their protocol has handled over $1.5 billion in trading volume.

Additionally, the rebalancing cost is zero, as the index does not trade assets but merely changes the oracle-fed prices.

Drawbacks

As of the time of writing, the assets under management are less than $2 million.

The Synthetix-based system and its oracles (which provide price information) carry significant counterparty risk.

Liquidity is limited, and most synthetic assets do not see substantial trading volume outside of the synth's own trading system.

Because it is synthetic, it is impossible to redeem for the underlying assets.

Fixed Weight Index: DEFI++ & PIPT

PieDAO launched in March 2020, focusing on building infrastructure to facilitate the creation of tokenized indexes.

Their flagship indexes DEFI++, DEFI+l, and DEFI+s track a wide variety of DeFi token baskets (collectively referred to as DEFI++). PieDAO's indexes actually hold the underlying tokens—similar to physical ETFs—and maintain constant weights, as the weights of each underlying asset are predetermined, and the fund is continuously rebalanced as prices change. The PieDAO community votes on updates to the index (discussed in their governance forum).

Constant weight funds are not particularly common, as they require continuous trading to maintain weights, which can be costly. However, the introduction of automated market makers has made continuous rebalancing cost-effective. PieDAO's index products are built on Balancer and introduce some novel governance and security features.

Powerpool launched their PowerIndex (PIPT) this month, which shares many similarities with DEFI++. PowerIndex is also built on Balancer and is used to accumulate voting power in DeFi governance tokens. A notable distinction is that PowerIndex includes CVP, Powerpool's native token, which has the same weight as larger DeFi tokens. While some are skeptical about this, others believe that including CVP will align PowerPool with the underlying tokens of the index.

Benefits

Both indexes generate revenue through trading fees, as traders can trade with the associated Balancer pools.

As market-cap-weighted funds tend to concentrate, fixed-weight funds have the potential to distribute risk more evenly.

Redeemability of the underlying assets.

Drawbacks

Counterparty risk in the underlying balancing system (which has been exploited before).

Risk of impermanent loss.

Fixed weights can be somewhat arbitrary, as you rely on the methodology to select the correct weights.

Market Cap Weighted Index: Index Coop's DPI

Set and DeFi Pulse launched the DeFi Pulse Index (DPI) in mid-September. This index is market-cap weighted, meaning the weight of each asset tracks its market capitalization. The index holds 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 crypto indexes.

DPI has quickly surpassed other indexes in assets under management, currently nearly four times that of other indexes. Part of the reason is almost certainly due to liquidity mining activities, where index cooperation encourages people to buy DPI. However, DPI may also gain more traction because DeFi Pulse's involvement has increased its credibility.

Index Coop introduced the concept of an "index methodology," where a designated individual proposes an index and is responsible for rebalancing it each month. While the community has a say, this structure requires each index to have a specific person (or entity) in charge (and they also receive a portion of the fees from the index). This clearly helps attract DeFi Pulse and has drawn in other reputable firms, such as CoinShares, into Index Coop.

Benefits

Market cap weighting eliminates subjective judgment and is almost certainly more efficient than relying on community votes to allocate asset weights.

Redeemability of the underlying assets.

Methodologists can enhance the credibility of an index.

Drawbacks

Due to the significant involvement of the Set team, it is (currently) less decentralized than other indexes.

Market cap weighted indexes can promote concentrated risk.

Notable Drawbacks

Many of the aforementioned advantages stem from the fact that these indexes currently face lower regulatory burdens. Guidance from the U.S. SEC indicates that reliance on third parties is a key factor in determining whether something is a security. Given that decentralized indexes are automatically executed and do not rely on a central authority, they may not be considered securities. However, this is highly uncertain, and the government could certainly view these tokens as investment products.

It is also possible that the current rise of decentralized indexes is merely a flash in the pan. It remains uncertain whether institutions are willing to purchase unregulated assets managed by the community. If institutional buyers are not interested, the market cap of decentralized indexes is relatively low.

Finally, DeFi tokens are still highly correlated—whether indexes can significantly diversify risk remains unclear.

Conclusion

Decentralized indexes are a textbook use case for DeFi. They are able to leverage smart contracts and permissionless financial tools to provide a better user experience, more liquidity, and lower costs.

I believe they may be among the first products in DeFi to bridge the gap and attract mainstream audiences. Given the astronomical market size of ETFs, I expect innovation in this space to continue to develop rapidly.

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