Exploring the common patterns and advantages and disadvantages of DeFi decentralized index funds

This article was published by the Blockchain Study Society, with the original title "Which Index, sDeFi, DPI, DeFi++, or PIPT, is Likely to Become the Leader in the Field?"

Bitcoin is a re-examination of currency, whether it is the terminator of currency is beside the point. At least, Bitcoin is trying to redefine finance, and DeFi is also attempting to reconstruct financial product models. Although DeFi is still largely spinning in a small circle, the core heavy users are the old friends in the crypto circle. But don't forget, all new things at the beginning seem like toys to people.

Although DeFi has not yet achieved the goal of inclusive finance, and there will inevitably be many waste products and defective products in the DeFi space, with projects running away, returning to the community, and being coerced by hackers, many problems will increasingly arise in the future. The demise of individual projects will, through a process of negation, make the overall ecosystem stronger.

According to Wikipedia, the Lindy effect refers to the idea that for things that are not going to die naturally, such as a technology or an idea, the longer they survive, the longer their expected remaining lifespan becomes. Bitcoin has been declared dead over three hundred times; it is time to witness the Lindy effect. Have you not seen that Singapore's largest commercial bank, DBS Bank, has officially launched the digital trading platform DBS Digital Exchange, allowing fiat currency to trade cryptocurrencies starting next week? The Singapore Exchange holds a 10% stake.

And JPMorgan, which has always been skeptical or even disdainful of Bitcoin, has recently entered the "true fragrance" stage, beginning to compare Bitcoin with gold. In Ray Dalio's view, Bitcoin and other cryptocurrencies have established their position over the past decade, "as alternative assets similar to gold."

In this context, we may be more confident in judging that for an ecosystem that can quickly learn and evolve, what does not kill me makes me stronger. And as mentioned earlier, all categories of traditional financial products will be revisited in the crypto world.

1. Index Funds and Crypto Asset Index Funds

Index funds are often one of the best entry-level investment products for new investors. Over the past decade, the market share of index funds has been continuously expanding. Taking BlackRock as an example, this company has risen to become the largest asset management company in the world, managing assets exceeding hundreds of billions of dollars. The rise of index funds has contributed significantly to this growth.

In the past decade, with the emergence and increasing attention to Bitcoin, companies like Grayscale, CoinShares, and Bitwise have begun to integrate crypto assets into the existing financial system through trust funds and index funds. Grayscale's every purchase always sparks heated discussions in the market, and some even refer to the current market as an institutional bull market.

The approach of institutions like Grayscale and the views of Ray Dalio and JP Morgan is to choose to include Bitcoin and other crypto assets in the basket, packaging or transforming crypto assets to provide them to traditional financial product investors, allowing investors to purchase and hold crypto assets through IRA, brokerage accounts, and products listed on exchanges.

On the other hand, the rise of DeFi represents another attempt in a different direction. What DeFi does is create a parallel space-time. In this space-time, leveraging the internet's reach, DeFi provides financial infrastructure that requires no authorization and is accessible to everyone, allowing people to gain a new financial space beyond traditional banks, exchanges, stocks, and funds.

Decentralized exchanges (DEX), automated market makers (AMM), derivatives, decentralized lending, and many other product models have emerged. In the past year, DeFi has made rapid progress, with the market share now approaching $15 billion, including standout products like Uniswap, Balancer, AAVE, and Synthetix.

Naturally, in the wave of innovative experiments in DeFi, index funds, which are indispensable products in the traditional financial world, are also beginning to take shape.

Some entrepreneurial teams have started to create cryptocurrency index funds, especially DeFi index funds. For example, DPI reached an asset management scale (AUM) of $25 million in just three months.

What projects are there for crypto index funds created on top of DeFi infrastructure, and how are they developing? This article will explore together.

2. What Problems Do Crypto Index Funds Solve?

For many investors, DeFi is one of the must-have products in the current crypto asset investment field. The projects that have survived and settled during the DeFi boom are gradually sinking and becoming infrastructure. On top of this, more variations can be played out. Besides increasing new investment targets, what can crypto asset index fund projects based on DeFi provide?

Decentralized index funds, similar to traditional index funds, offer the opportunity to passively obtain diversified investments. There is no need to invest in individual crypto assets with limited funds, risking not recouping transaction fees. With reliable decentralized index fund products, investors can directly buy a basket of crypto assets' index and simply hold it while still enjoying the advantages of decentralization.

However, decentralized index fund products also have unique problems. Unlike traditional fund operators, who are subject to securities and other legal constraints, decentralized index funds need to prove themselves and require more effort, with time and consensus being the most important.

Suppose a project issues a box token, claiming it contains several BTC, large treasure coins, and faith coins. Then, does this box token have the ability to anchor the value of the corresponding underlying tokens? Is the proportion of the index composition reasonable, and how to solve the risk of fund operators making decisions or even running away?

There are many factors to consider when designing decentralized index funds, such as the composition structure of the index fund, management methods, management fees, and many other issues.

In the following sections, we will look at the four most representative products in the market: sDeFi, DeFi++, PIPT, and DPI.

3. sDeFi

sDeFi is an index product issued on the derivatives trading platform Synthetix, anchored to a basket of DeFi tokens. However, it uses a derivative method that anchors the price, meaning that this index only tracks the price of the corresponding DeFi tokens, it can be traded but cannot be redeemed, and does not have the underlying DeFi tokens as support.

At its launch, sDeFi included eight types of DeFi tokens, and the composition ratio of various tokens and the decision to add new tokens are determined by the community through Synthetix's governance system. Currently, sDeFi includes 12 types of tokens, including assets like AAVE, SNX, YFI, REN, BAL, CRV, etc. The proportion of different token shares is determined by the community and adopts a fixed ratio approach.

However, sDeFi's trading does not include liquidity mining. Users first need to over-collateralize SNX to generate sUSD or purchase sUSD from a DEX, and then participate in trading sDeFi in the Synthetix market. In Synthetix's market, a no-slippage automated trading market mechanism is used; each time a purchase is made, the system will mint sDeFi for you, and each time a sale is made, sDeFi will be burned, returning sUSD to you.

The trading of this index does not incur additional fund custody fees; it only charges a 1% trading fee, just like other trading pairs on Synthetix. In addition to sDeFi, the platform also has a bearish DeFi index: iDeFi. After buying iDeFi, if the DeFi index declines, the price of iDeFi tokens will rise.

However, the current market size of sDeFi is not large. According to current statistics, the combined 24-hour trading volume of sDeFi and iDeFi does not exceed $1.6 million. Since it uses derivatives rather than physical (real tokens) anchoring, sDeFi is merely a price index that relies on the oracle chosen by Synthetix. Once the oracle fails or encounters network congestion causing price delays, the market trading of sDeFi will also be affected.

To summarize the advantages and disadvantages of sDeFi:

Advantages

• sDeFi is the oldest DeFi index trading product;

• The Synthetix team has a good reputation in the DeFi ecosystem, having processed over $1.5 billion in trading volume, thus providing a robust infrastructure for sDeFi.

Disadvantages

• Uses a synthetic derivative structure, unable to redeem the anchored assets;

• Relies on the oracle system, posing counterparty risk.

4. PieDAO

In contrast to sDeFi's derivative structure, which only anchors prices without real asset support, the DeFi team PieDAO, created in March 2020, has created index funds such as DeFi++, DeFi+L (large-cap index), and DeFi+S (small-cap index), which adopt a structure supported by real assets.

In simple terms, index funds like DeFi++ backed by real assets need to purchase and hold a corresponding basket of DeFi tokens according to a set ratio. In contrast, index funds like sDeFi, which have a derivative structure, only anchor prices without holding assets and do not redeem, which can be referred to as air coins, with their value serving as a price indicator for the corresponding basket of DeFi tokens.

To help readers better understand DeFi index funds, we will spend more time introducing the structure and operation of PieDAO's index products.

Overview of PieDAO Index Products

As shown in the image, PieDAO's index products include seven types, with BCP, DeFi+L, and DeFi+S having larger trading volumes. This article mainly focuses on DeFi index funds, specifically looking at DeFi++, DeFi+L, and DeFi+S.

DeFi+L has a market cap of $1.77 million, with a price of $1.3; DeFi+S has a market cap of $988,000, with a current price of $1.62, while the DeFi+S index product was created earlier than DeFi+L, covering six small-cap DeFi tokens, including UMA, REN, LRC, BAL, PNT, and MLN.

PieDAO's DeFi series index products are built on Balancer. When users purchase DeFi index tokens, they buy tokens through trading tools like Uniswap according to a fixed holding ratio, or if users hold enough corresponding tokens, they can directly join the liquidity pool to issue DeFi index tokens.

Since a fixed ratio is used, as prices change, the funds allocated to different tokens need to be periodically reconfigured, which can be directly assisted by external AMM automated market-making mechanisms. Compared to traditional index funds, which require manual buying and selling of corresponding stocks, bonds, etc., this is much more efficient.

Using DeFi+L as an Example to Understand Issuance and Redemption

DeFi+L's issuance mechanism has two methods: single asset and multi-asset options. If the single asset option is chosen, ETH needs to be paid, and the corresponding assets must be exchanged through swap trading tools like Uniswap or Balancer. To avoid the impact of slippage, an additional 5% of ETH needs to be paid, with the excess refunded.

If users choose the multi-asset option, they need to deposit the corresponding assets in proportion to provide liquidity for the DeFi+L fund. The following image shows the corresponding assets required to generate 1 DeFi+L index token.

Since PieDAO's index products adopt a structure supported by real assets, they can be redeemed for assets in real-time without incurring additional redemption fees. On the DeFi+L fund page, clicking Redeem allows users to select the quantity of assets they wish to redeem.

Understanding the operation and mechanism of DeFi+L also clarifies the other index products of PieDAO and the practices of similar structured products like PowerIndex.

To facilitate users who need both the DeFi+L large-cap fund and the DeFi+S small-cap fund, PieDAO has recently launched the DeFi++ index product, packaging these two for trading. Among them, the ratio of DeFi+S and DeFi+L is 30% and 70%, respectively. Currently, DeFi++ has a market cap of $520,000.

PieDAO has designed a liquidity mining mechanism. If users provide liquidity for index products like DeFi+S and DeFi+L in Balancer's token pool, they can receive native tokens DOUGH and BAL as rewards. However, it should be noted that in Balancer, the token pool ratio for DeFi+S/sWETH and DeFi+L/sWETH is set at 7:3, which I believe is relatively high, given the current insufficient depth.

PieDAO's DeFi series index products represent a paradigm for constructing crypto index funds, allowing real-time redemption through design and leveraging AMM to provide real-time liquidity and rebalancing convenience. It is expected to serve as a model for many future crypto index products.

The assets covered by the index and their proportions, although fixed, can be changed through community resolutions. The PieDAO community can make subsequent adjustments through proposals (PIPs), including ratios and the types of tokens held.

A similar project is the PIPT index issued by PowerPool, which is also created based on Balancer and adopts a fixed ratio model.

5. INDEX Coop

Index Coop is a decentralized index community launched by the SET protocol (Set Protocol), with the governance token being INDEX, which is also used as a reward for liquidity mining. The first index product is the DeFi Pulse Index (DPI), launched by the one-stop DeFi portal DeFi Pulse and Index Coop, with a market cap of around $20 million.

DPI aims to track the performance of relevant tokens in the DeFi industry, calculating their proportions based on the circulating market capitalization of the tokens. The underlying assets of DPI are selected based on a complete set of criteria, primarily aimed at choosing projects that can be developed, maintained, and operated long-term and have a broad audience.

DPI is built on the Set Protocol V2 protocol, using a basket of DeFi tokens as underlying support, allocating corresponding holding ratios based on the market capitalization of the tokens.

DPI allows users to redeem, meaning users can exchange DPI tokens for the corresponding underlying assets at any time. Currently, it includes 10 types of DeFi tokens, as shown in the following image.

Among them, AAVE has the largest share, accounting for about 19.4%, while BAL's current proportion is 2.27%. Unlike PieDAO's DeFi++ and other index products that use a fixed ratio, DPI's index composition based on circulating market capitalization weighting often requires rebalancing and token replacement.

The governance mechanism of the Index Coop community introduces the role of index strategy providers, but these strategy providers are not the managers of the index.

In the two months after its launch, 7.5% of INDEX tokens will be allocated to strategy providers. For example, DeFi Pulse, as they compile indicators, conduct research, and provide data, this portion of tokens will be distributed over 18 months. Additionally, each Index Coop index (like DPI) may also have fees, part of which will be allocated to the index strategy providers.

DPI Issuance and Redemption

It is worth noting that the entry for issuing and redeeming DPI index on TokenSets is hidden by default and needs to be clicked to display.

Unlike PieDAO's DeFi series index, which provides single asset/multi-asset options, DPI must be issued by transferring multiple corresponding underlying assets. Through the tokensets website, DPI tokens can be issued, requiring authorization for all relevant tokens to the contract. Since it is supported by real assets, DPI can also be redeemed for corresponding assets in real-time.

DPI's Liquidity Mining

In addition to the credibility added to DPI by DeFi Pulse's participation, making DPI's market cap lead among DeFi index products, the liquidity mining mechanism adopted by DPI is also crucial.

Users provide liquidity for the ETH/DPI trading pair on Uniswap and can then mine through the IndexCoop page to receive INDEX token rewards, currently priced at $4.6, with an estimated annual yield of 23%.

DPI's Index Maintenance Method

DPI is divided into two phases: the determination phase and the adjustment phase.

In the third week of each month, modifications for the next token ratio update will be determined, referencing the current number of circulating market capitalizations from CoinGecko to decide which tokens to add or remove from the index. This work will be announced to the community before implementation. After the determination phase ends, adjustments to the constituent tokens of the index will be made according to the corresponding instructions, conducted on the first working day of each month.

Considering the impact of token allocation on the market, as the number of assets tracked by the index expands, the adjustment phase's time may be extended to more than one day to reduce the impact of buying and selling on market prices.

DPI uses a circulating market capitalization weighting method, requiring no human intervention, making it more efficient than community voting to change weights. To facilitate understanding, let's look at the relevant information from Index Coop's asset balance report for November.

This process is conducted through IIP-5's INDEX improvement proposal.

Before execution, DeFi Pulse, as the index strategy provider, announced the new DPI weights and notified the community for verification. After confirmation, using the IndexCoopManager's smart contract, a multi-signature trustless method was employed, including DeFi Pulse, SetLabs, and the IC community, to complete the rebalancing of DPI.

6. YETI

At the end of last month, PowerPool issued PIPT, created based on Balancer, and within nine days, locked over $9 million. PIPT has a mechanism similar to the index funds created by PieDAO.

On December 4, a user named Ryan Watkins proposed in the PowerForum (PowerPool's governance forum) to create the Yearn ecosystem index YETI, focusing on the Yearn ecosystem, including seven tokens: YFI, SUSHI, CREAM, AKRO, COVER, K3PR, CVP, and PICKLE.

YETI adopts a fixed ratio and real asset-backed issuance method, meaning each YETI is supported by underlying assets and can be redeemed at any time. There are three options for issuing YETI:

• Transfer ETH, USDC, DAI, or any asset to mint, as it requires converting ETH into the corresponding eight assets, so the slippage is relatively high, with a default slippage of 2%;

• Single underlying asset, where users can transfer one of the eight underlying assets;

• Multi-asset issuance, as shown in the following image.

YETI Liquidity Mining

To incentivize user participation and enhance YETI's liquidity, liquidity mining incentives for the first month have been created. This includes two parts: depositing YETI through PowerPool can share a reward of 200,000 CVP tokens; providing liquidity for the YETI/ETH pool (with a ratio of 80:20) through Balancer can earn 250,000 CVP tokens as rewards.

According to the PowerIndex page, the equivalent APR is approximately 530%-595%, which is quite considerable. However, the eight tokens covered in the YETI index have higher price volatility compared to ETH and other tokens, so participation should be cautious.

According to PowerPool's governance method, subsequent changes in the types and proportions of YETI tokens should also be conducted through governance improvement proposals and take effect after voting.

7. Conclusion

The market prospects for index funds are broad, and the emergence of several DeFi index fund products in the DeFi space also indicates the community's unwillingness to settle and its continued exploration. All products that can be reconstructed with DeFi will be reconstructed by DeFi; however, given that the crypto market itself is a niche world, I prefer to understand the exploration of DeFi products as being in the prototype testing stage. Before reaching a broader audience, this step is certainly essential, but it is also important to recognize that the road is long and not achieved in a day.

Whether through the derivative approach adopted by Synthetix or the real asset-backed methods taken by PieDAO, INDEX Coop, and PowerPool, all are paving the way for DeFi + index funds. Given time, I believe these accumulations will pave an interesting path for DeFi to break out. The emergence of YETI is an interesting example, as the concept of an index product based on ecological scope could also be extended to the NFT and blockchain gaming fields.

DeFi has created a parallel financial space to explore various financial product models. On another path, traditional financial institutions are also approaching the crypto asset industry in their own way, with both paths running parallel without contradiction.

This article summarizes four currently representative projects and discusses some common patterns and advantages/disadvantages of DeFi decentralized index funds. Finally, it is worth reminding that although products like index funds aim to reduce investment risks, given that various tokens in the current crypto asset market are still highly correlated, they cannot achieve much in terms of risk diversification. Therefore, it is necessary to remind readers once again that while product models are worth paying attention to, participants should do their homework and manage risks effectively.