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Investing in stock market indices has become extremely popular thanks to the proliferation of exchange traded funds, or ETFs, which often track popular market indices such as the S&P 500 or Nasdaq-100.
Investing in the entire market can be a simple but effective strategy. Instead of spending energy and time trying to beat it – often unsuccessfully – investors are guaranteed average returns, which have been more than respectable in both stocks and cryptocurrencies for the past 10 years.
The rise of decentralized finance in the summer of 2020 appears to have reinvigorated the concept of passive investing in cryptocurrencies. In addition to creating a well-defined new category of crypto assets, it has enhanced the infrastructure required to create something akin to a crypto-native ETF.
Several projects and platforms launched their own DeFi indices in 2020. Some, such as the perpetual FTX DeFi contract or Synthetix sDEFI, are derivative products based on synthetic contracts. They simply track the price of a basket of assets, without owning the underlying tokens.
But DeFi grants the ability to create something much closer to an ETF. These types of funds always possess the underlying basket of assets that they are supposed to track. At the end of each trading day, some large institutions have the privilege of creating or redeeming shares in the ETF for its net asset value. They create new shares and sell them if the ETF is more expensive than the assets it owns and redeem the existing shares if it is worth less.
A DeFi-based index allows for the exact same type of arbitrage mechanism, but doesn’t need to be limited to a privileged set of maintainers.
Currently, there are three main ETF-like DeFi products: the DeFi Pulse Index, two different PieDAO indices, and PowerPool’s Power Index.
Indices differ primarily based on the assets in which they are made up and how each token is weighted. DeFi Pulse and PieDAO use market capitalization weighting, while PowerPool has a fixed quota for each token. The PieDAO and PowerPool indices can be changed by voting for governance with Dough and CVP, respectively.
While DeFi Pulse and PieDAO closely emulate the characteristics of a traditional ETF, the construction of the PowerPool index highlights that the DeFi indices could eventually grow beyond the possibilities offered by the equity markets.
The index allows holders to vote in governance proposals for the underlying protocols without leaving the index. This is part of the team’s vision of smart indices that retain the utility offered by direct ownership of the underlying tokens. While this is likely dictated by the project’s strong focus on meta-governance, it suggests that the possibilities offered by DeFi composability have yet to be fully explored.
The DeFi Pulse Index is currently the most popular, with a market capitalization of $ 36 million. The combined value of the two PieDAO indices is valued at $ 3.7 million, while the Power Index has reached its current limit of $ 500,000 in value.
While still small, these indices were launched relatively recently and are likely to be in the early stages of their growth cycle. However, some experts see severe limits on their maximum size.
A cryptographic product for crypto enthusiasts
Meltem Demirors, CoinShares’ chief strategy officer, believes using the term “ETF” for these redeemable index funds is not entirely correct. The concept of ETFs is specific to traditional markets. He told Cointelegraph:
“An ETF is an investment product that combines the benefits of diversification with the ease of trading a single stock via a single ticker. Like many financial products, they rely on a manager, an administrator and a range of brokers and have management costs, commissions, trading restrictions and the ease with which you can buy or sell them and varying degrees of quality. “
While crypto indices capture many advantages of ETFs, “they face the same challenges as traditional ETF buyers, without the benefit of regulatory oversight or standard documentation,” he added. “I would call these types of products something very different to make clear what people are buying.”
The differences are crucial in driving crypto index adoption, in his view. “These products will initially appeal to crypto enthusiasts and cryptographic savvy users,” Demirors said, mentioning the difficulty of using DeFi interfaces for non-cryptographic users.
Demand for DeFi indices for now is likely to come from retail and crypto users, while institutional investors will continue to use the safety and familiarity of their favorite brokerage accounts, Demirors concluded.
Joey Krug, co-founder of Augur and co-chief investment officer of Pantera Capital, shared the overall perspective. While he is more positive about tokenized indices such as “what a native crypto ETF would look like”, he said that “retail [will lead] at the beginning, even if in the long term, I could also see the demand from institutional traders “.
Diversification was problematic
The attractiveness of market index ETFs stems from the broad exposure they offer to holders. While individual stocks can rise and fall due to specific and unpredictable factors, a basket of them can mitigate these individual aberrations to provide an overall picture of the market.
In cryptocurrencies, diversification has so far been largely ineffective. “Historically, most crypto assets have been traded with a beta of one on Bitcoin,” Demirors explained. “Beta” is a financial measure that defines how well one asset tracks another: a beta of one indicates correlated price movements in both direction and magnitude.
This has been a major issue for previous crypto index projects, which often suffered from market cap-based over-allocations to Bitcoin (BTC) and Ether (ETH) which compounded the lack of diversification, Demirors noted.
Liquidity in the underlying assets is the limiting factor for any index fund, as when their holdings get too large, “the tail starts wagging,” he said. Market participants can begin to trade against overall rebalances and flows into the fund, potentially distorting the prices of underlying assets.
These market constraints place severe restrictions on the profitability of index funds, with Demirors noting that “it would be difficult to see crypto indices grow beyond the natural limits of these markets.”
However, DeFi or governance focused funds can help with diversification issues. Krug pointed out that DeFi tokens have recently moved independently or against BTC, suggesting that “correlations are breaking down a bit.” In the long run, the protocol’s presence of revenue and cash flows could further help break the correlation, he added.
Overall, thematic index funds such as the DeFi baskets offered today are useful for some niches of traders, both Demirors and Krug agree. For example, they can be used to build complex hedging strategies, Krug said.
But the prospects for mass adoption are somewhat murky, as these types of products will have to mature in step with the broader cryptocurrency and DeFi markets to remain useful.
