Token Indices In DeFi
On creating index instruments for crypto
Think about the average internet user today. Are they busy managing a portfolio of investments on a day-to-day basis or do they pass on that responsibility to a third party? Much of the world relies on the interest generated by banks to hedge against inflation. Folks with more wealth further diversify their wealth through investments in real estate, commodities or equity ownership. The digital asset ecosystem has a weird relationship with passive investors. We expect users to do everything ranging from holding their own keys to tracking news to generate a return. Scaling retail and institutional investments into digital assets will not be possible without institutional-grade products.
That is where indices come into play. An index fund allows investors to track the price of a mix of underlying assets. These instruments hedge a single asset crashing while giving the upside that comes with the investment theme itself rising. In the traditional world, Bitcoin ETFs have been instrumental in allowing large institutions to gain exposure to the cryptocurrency space without worrying about hacks or managing keys. There is over $60 billion parked in Grayscale's products alone. They require users to be accredited investors and often cater only to institutions. Where does one go to get thematic exposure in digital assets without those hassles? That's where a new group of token-based indices has become instrumental within DeFi. I wanted to dig a bit into them today.
How Token Indices Come To Life
There are generally three kinds of tokens involved with most token indices
1. The governance token that is used to make decisions related to the index like Index Token
2. The underlying assets that go into the index like Aave and Sushi
3. The asset that represents the underlying assets. - e.g.: DPI, Metaverse Index
I may have confused you already so let's take a step back. Generally, these projects launch with support for a mix of assets that is represented by a single index. In the case of PowerPool's flagship index named PowerIndex - it was eight prominent DeFi assets. If individuals were to buy each of these assets from a decentralised exchange, costs would rack up for individual transfer and auto-rebalancing of the index would be hard. To make up for this, users that already hold the underlying instruments are incentivised through token rewards to park their DeFi assets in a smart contract in a pre-designed proportion. Those parking these assets receive PIPT (Power Index Pool Tokens) for doing this alongside the native governance asset over time. These PIPT tokens are then traded in the free market. A user holding PIPT can claim the underlying eight DeFi tokens from Powerpool's interface or trade the token itself as it tracks the fair value of the underlying instrument.
Why do teams do this? It curates and generates buy-in from experts in a given industry. This is at the crux of what differentiates a centrally managed index fund against one that is generally found in DeFi. The ownership of the underlying protocol is with enthusiasts that care deeply about the theme instead of a few managers that are incentivised only to increase the value locked in them. As the nature of investible assets turns increasingly niche within DeFi, it will become essential to align ownership among people that understand them best. One instance this is playing out is with the Metaverse Index on Index Cooperative. You would rather have a team of people that are committed to spending their time and research understanding the Metaverse than money managers that are not—classic wisdom of the crowds at play.
Members can pass proposals for creating different thematic indexes once a community is created around those providing assets to the index. The value accrues to the governance token as the amount of capital locked in the index scales. Index-related tokens reward token holders through cash-flow generated through fees charged every time an individual parks money or redeems it on the index. These fees help reduce churn in the short run and incentivise users to be long-term participants of the index.
Prominent Indices In DeFi Today
According to DuneAnalytics data, IndexCoop has the most value locked. This is likely because they have an institutional offering that works directly with large funds. I found it quite intriguing to note that other index-based projects struggle to attract substantial total value locked. Powerpool for instance, had about ~$7 million in assets under management. The metaverse index on Index Coop has a similar AUM at ~$6 million. It may be because Index instruments create a low amount in yield through token farming.( I apologise if you are new to DeFi and the previous statement made no sense. Please do me a favour and e-mail me your interpretation of what that meant. For research). The yield on actively used products like automated market-makers and lending products is generally higher and has lower lock-in periods. I took a look at the interesting indice related projects today.
Here's what they offer
1. Index Coop
Index cooperative is a collective of DeFi enthusiasts that came together to make it easier to invest in DeFi. They are built on top of Set Protocol - a tool that allows anybody to make token-based indices. They have four key index offerings - one looking at DeFi instruments, another for metaverse-based assets and one each to take leverage on Ethereum and Bitcoin. In case you are looking to explore DeFi and indices in general, their documentation is a great place to start. I was curious to see how the DeFi pulse index has performed as it is the largest index in existence. The starting point for the graph below is the day the index launched. It turns out Ethereum still beats both the index and Bitcoin.
Note: The returns figure is only indicative. Had I chosen a different date to begin with the index does beat Bitcoin.
Powerpool's focus was on meta-governance for DeFi assets. An emergent issue with the rise of governance-related tokens in 2020 was that individuals may not have had enough tokens to get a vote passed on a proposal. Powerpool's initial focus was on helping resolve this. Passive investors could drop their assets to a smart contract run by Powerpool and forego their governance rights in exchange for yield generated by the index. The index, in turn, would delegate those voting rights to specific protocol politicians. More recently, the focus has moved from being an infrastructure solution for indices to being a community-managed platform that offers assets that service different users with varying risk profiles. The Powerpool forum is worth digging into if you would like to see how coordination on a decentralized project works.
Disclosure: I have personal exposure to Powerpool through assets that are vesting.
Instead of having users mint or redeem index assets at high gas costs, PieDAO pools the transaction and does it when the gas cost is under 100 gwei. Users that require their index tokens immediately can pay the entirety of the cost of the transaction. This is focused more on retail users during times when on-chain activity is high. What intrigued me about PieDAO is the mix of gaming-related assets in their Play Index. It gives users access to close to 15 different assets, including prominent NFTs in a single instrument. From an asset performance point of view, it may have done better than Bitcoin and Ethereum over the past sixty days. This is primarily because close to half of the index consists of Axie Infinity. The fastest-growing game in the digital asset space today.
In case you are wondering what traction on some of these indices look like as of today - I have summarised it below. DeFi Pulse Index and Metaverse index is based on Index Coop. Yearn Ecosystem, Power Index and Young Lazy Apes Indices are on PowerPool. Play Index is from PieDAO.
What The Future Looks Like
Token indices are fascinating because they are a low op-ex business that can scale substantially. As a new generation of users enters the digital assets space, they will not be looking for ridiculous figures in yield generated but rather for secure, curated and thematic investments they can buy into without worrying. If the traditional financial world offers any clues, token indices could likely be one of the largest product categories in the future. Several critical challenges curb their growth. One is the on-chain fees paid in minting and redeeming index assets. PieDAO has tried a novel approach to solve this, but it has not had substantial adoption yet. The other challenge indices face today is with distribution. Retail buyers find tokens on exchanges and the exchange business model is predicated on average users buying and selling tokens repeatedly. There likely needs to be work done on educating people about how they can get a thematic investment without spending heavily on fees. It may take a few years, but we will eventually reach there. Hopefully.
P.s - The reading list for the weekend will be live on the website tomorrow. I will not be sending out an email to avoid spamming you. Also, join this telegram group in case you want to discuss this further.