The Bull Case for Decentralized Index Funds
Why decentralized exchange traded funds (ETFs) will surpass their predeccesors
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These products could be one of the driving factors behind DeFi adoption—the way we cross the chasm. Companies like Blackrock now sit at over $7T in assets with hundred billion dollar market caps—a lot of that growth has happened in the past decade.
We’ve also seen Grayscale grow to billions in recent months as they offer similar products through a Trust model, allowing people to gain exposure to BTC, ETH and others through their brokerage account. While it’s great for the broader adoption, having crypto exposure through your Schwab account isn’t the point.
It’s not better finance. It’s not bankless.
So let’s peak at the future. Let’s look at decentralized index funds. Less overhead. More liquid. Less paperwork. They live in open internet accounts accessible anywhere in the world—no bank required.
The 2010’s saw significant capital flow to traditional ETFs. The 20’s will belong to their decentralized counterparts.
Regan breaks down why.
Let’s get into it.
This Time is Different: The Bull Case for Decentralized Index Funds
Index funds have spent the past decade eating the asset management industry.
In September 2019, index funds surpassed active fund managers in size for the first time. And over the past 10 years, $1.36 trillion flowed into mutual funds and ETF’s while $1.32 trillion fled out of actively managed investment vehicles. This seismic shift in capital flow has produced big winners, catapulting Blackrock into the world’s largest money manager with a whopping $7.32T under management (and a $100B+ market cap).
The rise of passive index funds has not been the only seismic shift in financial services over the past decade though.
Starting in the early 2010’s, a number of well-funded companies worked tirelessly to integrate Bitcoin into the financial system. Companies like Grayscale and Coinshares made it easy for investors to purchase Bitcoin through IRA’s, brokerage accounts, and exchanged traded products (ETP’s). These companies have done well in the process, growing their AUM to more than $5B and $1B, respectively.
Over the past three years, regulated digital asset managers have started to launch crypto index funds. Bitwise launched its ‘Hold 10’ index fund in 2017, letting investors hold an index of the top 10 largest cryptocurrencies through an IRA or brokerage account. Grayscale and Coinshares also recently launched index products. However, these indices have fallen far short of the success of traditional ETF’s. At the time of writing, these indices hold under $250M AUM, a drop in the bucket of the ~$500B crypto asset market (and nowhere close to the 45% market share that traditional index funds have).
More recently, crypto entrepreneurs have focused on building a new financial system centered around crypto assets and decentralized, blockchain-based infrastructure.
This stands in stark contrast to their predecessors' focus on integrating crypto assets into the existing financial system. Decentralized Finance (or DeFi) focuses on building a parallel financial infrastructure that is global and permissionless (meaning anyone can access it), and more efficient than what it’s replacing. This space has exploded over the past twelve months, skyrocketing from under $1B to nearly $15B AUM today. Some of the biggest success stories include Uniswap, a decentralized exchange, and Compound, an Ethereum-based money market.
This wave of innovation has spurred a number of teams to launch crypto native index funds. These products are markedly different than their predecessors—they live in Ethereum wallets rather than in brokerage accounts and are traded on decentralized exchanges rather than regulated OTC markets. And the early signs are promising. For one, DPI (an index of DeFi tokens) hit $25M AUM in less than three months.
Just for reference, it took Bitwise three years to get to $100M AUM.
Below I’ll provide some historical context and end with my thesis on decentralized crypto index funds. We’ll run through:
The history of crypto index funds and the headwinds they’ve faced
An overview of the most recent wave of decentralized index funds
Why I believe this new wave of funds will be more successful
A Brief History on Crypto Index Funds
To understand the history of crypto index funds, let’s take a look at the most important players: Grayscale, Coinshares, Bitwise, and Coinbase.
Grayscale, a subsidiary of Digital Currency Group, is a pioneer in bridging crypto and regulated U.S. markets. Grayscale’s main focus has been single asset trusts, like their Grayscale Bitcoin Trust. The Bitcoin Trust launched in 2013 and has exploded in volume over the past few years, currently holding over 2% of all Bitcoin. This is appealing for investors that cannot hold Bitcoin directly for regulatory reasons or who want to purchase Bitcoin through an IRA or brokerage account.
Grayscale entered the index fund market in early 2018 with the launch of their ‘Digital Large Cap Fund,’ which tracks large market cap digital assets. It currently holds BTC, ETH, BCH, XRP, and LTC. While Grayscale has heavily marketed their core products, they have not focused on advertising the index fund. The fund has $131M in AUM at time of writing, making it approximately 10% of the size of Grayscale’s Ethereum Trust and 2% of the size of its Bitcoin Trust.
Like all of Grayscale’s products, the Digital Large Cap Fund is limited to accredited investors and requires an extensive onboarding process. The fund has a 3% annual management fee and a $25,000 minimum investment.
Across the Atlantic, Coinshares has built a substantial business by launching regulated crypto trusts for European consumers. The company’s ETP provider, XBT, has a line of single-currency products that offer exposure to Bitcoin, Ethereum, Litecoin, or Ripple and are traded on regulated European exchanges. While these products are more retail focused than Grayscale’s Trusts and have significantly lower minimum purchases, they still come up with a hefty 2.5% management fee.
Coinshares entered the index market in April 2020 by launching the CoinShares Gold and Cryptoassets Index (CGCI). The CGCI, which tracks a basket of Bitcoin and Gold, aims to offer investors “exposure to crypto assets without extreme volatility” due to the low volatility of gold and low correlation between the two assets. While the fund is now live and tradeable on OTC markets, it is not yet tradeable on exchanges.
Bitwise made crypto index funds their primary focus and publicly launched in 2017 with their flagship Bitwise 10 fund. The company has leaned into its institutional credibility, hiring a number of Wall Street Veterans and raising $4M from prominent investors including Khosla Ventures, General Catalyst, and Naval Ravikant. The Hold 10 fund has a $25,000 minimum investment, a 2.5% management fee, and is only open to accredited investors.
📰 HOT OFF THE PRESS: Bitwise just released the $BITW, a crypto index fund composed of the top 10 crypto assets by market cap; holding 76% in BTC, 12% in ETH.
Coinbase has taken two tries at indices and shuttered them both in short order.
The US-based exchange first launched its ‘Coinbase Index Fund’ in June 2018. The product, which tracked the assets listed on Coinbase, was only open to accredited investors and had a minimum investment of $250,000. Due to low adoption, Coinbase shuttered the product less than six months later. Coinbase launched a rehashed index product, Coinbase Bundle in September 2018. The product was more retail-focused and had a significantly lower minimum investment of $25. However, the company took down the bundle less than nine months after launch (seemingly because of low demand).
Headwinds to Adoption
While the aforementioned companies have all built sizable businesses, index funds remain a fraction (.06% to be exact) of the crypto market. Index funds have grown at a slower clip than the overall market because of regulation and lack of demand.
Digital asset managers like Grayscale and Bitwise fall in a challenging regulatory area in that they are both highly regulated, but not tradable on major exchanges. This is the worst of both worlds—the vehicles are both harder to access and less liquid than their underlying assets like Bitcoin.
Regulations also make these vehicles expensive to administer and hence expensive for investors. Index funds have to use regulated custodians and navigate a patchwork and changing legal environment. This means that companies like Bitwise likely face significantly higher legal costs than ETF administrators. Bitwise currently has a 2.5% expense ratio, which is 10x higher than that of many popular stock ETF’s.
Finally, the designation of these vehicles as securities (but not allowing them to trade as ETF’s) means that vehicles have poor liquidity. While Coinshares ETP’s trade on popular European stock exchanges, no U.S. vehicles have gotten approval to do so. The poor liquidity of these vehicles stands in stark contrast to their underlying assets, such as the dozens of deeply liquid, 24/7 spot markets for Bitcoin.
There is also the question of whether or not there’s actually investor demand for crypto index products (at least in their current form). The stunning success of Grayscale’s Bitcoin Trust is compelling evidence that a large number of investors are willing to deal with the administrative overhead of a regulated trust, but would prefer to simply hold Bitcoin. Moreover, given that BTC and ETH generally make up more than 80% of most indices, it is very easy for investors to simply hold these assets without having to deal with the overhead of an index fund. The underlying assets of these indices remain highly correlated, which also partially defeats the purpose of holding an index fund.
Crypto Native Index Funds
Building a blockchain-based financial system may have been a cypherpunk dream in the early 2010’s, but today Ethereum-based financial products are very real as they transact billions of dollars daily. Popular DeFi applications include MakerDAO’s Dai, a stablecoin which tracks the US dollar, and Uniswap, a decentralized exchange that lets anyone easily swap any Ethereum token.
By attracting huge amounts of human capital, DeFi has become the most investable asset class in crypto.
As the number of high-quality teams launching compelling DeFi tokens has grown, it has also become very hard to keep up with. Against this backdrop, a number of decentralized index funds have emerged to allow investors to get passive, diversified exposure to the DeFi market. In order to understand the different approaches to constructing a decentralized index, let’s take a look at four of the most prominent indices: sDEFI, DEFI++, PIPT, and DPI.
Synthetic Fixed Weight: sDEFI
In November 2019, Synthetix introduced sDEFI, an ERC20 token that tracks a basket of DeFi tokens. sDEFI is a synthetic asset—it does not hold any underlying tokens, but rather uses price feeds to track their value. The index was composed of nine tokens at launch with pre-defined weights (based on Twitter polls and community feedback). The Synthetix community votes on weight rebalancing and index composition quarterly through Synthetix’s governance system.
sDEFI is built on top of the Synthetix protocol, which allows users to mint and trade synthetic assets (called synths). These are essentially derivatives that track the price of some specific asset. Users create synths by depositing collateral (in the form of SNX) and then minting synths against that collateral. Synthetix uses oracle price feeds to determine the value of synths (further reading).
sDEFI has so far proved resilient. It's the oldest DeFi index and has weathered major drawdowns like the March 2020 crypto price crash.
sDEFI is built on solid infrastructure. Synthetix is one of the most respected teams in DeFi and their protocol has processed $1.5B+ in trading volume.
There are also zero rebalancing costs because the index does not trade assets, but rather switches price feeds.
The market has not jumped on sDEFI. As of time of writing it has less than $2M in AUM.
Substantial counterparty risk in both the underlying Synth system and its oracles (which provide the price feed).
There’s limited liquidity. Most synths have failed to gain significant trading volume outside of Synthetix’s own trading system.
It’s not redeemable for the underlying assets as it’s a synthetic.
Physical Fixed Weight: DEFI++ & PIPT
Their flagship indices, DEFI++, DEFI+L, DEFI+S track various baskets of DeFi tokens (from hereon I’ll refer to them collectively as DEFI++). PieDAO’s indices actually hold the underlying tokens - analogous to a Physical ETF - and are constant weight as the weight of each underlying asset is predefined and the fund constantly rebalances as prices change. The PieDAO community votes on updates to the indices (discussed in their governance forums).
Constant weight funds have not been especially common because they require constant trading to maintain weights, which is costly to execute. However, the introduction of automated market makers makes constant re-balancing cost-effective (this is a great explainer as to why). PieDAO’s index product is built on top of Balancer and introduces some novel governance and safety features.
Powerpool launched their PowerIndex (PIPT) this month, which shares many similarities with DEFI++. PowerIndex is also built on top of Balancer and is designed to accumulate voting power in DeFi governance tokens. One notable distinction is that PowerIndex includes CVP, Powerpool’s native token, on an equal weight with much larger DeFi Tokens. While some have viewed this cynically, others have argued that including CVP aligns PowerPool and the index’s underlying tokens.
Both indices produce yield through trading fees because traders can trade against the underlying Balancer pools.
Fixed weight funds can potentially spread risk more evenly as market cap weighted funds tend to get concentrated.
Redeemable for the underlying assets.
Counterparty risk in the underlying Balancer system (which has been exploited before).
Risk of impermanent loss.
Fixed weighting is somewhat arbitrary as you’re relying on the methodologist to pick correct weights.
Physical Market Weight: Index Coop’s DPI
Set and DeFi Pulse launched the DeFi Pulse Index ($DPI) in mid-September. The index is market-cap weighted, meaning that each asset’s weighting tracks its market cap. The index holds the underlying assets and uses Set Protocol as its underlying infrastructure. In early October, Set launched the Index Coop, a decentralized community organization that will create and manage crypto indices.
DPI has rapidly overtaken other indices in AUM and is currently nearly 4x larger than any other. Part of this is almost certainly due to a liquidity mining campaign whereby Index Coop is incentivizing people to purchase DPI. However, DPI has also likely gained more traction because DeFi Pulse’s involvement lends it credibility.
Index Coop has introduced the idea of an ‘index methodologist’ who proposes an index and is responsible for rebalancing each month. While the community has a say, this structure dictates a specific person (or entity) responsible for each index (and who also earns a portion of its fees). This clearly helped attract DeFi Pulse and has attracted other credible firms like CoinShares into the Index Coop.
Market cap weighting removes human judgement and is almost certainly more effective than relying on community votes to assign asset weightings.
Redeemable for the underlying assets.
Methodologists can bring credibility to an index.
Less decentralized (at the moment) than other indices given heavy involvement of Set team.
Market cap weighted indices can promote concentration risk.
📚 Learn more about the Index Coop and their mission to become a decentralized Blackrock.
The Bull Case for Decentralized Index Funds
The market for decentralized index funds has heated up significantly over the past six months.
It should come as no surprise that they’re on a stronger growth trajectory than their predecessors given how much quicker they’re able to move. As an example, Yearn has been executing at an impressive rate, announcing five mergers or partnerships in the past two weeks. Less than a week later, Ryan Watkins proposed YETI, a Yearn Finance ecosystem index, in the Powerpool governance forums. While it has not yet been implemented, it is very impressive that an index could be launched and tradeable within two weeks of ideation.
Decentralized indices also have an inherent structural advantage when it comes to liquidity. Since they are represented as standard Ethereum tokens - and because exchanges don’t need permission to list them - it is much easier to create a liquid market. For example, DPI has $40M of liquidity on Uniswap less than three months after launching, whereas Bitwise’s flagship index is still not liquid three years post-launch.
Using smart contracts to handle rebalancing, minting, custody, and redemption gives decentralized indices a major cost advantage. All of the aforementioned index funds have expense ratios under 1% annually, compared to the 2.5-3% of their centralized predecessors. The initial purchasing process is much easier as well—it takes 30 seconds to mint DPI compared to the week-long subscription process at Bitwise.
Decentralized indices also benefit from the composable nature of building on Ethereum. For example, there is a broad and growing range of investable assets including NFTs and Social Tokens. As long as these assets are represented as ERC20 tokens, it is nontrivial to integrate them into indices. The composable nature of decentralized indices also gives them utility within the broader DeFi ecosystem. For example, tokenized indices can be used as collateral, locked up or staked to access other value (e.g. staking $DPI to earn INDEX).
Some Drawbacks Worth Highlighting
Many of the advantages described above stem from the lower regulatory burden that these indices currently face. There has been SEC guidance that suggests that reliance on a third party is a key prong as to whether something is a security. Given that decentralized indices run self-executing code and are not reliant on a central party, it is possible that they are not securities. However, this is highly uncertain and it is certainly possible that governments will treat these tokens as investment products.
It is also possible that the current excitement around decentralized indices is a flash in the pan. It’s very uncertain as to whether institutional purchasers will be comfortable purchasing an unregulated asset that is governed by a community. If institutional purchasers are uninterested, there is a fairly low ceiling on the market for decentralized indices.
Finally, DeFi tokens are still highly correlated—it’s not yet obvious that an index diversifies risk significantly.
Decentralized indices are a textbook illustration of the benefits of decentralized finance. They’re able to leverage smart-contracts and permissionless financial tools to offer a better user experience, more liquidity, and lower costs than their centralized counterparts.
I believe that they may be one of DeFi’s first products to cross the chasm and engage a mainstream audience. Given the truly astronomical market size of ETF’s, I expect innovation here to continue at a rapid pace in the coming future.
Thanks to Reuben Bramathan, Dmitriy Berenzon, Spenser Huang, Greg Doctor, Overanalyser, and Michael Petch for feedback on this piece. I hold BTC, ETH, DPI, INDEX, SNX, and CVP. I am an investor in Set Labs and an active community member of the Index Coop. This is not legal or financial advice.
Consider the bull case for decentralized ETFs
Read our previous Bankless pieces on DeFi Indexes
Regan Bozman is Director of Business Operations at CoinList. He's a co-founder of Free Company, a collective of Web3 operators investing in early stage projects. Free Company has backed teams like Audius, Boardroom, Dune Analytics, and Rabbithole.
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