Can DeFi indices finally be worthwhile for passive cryptocurrency-based investments?

Indices for investments on the stock exchange have become very popular thanks to the increasing spread of Exchange Traded Funds (ETFs).which are often followed by popular market indices such as the SP 500 or the Nasdaq-100.

Investing in the entire market can be a simple but effective strategy. Rather than investing energy and time to beat them – often unsuccessfully – investors are guaranteed an average return that has been more than respectable over the past 10 years in both stocks and crypto.

The rise of DeFi in the summer of 2020 appears to have revived the concept of passive investing in cryptocurrencies. In addition to creating a well-defined new category of crypto assets, it pushed the infrastructure necessary to create something analogous to a crypto ETF.

Can DeFi indices finally be worthwhile for passive cryptocurrency-based investments?
Can DeFi indices finally be worthwhile for passive cryptocurrency-based investments?

Various projects and platforms launched their own DeFi indices in 2020. Some, like the perpetual FTX DeFi contract or Synthetix sDEFI, are derivatives based on synthetic contracts. You simply track the price of a basket of assets without owning the underlying tokens.

P.ero DeFi gives the opportunity to create something that is much closer to an ETF. These types of funds always have the basket of underlying assets that they are designed to track. At the end of each trading day, some large institutions have the privilege of creating or redeeming shares in the ETF for their net asset value. They create new stocks and sell them when the ETF is more expensive than the assets you own, and they swap out existing stocks when they are worth less.

A DeFi-based index enables exactly the same arbitrage mechanism, but does not have to be limited to a privileged group of carers.

There are currently three main DeFi products that are similar to the ETF: the DeFi Pulse Index, two different PieDAO indices, and the PowerPool Power Index.

The main differences between the indices are the assets they are made up of and the weighting of each token. DeFi Pulse and PieDAO use market capitalization weighting, while PowerPool charges a fixed fee for each token. The PieDAO and PowerPool indices can be changed through governance coordination with Dough or CVP.

While DeFi Pulse and PieDAO come very close to the characteristics of a traditional ETF, the construction of the PowerPool index shows that DeFi indices can grow beyond the possibilities of the stock markets.

The index enables holders to vote on the governance proposals of the underlying protocols without leaving the index. This is part of the vision of the smart indexes team that will retain the benefit of direct ownership of the underlying tokens. This is likely determined by the project’s strong focus on meta-governance, but suggests that the possibilities that DeFi composability offers have not yet been fully explored.

The DeFi Pulse Index is currently the most popular with a market cap of $ 36 million. The combined value of the two PieDAO indices is $ 3.7 million while the Power Index has reached its current cap of $ 500,000.

Even though they’re still small These indexes were released relatively recently and are likely early in their growth cycle. However, some experts see strong limits on the maximum size.

A crypto product for cryptocurrency enthusiasts

Meltem Demirors, Chief Strategy Officer at CoinShares, believes that the use of the term “ETF” for these refundable index funds is not entirely accurate as the concept of an ETF is specific to traditional markets. He said to Cointelegraph:

“An ETF is an investment product that combines the benefits of diversification with the ease of trading a single stock through a single ticker. Like many financial products, they are dependent on a manager, a manager and multiple intermediaries and charge management, commissions, trading restrictions and the ease with which they can be bought or sold and the different levels of quality. “

While crypto indices offer many of the benefits of ETFs, they also “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 completely different to differentiate what people are buying“.

In his opinion, the differences are crucial for adopting the crypto index. “”These products will appeal to crypto enthusiasts and knowledgeable users first.Said Demirors and mentioned them Difficulty using DeFi interfaces for non-crypto users.

Demand for DeFi indices is likely to come from home and equity crypto users for now, while institutional investors will continue to leverage the security and familiarity of their preferred brokerage accounts.Demirors closed.

Joey Krug, co-founder of Augur and co-chief investment officer of Pantera Capital, shared the same big picture. Although he’s more positive about token indices like “What would a crypto-native ETF look like,” he said “sale [liderarĂ¡] Initially, albeit in the long term, you might also see demand from institutional actors“.

Diversification was problematic

The appeal of market index ETFs is based on the extensive commitment they offer to holders. While individual stocks can go up and down due to specific and unpredictable factors, a basket of them can make up for those individual aberrations to get an overall picture of the market.

In cryptocurrencies Diversification has so far been largely ineffective. “In the past, most crypto assets traded on Bitcoin at a beta of one,” said Demirors. Beta is a financial measure that defines how close one asset is to another. A beta of one indicates price movements that are correlated in both direction and size.

This was a big problem for previous crypto index projects, which often suffered from market capitalization over-allocations for Bitcoin (BTC) and Ether (ETH), resulting in a lack of diversification, Demirors said.

The liquidity of the underlying assets is the limiting factor for any index fund. When its populations get too big, “the dog’s tail begins to wag,” he said. Market participants can begin trading against the fund’s global realignments and flows, which can skew the prices of underlying assets.

These market constraints place significant constraints on the profitability of index funds. Demirors stated that “it would be difficult to see crypto indices grow beyond the natural limits of these markets”.

DeFi or governance-focused funds can, however, help with diversification problems. Krug emphasized that DeFi tokens have recently moved independently of or against BTC, suggesting that “the correlations are fading a bit”. In the long run, having log revenue and cash flows can further help resolve the correlation, he added.

Usually, Thematic index funds like the DeFi baskets on offer today are useful for certain niche traders, as both Demirors and Krug agreed. For example, they can be used to develop complex hedging strategies, Krug said.

The outlook for mass adoption is a little bleak, however, as these types of products need to mature at the same pace as the broader cryptocurrency and DeFi markets to remain useful.

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