Crypto Index Fund Construction - Part 1
Smart contracts allow different approaches to index fund construction that are not practicable in Traditional Finance.
Introduction
I’m not a computer coder or developer. I’ve been a holder of TradFi index funds since 2000 and crypto currencies since 2013. This post is based on my understanding of how smart contracts can be used for index fund creation. It is primarily based Tokensets and Balancer protocols. Errors and exceptions should be expected. Some terminology and names are undoubtedly incorrect (blame the proof reader — me).
The DeFi space replicates many of the features of TradFi markets. However, there are significant differences and protocols which offer different economic models.
Market cap weight
The simplest implementation of a market cap methodology is to lock the relevant tokens in a hardware wallet and lock the seed away. Zero fees to maintain, off line and secure. However, it has no access to the composability that makes DeFi so powerful. In addition you have to use blockfolio to work out how much it is worth today — how 2017.
So, how do we build a fund using smart contracts to fully integrate with DeFI. My mental model, based on my understanding of TokenSets implementation of $DPI is the following: The fund operates as a smart contract. This contains all the underlying tokens in the market cap weighs. The value of the pool can grow in two ways: 1) the contained assets become more valuable 2) more index units are issued by addition of the underlying tokens. This is controlled by the Issue smart contract that ensures that the tokens added match the exact proportions of those in the pool. Therefore the % composition based on coupon numbers is unchanged. Then a unit token is minted and given to the originator as proof of ownership of a proportion of the pool.
Redemption is the opposite process; the user returns the fund unit token (which is burnt) and in return receives the equivalent of the underlying tokens (So in table 1 in Part 2, redemption of one fund token would produce $40 of A, $10 of B, $20 of C and $30 of D). In addition the control contracts allows the composition of the pool to be modified to account for additions and deletions to the reference Index, inflation of the underlying token numbers, and the removal of and fees.
Direct issue and redemption has two main problems, for the 11 tokens within $DPI you would need to hold all 11, in the correct market cap weighings, and then do a single transaction to combine and deposit all 11 tokens. At 50 gwei gas price, Issue from the individual tokens costs ~ $18. Indirect purchase from ETH can be done using 11 Uniswaps to acquire the individual tokens which are then combined with the Issue contract to produce the fund unit. This would cost ~$50. For many smaller traders, it is much easier and cheaper to access the fund token by the secondary market (e.g. Uniswap) where the fees will be closer to $3 gas+ 0.3% pool fee + slippage. [Note for Whales: Issue and Redemption have no slippage!]
The presence of a secondary market makes it possible for arbitrage between the primary market and the secondary markets. At any time when the price on the secondary market is significantly miss aligned with the underlying Net Asset Value (NAV) then there is an opportunity for arbitrage. i.e. if the fund token is available for $95 on the secondary market but the token represents a combined value of $100 in the underlying tokens, an arbitrator can buy on the secondary market, redeem the underlying tokens and then sell them for a $5 profit per unit token (before fees).
For efficient market operation of such a fund, there needs to be a large secondary market to ensure arbitration keeps the secondary market price of the fund unit token close to the NAV of the underlying tokens. Smaller liquidity pools are likely to be less accurate at following the index price (but do present opportunities for smaller buyers to purchase the fund at a discount to NAV).
Part 2 can be found here
Part 3 can be found here
Disclosure and Disclaimer
I’m a long term investor in crypto currencies including DeFi. I hold $SNX, $INDEX and $DOUGH as well as $DPI and $DeFI+S along with other others (You could say that I like to diversify my risks…). I am an active member of the INDEXcoop which manages the $DPI fund.
This is not financial advice, all investments are risky, crypto investments are more risky than most. Do your own research. Do not invest more than you can afford to lose.