Who Interacts with INDEX Funds?
My thoughts on who owns, uses, and interacts with a decentralised crypto fund.
This is a repost from my old blog from October 2020
I’ve been thinking about index funds for a while, and this blog is really an opportunity to capture my thoughts for myself, to share what I’ve learnt, and possibly provide insights for others. I think I have identified four main groups that interact with DeFi index funds: holders, market participants, other protocols, and the DeFi community. Most people would refer to these groups as stakeholders, but I’m avoiding the term due to the common usage of staking within DeFi and Ethereum.
I’m using the following as my starting point: A crypto index fund is a single tokenised entity that represents ownership a diversified selection of underlying tokens. The underlying tokens are selected and managed by a third party. This allows delegation of portfolio management ( and gas fees) and so saves the holder time and attention compared to holding the underlying tokens. A key benefit is protection against downside inherent in diversification.
Holders
I believe that Small Retail holders are looking for an easy way to get secure financial exposure to a market section with out taking the time to select and monitor individual token purchases. They are happy to accept that they will not beat the market, but believe that the market will trend upwards. They value the time, gas and energy saved by relying on others to select and manage the fund so long as the long term fees are not excessive.
Larger retail holders have similar goals to the smaller ones — exposure to a sector they believe is going to appreciate, downside protection and minimal effort to maintain it. However, they also need to be assured that the market has sufficient liquidity to allow large buy and sell orders. This can be directly with the primary market (i.e. issuing new fund units by depositing all the underlying tokens) or by purchasing on the secondary market without undue slippage.
For some larger holders, the act of delegation of component selection / weights can be a significant positive. This is because it allows the holder to maintain a credible neutrality in individual asset selection and removes any potential accusations of bias towards a particular protocol. This may be useful for high profile individuals, external TradFi investors or protocol governance who many be call on to justify their investment decisions. Recently $YAM treasury purchased $250 k of DPI. This is effectively a long term belief that diversified DeFI will grow, without endorsing any particular protocol.
Market participants
I would propose that there are three main market participants involved in a crypto index. Short term traders are primarily interested in low cost purchase and sale of a diversified asset so they can profit from general market moves. This can be by buying the index, or by shorting it. This could just be a sector play, or as a hedging strategy (e.g. short a single token, but long the index of similar tokens). The short term trader isn’t too concerned about the long term prospects for the index fund, rather they are more interested in liquidity in the market to allow large trades without excess slippage.
I believe that the prime interest of most liquidity provider is to capture as many fees as possible without suffering undue divergence / market maker losses. This effectively means providing liquidity to a pool that has lots of trading due to volatility or utility of the tokens. Ideally this should be combined with little relative change in the token prices over the long term. Large liquidity pools reduce slippage to the benefit of large holders, traders and arbitrators.
Arbitrators are focused on immediate gains that can be captured due to imbalances in the market. Abritrage is essential for efficient markets and allows everyone to access the same price. This is typically done by selling on one exchange, while buying on a second. For index funds there is a second method that arbitrage can work; If the fund unit is valued below the value of the tokens represented by the underlying tokens, then buying, redeeming and selling the tokens can be a profitable trade. Arbitration is very cost sensitive, so gas prices, slippage and issue / redemption fees all reduce the efficiency and so missed priced tokens to persist. Larger liquidity in the market allows the arbitrators to make larger trades. Efficient (i.e. more) arbitration means more fees for liquidity providers.
One other market participant would be the centralised exchanges who want to offer customers access to attractive tokens whether to hold or trade.
Other protocols
Tokens included in an index gain an indirect route to new holders which can be expected to increase the token price. In addition the long term buy and hold nature of many index holders means that there may be some dampening of the prices of the tokens based on short term news. The diversified nature of a fund means that the holder is less likely to panic sell when a single token has a sudden drop. The downside of such indirect ownership is that the ultimate (passive) owners may be less likely to become involved in governance or staking of tokens. In addition, inclusion in an index can be seen as a vote of confidence in the protocol which increases the tokens reputation.
The second way that another protocol can become involved in an index fund is to use the fund token within its own structure. Most commonly this would be adding the index fund as collateral. Then the other protocols can lend the index token to market participants wanting to short or long the sector. Other uses may include offering insurance or call options on the fund. Such applications allow access to asset values, without incorporating many individual tokens, and includes the benefits of the underlying diversification.
Key factors in becoming incorporated in other protocols are the size of market, customer demand, and a track record of being a secure asset. Such incorporation means that the passive index fund becomes a productive asset and so increase its potential utility and value for the fund holders.
Understanding the composition and downside protection within the index funds structure is essential to the decision to take the time to build the index fund token into a protocol and to select suitable risk parameters (collateral ratios etc). This should include consideration of the impact of a single underlying tokens value collapse, the potential for pausing the issue and redemption contracts ( and other liquidity constraints) and whether the fund participates in token lending.
Community
By definition, DeFi implies distributed ownership (in addition to execution) of protocols. For many protocols, the governance rights are held by token holders. This means that index funds that contain governance tokens (i.e. most current ones) become proxy owners of those rights. As index fund AUV grow larger, they can become larger participants in the protocols governance. At the moment, $DPI represents ~0.4% of the circulating tokens for all the underlying tokens (see below for the current holders of %YFI). As funds AUV increase they are likely to become governance whales in many protocols.
“With great power, there must also come great responsibility” [Stan Lee]. For index funds, this means that they should become involved in other protocols where they can. Ideally, they should vote in line with their customers (long term holders) best interests. Funds should act to encourage long term growth of the underlying protocols as the holders want to see valuations increase. While failure to vote in line with the ultimate owners’ interests is unlikely to have an immediate effect, it may encourage some fund holders to redeem the underlying tokens to allow direct voting.
Such concentration of ownership within passive funds is not restricted to DeFi, in TradFi passive funds currently own ~45% of the available shares with the State street global S&P 5600 EFT having ~$300 Billion AUM, compared to the index market cap of ~$28 trillion. However, TradFi fund managers have been criticized for voting against holders wishes.
Final thoughts
The use of collective instruments, such as index funds, allows holders to benefit from time and energy savings combined with the downside protection of diversification. It also allows the aggregation of significant governance rights and liquidity within the fund. The former can be used to help promote growth across DeFi. While the latter can be built into the DeFi money Lego and allow further use by others.
Passive index funds can be criticized for having no ambitions. However, they can become key parts of the overall financial system we are building.
Disclosure and Disclaimer
I’m a long term investor in crypto currencies including DeFi. 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.