Index methodologies and their place in DeFi
A ramble for those with too much time.
Before we begin..
We will be announcing soon the details for community governance and rebalance voting. But before that, let’s get this out of the way so it’s unambiguous:
BDPI’s mandate will be to provide diversified exposure to DeFi blue chips, while charging no fees and farming yield safely. It is aimed at the long term passive investor as a safe set-and-forget investment.
BDPI will not be a yield maximizing token; safety and security of funds will always come first, and we will have strict inclusion criteria both for tokens and acceptable farms.
New indices can be created to maximize-yield or carry out other mandates in the future, depending on market demand and community direction. They will have their own criteria to accommodate the risk profile and mandate of that index.
Now we ramble.
An important topic of discussion as it has the biggest obvious impact on the index.
What should we use? Market cap? Equal weight? Market Cap / TVL Ratio or some other analogy for value?
Matt Levine mentions an interesting point here: https://www.bloomberg.com/opinion/articles/2020-01-16/buy-high-or-low-but-not-both for those who have access to Bloomberg, but we’ll summarize our take here for those who don’t like shelling out $20k a year for a messaging app.
If your index includes tokens based on market cap (indices usually do), and you weigh tokens by anything NOT directly proportional to market cap, you can get undesirable behaviors, like the one below:
Say you want token X to always be 1% of the index, but X drops in price and it ends up being excluded from the index. What happens is that as the price of X goes down, you will buy more, and you will keep buying X until it gets excluded, at which point you sell all purchased X at a loss.
Market cap weighted indices generally don’t have this problem as the token price and the market cap will move together, so you won’t be buying or selling as price moves. You will still sell if token X drops enough in price to get excluded however. Unfortunate, but unavoidable. Not every constituent in an index remains forever, and companies and tokens can have their values go to zero.
Indices often have some sort of capping just to prevent things getting out of hand. I’ll borrow this simple example from the HSI index methodology guide.
Why could we want this? Because buying an index just to hold 33% UNI is maybe not what we want for a diversified DeFi index 🤷♀️
This has been beaten to death so I won’t link a source, but to paraphrase, passive funds tend to outperform most active funds in the long run.
Why? Simple. Not only do most active funds not have as much alpha as they like to believe, but excessive trading just adds slippage and trading fees. On top of that, they charge large management and performance fees. In TradFi, some of these are unavoidable.
Unlike some competitors, we see no need to replicate these failings in DeFi.
Rebalancing is necessary to update weights and add or remove tokens, so it is inevitable, but in the context of DeFi, things like gas cost and slippage can have a larger impact too.
Anyways, rebalancing should be kept at a sensible minimum.
The S&P500 rebalances quarterly, but this is DeFi, and things are a bit more dynamic. Once a month seems fine to begin with.
Token inclusion criteria
How do you ensure an index sticks to it’s mandate? You can start by defining what’s allowed in it.
Common criteria will look at things like:
- Market cap (So that you aren’t just adding random shitcoins. Unless that’s the mandate of the index)
- Liquidity (So rebalances and additions have a reasonable cost)
- How long it’s been around (So you don’t just add the new flavor of the month)
- Circulating supply (Just so tokens aren’t all just locked up by founders)
Etc. Lots more we could say here.
Fast token inclusion
What is this?
Maybe for whatever reason, we do want to include a token that doesn’t meet all our regular criteria. There can be reasons for this. We may also be wrong in wanting to do so, but if 100% of the community wants it, who are we to say no?
Having said that, we’ll be saying no for now. As a team, we have decided that this will be possible in the future if the community votes to allow so. Simply put, we’re introducing a lot of things already right now. Let’s not get too ambitious just yet. This point will be elaborated on a bit more later.
Acceptable farm criteria
Security of funds is non-negotiable. We like sleeping at night, we hope you do to.
Compound and Aave are considered as close to riskless as we’ll get in DeFi so we started there for BDPI. There will be inclusion criteria for adding other farms, that the community will be able to vote on.
xSushi was the only exception. Farming Sushi in xSushi doesn’t really add additional protocol risk.
The decentralization problem
Nice article here on the difficulties for decentralization.
In essence, baby steps. We will be gradually introducing more variables for the community to control as it evolves and matures.
We see a definite irony in having a centralized index provider in DeFi, which from experience not only hamstrings what teams can do, but increases costs to the end user, for very little benefit.
But that’s just our opinion.
And what value does the index provider really add? Realistically, if the index isn’t ridiculous, it will perform fine. If you took the S&P 500, and picked the top 400 instead, sure there will be divergence, but no one can easily predict which way that can go long term (Billion $ trading alpha if you can however), so we’ll end with this:
BDPI will diverge from DPI. It may go higher. It may go lower. If DPI decides to hold 100% ALCX and ALCX pumps, I’m sure we will underperform. But that’s not the mandate. The mandate is to provide safe, diversified blue chip exposure.
There’s a lot of things we can’t control, and we can’t tell which constituents will over or underperform over the long term. But in those factors we do, (e.g. yield farming, no fees, actual decentralization, transparency), we believe we have an edge.
Anyways, what do we know. We are simple builders. And we’ll just leave it there.