Why I Invested in DeFi Pulse Index and Index Cooperative
Summary:
Despite becoming 10x more bullish on Ethereum, its relative size within the BEST Portfolio has remained unchanged. Instead, incremental funds have been invested in the DeFi Pulse Index (DPI) and Index Cooperative (INDEX). On December 12th, I invested ~2% of the BEST Portfolio in DeFi Pulse Index (DPI) and ~1% in Index Cooperative (INDEX).
Ethereum (ETH) Thesis: Ethereum will absorb the vast majority of the world’s financial transactions in the 2020s. My expectation is that Ethereum will be worth over $1 trillion by the end of 2023, a 12x return potential.
DeFi Pulse Index (DPI) Thesis: DPI is the S&P 500 Index of Decentralized Finance (DeFi). DPI is a decentralized index for the nascent DeFi industry. I believe that DPI has the potential to return over 100x by the end of 2023.
Index Cooperative (INDEX) Thesis: If DPI is the S&P 500 of Crypto, then Index Cooperative is the Vanguard of Decentralized Index Funds. I believe that the governance token of Index Cooperative, INDEX, has the potential to become worth $100 billion over the long-term (10+ years), a 2,000x return potential from its current valuation.
Background
During the summer months of 2020, I was pondering ideas for businesses I could build in the future. One idea that stuck was to make the BEST Portfolio into a decentralized fund on Ethereum that anyone in the world could purchase for a small management fee, much like an exchange traded fund (ETF) in traditional equity markets. My thinking was that I would be able to use the Synthetix protocol to create synthetic assets for Tesla and Square and then use the functionality of the Set Protocol to create the fund as a set of the four assets: Bitcoin, Ethereum, Square, and Tesla.
I began researching and learning about many different Ethereum-based asset management projects. That rabbit hole led me to a renewed bullishness on Ethereum, the DeFi Pulse Index (DPI), and the Index Cooperative (INDEX).
Ethereum: The Best Is Yet to Come!
Ethereum has been an enigma to me since I first discovered it in 2017. I was always bullish on Ethereum as a network for smart contracts but was skeptical that its native token (ETH) would be able to capture the value that the network created. John Pfeffer’s blog post in December 2017, An (Institutional) Investor’s Take on Cryptoassets, was highly influential in my thinking that Bitcoin was more suitable as a global reserve currency than Ethereum, and that Ethereum did not have a mechanism for capturing the utility its network could create.
However, Ethereum has come a very long way since the ICO Boom of 2017. There are now solutions in development that address the foundational issues John Pfeffer brought up near the peak of the ICO Boom.
There are now three things I believe to be true that I did not believe a year ago when Ethereum was first added to the BEST Portfolio:
ETH will capture a significant portion of the value created by Ethereum and the value of the token will increase as the network gains transactional adoption.
The transition from Ethereum 1.0 (Proof-of-Work consensus) to Ethereum 2.0 (Proof-of-Stake consensus) has the potential to be as economically transformational as the launch of Bitcoin in January 2009. The transition to Proof-of-Stake (PoS) is so fundamental because it will enable the network to scale transaction throughput from 15 transactions per second (Bitcoin only does 7 per second) to between 1,000 and 4,000 txns/sec in mid-2021, and potentially up to 100,000 txns/sec within 5 years. For context, Visa’s network can process up to 65,000 txns/sec.
The so-called “Ethereum killers'' like Cosmos and Polkadot will not unseat Ethereum as the dominant smart contract platform. The talent and capital that has flowed to Ethereum since the 2017 ICO boom and during the 2019 DeFi Spring, has compounded Ethereum’s first mover advantage in a self-reinforcing cycle that is very unlikely to be broken by a competitor blockchain.
These developments give me the confidence that Ethereum will both appreciate as an investment asset and that the network will be adopted for the vast majority of financial transactions globally.
With these fundamentals underpinning the analysis, this leads us directly to the DeFi Pulse Index (DPI) and the Index Cooperative (INDEX).
DeFi Pulse Index (DPI): The S&P 500 of Crypto
“Cryptocurrency’s promise is to make money and payments universally accessible– to anyone, no matter where they are in the world. The Decentralized Finance (DeFi) or Open Finance movement takes that promise a step further. Imagine a global, open alternative to every financial service you use today — savings, loans, trading, insurance and more — accessible to anyone in the world with a smartphone and internet connection.”
The scaling of Ethereum’s transaction throughput, while retaining the decentralization of the network without reliance on third parties, will enable a utopian vision for Crypto beyond the Store of Value (i.e. Bitcoin is Digital Gold) and Payments (i.e. Cash App and PayPal) use cases. It will empower Decentralized Finance (DeFi), a global alternative and parallel financial system to the existing order.
Scaling the network’s throughput to 100k txns/sec should enable every financial transaction imaginable with miniscule fees. DeFi will absorb the world’s financial activity because DeFi applications are open, global, permissionless, interoperable, and have the super simple user-friendly experiences we have become accustomed to from traditional internet applications like Google and Facebook.
Ethereum is already enabling an efflorescence of DeFi applications that are creating real value even with its network transactional throughput limited to only 15 txns/sec; these include protocols like Synthetix (synthetic assets), Uniswap (decentralized token exchange), and Maker (decentralized cryptodollar issuance). In 2020, Total Value Locked (TVL) in DeFi applications grew from ~$0.7B to nearly $15B, an over 20-fold increase during the year. I believe that Ethereum’s market capitalization will exceed $1 trillion by the end of 2023, and that DeFi represents an even greater opportunity for investors.
The DeFi Pulse Index (DPI) is the simplest, most efficient way for investors to gain exposure to this industry amidst meteoric growth. DPI is a market capitalization-weighted index that tracks the performance of decentralized financial assets. As of this writing, the six largest assets by market capitalization command nearly 85% of the value of the index. Those six assets have a combined market value of ~$5.6B, less than the value of a single “zombiechain” asset like BCH ($6.6B) or XRP ($6.7B). Another striking example of DeFi’s undervaluation is the valuation of Uniswap, an Ethereum-based decentralized token exchange, relative to the anticipated valuation of the Coinbase IPO. Per Jeff Dorman, Coinbase, a centralized platform for buying, selling, and transferring crypto assets, has only 2x the dollar-based volume of Uniswap, but is expected to have an IPO valuing the company at ~30x that of Uniswap’s market value. In fact, Uniswap has so much trading volume that its fee revenue is now 50% that of Bitcoin’s [Crypto Fees]!
I do not believe that DeFi’s steep undervaluation will persist over time. The market will eventually reprice these assets, and I believe it will reprice them far higher. As Bitcoin becomes consensus and “crosses the chasm”, capital will flow from Fiat into Bitcoin and then from Bitcoin further up the risk curve into Ethereum and DeFi. Companies like Alto IRA will integrate with exchanges to empower retail investors to use tax-advantaged IRAs to invest in DPI and BED, unleashing a new wave of capital into the crypto asset ecosystem. In fact, the CEO of Alto IRA has told me they are already working on an integration with Coinbase! The Alto IRA team is having discussions with the Set Protocol team and members of the Index Coop community to make DPI available for purchase to investors through the Alto Crypto IRA.
I believe investors will do this because I have done so myself; approximately 95% of my crypto asset portfolio is invested in BED (Bitcoin, Ethereum, DPI).
In conclusion, while I believe Ethereum offers a 12x return potential over the next 3 years, I believe DeFi may grow 100x or more over the same time period; this is the reason why the position size for Ethereum remained constant in the BEST Portfolio and ~2% of funds were invested in DPI.
Index Cooperative (INDEX): The Vanguard of Decentralized Indexes
After investing in DPI, I started thinking more about the decentralized autonomous organization (DAO) that created it, Index Cooperative (INDEX).
Index Cooperative immediately clicked with me because of my experience running a student-run actively managed investment club at the University of Washington called Husky Traders. One of the unique features of Husky Traders was that we did not take money from the university, all funds were contributed by the clubs' members. As a shareholder, your financial contribution became the share of the fund you owned, up to a maximum of 10%. Your share became your relative voting power in governance decisions for the fund like voting on investment proposals or the management team. For instance, the shareholders voted to buy shares of Tesla, and later voted to sell those shares after Tesla’s run-up in 2013.
Being a part of Husky Traders was a life-altering experience. I learned more from being a shareholder than any other experience I had while I was college. To this day, some of my strongest friendships were made in the club. I have often pondered different ideas for businesses that could potentially scale the unique Husky Traders governance model to something much bigger. I believe that Index Cooperative may be able to achieve that dream, and much more, as a decentralized asset management organization.
Paradoxically, it often makes sense to invest in something and then learn about it rather than vice-versa. After I made that initial investment (~0.1% of the BEST Portfolio), I started digging further into Index Cooperative in the governance forum and in the Discord Server, becoming captivated with the possibilities.
In An Expanded Vision of Index Coop, Felix Fang, the CEO of Set Protocol states that “The DeFi Pulse Index is the product that is the tip of the spear that is expected to pierce to the broadest audience.”
In other words, the DeFi Pulse Index is just Zero to One for the Index Cooperative.
The market opportunity for the Index Cooperative is far greater than just DPI or even the market for decentralized index funds. The market for Index Cooperative is the market for all structured products which includes indices, leveraged/inverse tokens, as well as bond ETPs and volatility indices. In this expanded vision, the Index Cooperative is more akin to a decentralized Blackrock than a decentralized Vanguard.
In that same forum post, Felix outlines the market opportunity, stating, “Blackrock has a $100B market cap and the total market value of structured products can be estimated to be 5-10x bigger ($500B-$1T).”
In other words, at a current valuation of ~$50m, the native token of the Index Cooperative, INDEX, has a greater than 2,000x return potential. Wow!
Of course, there are serious and significant risks to this vision becoming reality. As Regan Bozman notes in The Bull Case for Decentralized Index Funds, index funds remain only a tiny fraction of the Crypto market (just 0.06%!). This is likely due to the “winner-take-all” nature of currency markets that make investing in just Bitcoin preferable to purchasing a basket of shitcoins, but it could also be due to the challenging and complex regulatory landscape. By contrast, traditional index funds have 45% market share! It is very possible that the regulatory environment will remain opaque, or even worse, become punitive. The SEC could change their guidance and designate INDEX, or the tokens contained within DPI, as securities. Investor trust in the Index Cooperative and DPI could be destroyed if an exploit was discovered by attackers that enabled them to drain the funds from DPI. The Index Cooperative is also not without competition; there are other decentralized index organizations such as PowerPool and PieDAO.
However, the Index Cooperative has significant advantages that make me believe it is the project that is most likely to significantly expand the market for decentralized structured products and capture the vast majority of the value created.
First Mover Advantage
As of this writing, the Index Cooperative has more assets under management than its next two largest competitors combined.
Superior Distribution, Marketing, and Partnerships
I first learned about the DeFi Pulse Index after seeing the announcement on the header of the DeFi Pulse home page. I have been a regular visitor of DeFi Pulse since the website was first launched, and it is widely regarded as the go-to source for data and analytics on the growing DeFi ecosystem. Its Twitter account has 54.2k followers compared to 19.1k for Set Protocol, 8.7k for Index Cooperative, 8.9k for PowerPool, and 6.8k for PieDAO. For comparison’s sake, Messari is one of the most credible and popular sources of news within Crypto and has ~58.2k Twitter followers, just 4k more than DeFi Pulse.
Investors will select the structured products that they believe will generate the greatest risk-adjusted returns for their portfolios. The Index Cooperative community and Set team have rightly prioritized attracting highly credible Index Methodologists like DeFi Pulse by incentivizing them with rewards for creating new index methodologies. In addition, the Set team and Index Cooperative are partnering with Coinshares, a UK-based company that launched the first Bitcoin based investment fund in 2014, to create a Gold and Cryptoassets Index (CGCI), leveraging the trust and relationships built by Coinshares with its clients over half a decade.
By contrast, the indices created by PowerPool and PieDAO were created by their respective communities, not by external, well-respected index methologists, and therefore they lack the distribution to investors that index methodologists like DeFi Pulse and Coinshares provide.
Ultimately, I believe that the winning decentralized asset management organization will succeed by partnering with the best Index Methodologists to implement their strategies as structured products.
Attractive Valuation
Aside from these significant advantages, as of this writing the native token of the Index Cooperative (INDEX) is also much more attractively valued relative to the competition. Of the native tokens of the top three decentralized asset management organizations, INDEX is the most underpriced per dollar of assets under management (AUM).
When examining the market capitalization of the respective organizations relative to AUM in their indices, Index Cooperative is nearly 80% less expensive than its closest competitor, PieDAO. At the present moment, a dollar invested in INDEX buys future potential fee revenue derived from almost 5x the AUM of PieDAO and nearly 7x that of PowerPool.
Further analysis of market capitalization relative to unincentivized AUM reveals that INDEX is even more undervalued relative to its peers than a simple analysis of AUM indicates. Unincentivized AUM are assets invested in a decentralized index that are not staked to earn yield in the native token of the respective DAO (i.e. INDEX, CVP, or DOUGH). Currently, investors can stake their DPI liquidity to earn ~24% APY in the INDEX token. By comparison, investors in PowerPool index funds can currently earn 150% APY in the native token of PowerPool, CVP, by staking their funds.
Unincentivized AUM is superior to incentivized AUM because it is non-dilutive to holders who have rights to streaming fees in proportion to their ownership of the decentralized organization.
Rough estimates of the unincentivized AUM in the various decentralized index funds, derived from Etherscan, reveal that PowerPool (CVP) and PieDAO (DOUGH) token holders are paying a premium relative to INDEX token holders per dollar of unincentivized AUM. Whereas INDEX token holders are paying approximately $4 per dollar of unincentivized AUM, DOUGH token holders are paying nearly $115 and CVP token holders are paying $356 for the same dollar of unincentivized AUM!
Conclusion
There are significant risks for the Index Cooperative, but the decentralized organization also has advantages that give it a real chance of success with tremendous upside potential. However, because ~1% of the BEST Portfolio was invested in INDEX, even if Index Cooperative fails, I can only lose up to 1% of my portfolio. Yet, if the Index Cooperative realizes its full potential, my 1% allocation could grow to 20x the size of the BEST portfolio today.
ETH, DPI, and INDEX make up approximately 5%, 2%, and 1% of the BEST Portfolio respectively. Ultimately, I believe that ETH will return 12x over the next 3 years, DPI could return over 100x over the same time horizon, and INDEX could possibly return 2000x over more than a decade.
This blog post is a submission for the Index Creative Challenge.
Thank you to Lemonade Alpha, Dark Forest Capital, DevOnDeFi, over-analyzer, Daniel O’Connell, and Tom Pinckney, for reviewing and providing feedback!