Mechanics

There are three key agents involved in the provision and use of ETFs. The process starts with a fund sponsor, such as BlackRock or StateStreet, which are among the largest in the industry. Fund sponsors operate in the primary market, where they issue creation units of a given ETF and handle redemptions. Creation units are large blocks of ETF shares, often numbering in the tens of thousands, that are exchanged for either a basket of underlying assets or cash. The second actor is the Authorized Participant (AP), represented by firms like JPMorgan and Goldman Sachs. APs can purchase creation units and redeem ETF shares (opposite of creation). They interact with the final actor: investors who purchase ETFs on secondary markets, where individual shares are traded. APs serve as intermediaries and play a crucial role in arbitrage, helping to eliminate any price deviations from the net asset value of the underlying assets, such as premiums or discounts.

Benefits

The key benefits of ETFs are cost savings whilst still being able to diversify risk across a basket of assets. For instance, consider the following simplified analysis. Imagine an ETF with 50 underlying assets where each asset has equal weighting, and for the sake of argument, the underlying assets come from different sectors to achieve some level of diversification. An investor purchases 50 shares of this ETF (in a single order) so they are indirectly holding 1 share of each underlying asset. If an investor wanted to achieve the same portfolio without using an ETF, in the worst case, they would have to execute 50 orders, pay transaction fees on all of these, and possibly be liable for capital gains tax at the point of sale for all 50 orders (as opposed to a single order in the case of using ETFs). While ETFs do have associated fees, such as management fees, these are generally lower than the costs saved by avoiding multiple transactions.

On-chain ETFs

There exist several protocols facilitating the creation of on-chain ETFs, to give some background as to how these protocols generally work, we focus our attention on Set Protocol. Other protocols include Index Protocol, created by Index Coop, which was a “good faith” fork of Set protocol and Enzyme Finance which was the first protocol to bring structured products functionality on-chain in 2017. Note that as of May 2023, Set Labs (the team behind Set Protocol) is no longer actively maintaining Set Protocol V2, however, given the autonomy of smart contracts, the protocol continues to operate as usual with the caveat that there won’t be any future upgrades.

Set Protocol and other similar protocols are the foundational building blocks for on-chain ETFs, most analogous to technological infrastructure used by fund sponsors to initialize an ETF. The protocol allows the permissionless creation of Sets (analogous to funds). A Set is defined by the basket of underlying exchanged for units of a given Set (e.g., BTC, ETH and DYDX token could make up a Set), the amount of each underlying making up a single Set token (e.g., 0.1 units of BTC and ETH, 3 units of DYDX could make 1 Set token), the modules available to the Set and the manager of the set. The manager is analogous to fund sponsors; they have special permissions and can exchange the underlying as well as providing support for additional modules. Whilst the protocol is permissionless and trustless, investors trust managers to some degree to ensure they do not misappropriate any funds (since everything is transparently on-chain, it is simple to independently identify this). For example, a manager could rebalance the underlying and whilst doing so purchase risky tokens for which they may have vested interests. Modules provide useful functionality such as allowing managers to take a fee when certain events occur or utilize leverage to achieve greater returns.

A key difference between traditional ETFs is that in this model, investors can directly create or redeem Set shares, something done only by APs in traditional ETFs. Therefore, given enough liquidity, Set tokens can also trade on exchanges which can create familiar arbitrage opportunities for any investor. However, this is a function of the choices made by the issuing team because Set Protocol comes with parameters to make redemption and creation available to only whitelisted addresses.

In the following section, we analyze two protocols/entities that are key in the on-chain ETF ecosystem. Where possible we make comparisons between their different approaches as well as comparisons to traditional ETFs.

Index Coop

Index-Coop, originally launched by Set Labs as a Decentralized Autonomous Organisation (DAO) in 2020 aims to launch and maintain the best index funds in the digital asset space. Their products were previously built on top of Set Protocol however, since the beginning of 2023, Index Protocol is the primary platform that Index Coop uses to launch their products.

This move allows Index Coop to have control of what products are available on their platform, facilitating the compliance of potential future regulatory requirements imposed on index providing protocols. We analyze their flagship product, the Defi-Pulse Index (DPI), released in collaboration with Defi-Pulse (whose index division is now known as Scalara), examining how some of the key mechanisms behind it work.

Selection of DPI constituents

DPI constituents must satisfy criteria initially set by the Defi-Pulse team (the criteria can be extended if beneficial to users). This criteria is extensive including requirements on the user safety and the traction of each candidate protocol as well as constraints on the supply and characteristics (e.g., token must be available on Ethereum) of a given protocol’s token. Given a set of protocols included in the index, the weightings of each token are determined by calculating the relative market cap (circulating token supply). Constraints such as the minimum weight filter or flexible capping are set in order to improve tradability and diversification, respectively.

Rebalancing

Rebalancing is necessary to ensure DPI follows the index specification and currently occurs on a quarterly basis. A rebalancing proposal, which includes key parameters like the target weighting of the index, must be submitted by a Set’s manager. Once submitted a gracing period kicks off to allow holders of the Set token to decide whether to exit or remain if they are happy with the proposal. This mitigates some of the trust dynamics between the managers and Set token holders mentioned earlier.

Below we look at the most recently completed rebalancing of DPI (May 2023) to see the cost of sticking to an index specification for on-chain ETFs. To provide some context, the following table specifies the desired outcome of this rebalancing.

In the course of several days, the manager executed a total of 148 transactions on decentralized exchanges (DEXs) to attain the targeted asset allocations. Two primary considerations in this phase were the gas fees, shouldered by the manager, and the trade price impact, which affects DPI holders. The aggregate gas expenditure for all rebalancing activities amounted to $5,895.99. For DPI holders, the inherent illiquidity of DEXs compared to centralized exchanges (CEXs) led to suboptimal trade execution. We quantify the maximum potential losses attributable to price impact, showing that DPI holders incurred up to $68k in losses due to inefficient execution.

See calculation approach in footnote. ^[1]

Future of IndexCoop

Index Coop has long expressed their desire to work more and collaborate with institutional clients. For instance, recent activity on their forums includes plans to launch an index in collaboration with CoinDesk called the Index Coop CoinDesk Eth Trend Indicator (cdETI). The methodology behind this index is to allocate between ETH and USDC based on indicators provided by CoinDesk and is summarized in the table below. CoinDesk’s indicator is proprietary software thus investors must trust their ability to provide optimal signals.

Alongside

Alongside is similar to Index Coop in the sense that they are acting as fund managers (governed by DAOs) building Index based ETFs for investors. A key difference between the two is in the underlying implementation of their products which is a function of Alongside’s desire to provide a highly diverse index. Currently the only product they have is Alongside Crypto Market Index (ACMI) which tracks 25 crypto assets (for reference, DPI only tracks 10), their index is chain agnostic whereas DPI is constrained by the assets available on Ethereum as well as bridged assets (like wBTC) of which there aren’t many, limiting index diversity. Alongside use a similar market share weighting method to determine the weightings of assets included in the index with the key difference (with DPI) being that there is no upper limit for more prominent crypto assets (e.g. BTC) that have a much higher market share.

Given the chain agnostic approach, using protocols like Set Protocol as the underlying infrastructure becomes infeasible. Instead, Alongside has an ERC-20 token on Ethereum, which has also been bridged to Polygon and Arbitrum, representing a basket of underlying assets that are held across various chains. These assets (excluding BTC and ETH) are held on custodial services (Coinbase Prime), but are monitored by Chainlink Proof of Reserves (PoR) to ensure ACMI is fully backed. Clearly in relation to DPI, there is some compromise on trust aspects but this is a necessary trade off in order to have an index tracking the wider crypto ecosystem.

Unlike DPI, redeeming or creating ACMI is not permissionless, in fact, it is the same as traditional ETFs where only Merchants (equivalent to APs) have the right to redeem or create tokens. To date, a single address has minted over 99% of the circulating supply of AKMT. Thus, arbitraging price discrepancies is limited to Merchants who must be whitelisted by the Alongside DAO.

Value of AKMT relative to NAV

• During the last month the price of AKMT relative to the NAV ranged between a 2.84% premium and a 1.94% discount.
• In comparison to highly liquid ETFs that typically range between +/- 0.01 (e.g., S&P 500) the higher range for AKMT highlights the illiquidity of exchanges (reducing profitability of arbitrage due to price impact)
• We can proxy the liquidity by considering monthly volumes of AKMT on all exchanges using DPI as a baseline.

Reconstitution and Rebalancing

ACMI reconstitution occurs quarterly whereby the DAO must input the new list of assets and respective weightings of each asset to their smart contract. Then, custodians must execute trades to achieve the new portfolio, by working with highly reputable companies like Coinbase there is not much risk of funds being misappropriated during this step. Investors can then verify this new portfolio using Chainlink PoR. One benefit of this is that there is less rebalancing costs relative to exclusively on-chain methods (DPI) since custodians have access to much more liquidity and can also use methods such as dollar cost averaging more effectively to minimize the price impact of larger order sizes. Unlike DPI, Alongside distinguishes between reconstitution and rebalancing. The latter occurs monthly on the first day and Its purpose is to react to changes in market prices or circulating supply in order to keep the index weightings correct.

Conclusion

The landscape of on-chain ETFs is still in its nascent stages, but it is rapidly evolving with entities like Index Coop leading the way. Based on investor demand it’s fair to say that thus far, on-chain ETFs have been nowhere near as popular as their traditional counterparts. Perhaps because crypto native investors believe they can outperform the market by consistently picking the right asset or because a relatively high correlation between crypto assets makes diversification focused indices less appealing. In any case, as the crypto market itself becomes more popular and appealing to the average investor, the value proposition of diversified on-chain ETFs could become increasingly compelling, rewarding those that are laying down the building blocks today.

Footnotes

^[1] Note that in this analysis, the optimal amount is calculated by assuming perfect liquidity at a given price, therefore the total loss is an upper bound on actual losses. The loss metric still highlights the inefficiency of using exclusively on-chain exchanges in addition to a single dex as opposed to routing via an aggregator (e.g. 1Inch). For example, in the above transactions, trading Syntetix for Eth resulted in the largest losses. The 2% market depth on Binance for the most liquid Synthetix market is 200k but on Uniswap it is 15K. By using CEX’s (similar to AlongSide) better execution could have been achieved.