DeFi, short for decentralized finance, has become a popular topic in the financial industry over the last decade as its use cases have become more apparent. DeFi simply refers to the collective system through which intermediaries like banks and brokerages are eliminated using blockchain technology. Anyone with an internet connection can now enjoy the open network environment, transparency, and immutability that DeFi offers. Perhaps DeFi's most significant use case is that of asset tokenization, a process that creates digital tokens to represent any real-world asset, digital or physical. The resulting digital tokens, which carry the value and essence of the underlying assets, can then be traded on DeFi platforms as a new form of alternative investment. Many of the most popular DeFi tokens on the Ethereum blockchain have been indexed using the DeFi Pulse Index (DPI), which aims to measure their aggregate performance across the market. Read on to learn more about the DeFi Pulse Index and how you can potentially benefit as an investor.
Inclusion In the Defi Pulse Index
Like stock market indices, the DeFi Pulse Index aims to track the collective performance of a group of underlying (digital) assets. To be included in the DPI, tokens must pass five objective criteria related to their characteristics:
- Tokens must belong to the Ethereum environment.
- Tokens must be regarded as non-securities by regulatory agencies.
- Tokens must represent primary ownership. Derivatives, synthetics, and all forms of tokens with secondary ownership will not be considered.
- Tokens must be connected to a decentralized finance protocol.
- The supply of a token must be able to be predicted with a high degree of accuracy in five years.
If tokens pass all characteristic criteria, the project's intended usage, solvency, security features, and age are evaluated and used as an additional screening instrument. Only after passing all criteria related to token characteristics, supply, adoption, and security features can a token be included in the DPI.
Weighting Of The Defi Pulse Index
Like the S&P 500 index, the DPI is a market capitalization-weighted index. This means that the index's weighting scheme uses market capitalization to measure the performance of individual tokens. This method assigns a weight to each included token by multiplying the number of units outstanding at any given time with the valuation of an underlying asset. For example, if a DPI token has 10 units in existence and one unit is worth $1, then that token has a weight of 10. If said token's price increases to $2, then those same tokens now have a weight of 20 due to the increase in valuation. Tokens will receive their proportional weights based on their market capitalization during the first business day of each month. During the reconstitution phase, tokens may be added or removed based on their circulating supply and price.
The Current Defi Pulse Constituents
The DeFi Pulse Index currently consists of the top 18 DeFi projects on Ethereum by market cap: Aave, Balancer, Compound, Cream, Farm, KNC, Loopring, Maker, meta, REN, Sushi, Synthetix, Uniswap, Yearn, Instadapp, Badger, Rari Capital, Vesper. (Source) Given the nature of the smart contract system and DeFi protocols, it shouldn't come as a surprise that almost all projects in DPI interact with one another.
Diversification.
Like stock index funds, the DeFi Pulse Index can be used to diversify portfolios. The index itself is designed to replicate the market performance of digital assets pegged at their face value, rather than attempting to outperform the market. This creates a low-cost alternative for traditional investors looking to benefit from DeFi's growing popularity. By investing in the DPI, many of the transaction fees typically associated with purchasing tokens from decentralized platforms are avoided altogether.
Since its launch in September 2020 to December 2021, DPI prices have more than doubled and are currently worth $295 (as of December 24, 2021). The index's value fluctuated greatly over the past year, reaching a 52-week high of $750 in March of 2021 before experiencing a sharp price decline in May of 2021 (current valuation here). Because the price of the DPI is closely correlated to the broader crypto market, its value has been affected by many of the same events as various cryptocurrencies. For example, a decline in Bitcoin or Ethereum prices would be accompanied by a decline in DPI prices as more investors begin to reallocate their portfolios into alternative assets.
Purchasing DPI Tokens
Investing in the Defi Pulse Index is straightforward and can be done using most Crypto exchanges (CEXs) like Binance and Crypto.com. Many existing secondary marketplaces like Uniswap and DeFi protocols like Pillar Wallet can be used to purchase the DPI as well, although these generally have higher transaction fees than most CEXs. To avoid high gas fees and simplify the purchasing process, the producers of the DPI have partnered with TokenSets to offer the DPI as a token set. Using the TokenSets website (TokenSets.com), investors can purchase and issue a DPI index token in less than 30 seconds assuming that there is sufficient liquidity. By using TokenSets, the DPI token version is created solely in the Ethereum blockchain in a way that allows it to be traded like any other ERC-20 asset on exchanges like Binance and Crypto.com. Index Coop, the founders of the DPI, have also recently released plans for continued integration within existing crypto exchanges and DeFi protocols, which should provide additional low-cost purchasing options for future investors.
Growth & Performance
The DeFi Pulse index offers a unique alternative to traditional stock market indexes. At $295, the DPI has returned more than five times as much as the S&P 500 over the past year, while avoiding many of the transaction fees typically associated with decentralized exchanges. It should be noted that because the DPIs basket of tokens is limited to top tokens by market cap, profits will be milder than the occasional DeFi projects with 10,000% gains that riddle news headlines today.
As DeFi applications continue to surge in popularity and the market matures, growth can be expected to follow. As of 2021, the DeFi industry’s market capitalization is still less than 1% of the financial industry’s $24 trillion market capitalization. This indicates a large potential upside if DeFi were to achieve market penetration comparable to other disruptive technologies like Fintech. Because DeFi is still in its early stages of adoption, investing in the Defi Pulse Index may offer a lucrative passive investment opportunity for those looking for relatively low volatility and high liquidity from a cryptocurrency portfolio.