Learn about how Scalara curates the DeFi Pulse Index through its methodology and the rationale for each rule.
The DeFi Pulse Index is a benchmark that offers exposure to the Decentralized Finance (DeFi) sector. The index is maintained by Scalara, the methodologist and index provider. It is implemented as a single token, DPI, by the Index Coop and Set. In the following article, Scalara highlights the selection criteria for a protocol to join the DeFi Pulse Index. For each rule the purpose or rationale is listed.
Goal and rationale
The DeFi Pulse Index is designed to be a benchmark of the decentralized finance space. Similar to other basket indices, its main goals are:
Diversification is one of the key features of indices. A broad index diversifies away the specific risk attached to any single asset. The remaining systematic risk of the targeted factor, the DeFi sector, remains. In the long run, passively tracking a broad market benchmark has proven to beat most attempts to actively pick and chose winners.
Exposure to DeFi sector
The DeFi Pulse Index aims to generate returns that on average would mimic that of the broader DeFi sector. More specifically, the index seeks to provide exposure to large, high quality DeFi projects.
At a low cost
Constructing one’s own DeFi portfolio is time consuming, requires constant maintenance and may cost a lot in gas. The DeFi Pulse Index takes care of rebalancing and general maintenance and effectively socializes related costs.
The DeFi Pulse Index methodology ensures that the index can be replicated by a token implementation. As a result, users are able to hold a single ERC20 token that represents the full basket of index components.
Related: Why invest in an index?
The core of the DeFi Pulse index methodology is the selection of eligible index components. The four key goals previously discussed are the basis for the formation of the DeFi Pulse Index methodology and its evolution.
DeFi related tokens are reviewed on a quarterly (at index inception monthly) basis to determine which tokens qualify. The methodology is broken down into four subsections consisting of a variety of qualitative and quantitative criteria. These subsections are as follows: Token Descriptive Characteristics, Token Supply Characteristics, Project Traction Characteristics and Protocol User Safety Characteristics.
Token Descriptive Characteristics
The token and protocol must be available on the Ethereum blockchain. The Ethereum blockchain remains the prime standard from a security and maturity perspective. User activity and project viability on Ethereum can be a strong indicator for long-term resilience.
DeFi Pulse Leaderboard
The token must be associated with a DeFi protocol listed on the DeFi Pulse Leaderboard. The DeFi Pulse Leaderboard screens protocols for their true total value locked (TVL). This value is used as a preliminary metric for assessing a project’s traction and usefulness.
Not considered a security
The token must not be considered a security by the corresponding authorities across different jurisdictions. If a singular constituent is a security it would disallow some market participants from investing in the index. It is important for the DeFi Pulse Index to be accessible to everyone.
While DeFi and blockchains are still a nascent technology and not yet as standardized as traditional financial markets, simplicity is an important aspect. In order to mitigate financial and regulatory risk, the DeFi Pulse Index will not include non-bearer instruments such as wrapped tokens, tokenized derivatives, synthetic assets and tokens tied to physical assets or other tokens.
Token Supply Characteristics
Predictable token supply curve
It must be possible to reasonably predict the token’s supply over the next five years. This is necessary as large token unlocks and amounts being released into supply may cause disadvantages such as dilution, especially towards passive holders.
Sufficient circulating supply
Liquidity is key for executing transactions that will allow buyers to enter and exit the market as they please. This is essential for efficient price discovery. Furthermore, low float assets can be easy to manipulate. A minimum of 7.5% circulation of the five year supply acts as a baseline filter for liquidity requirements.
Reasonable and consistent DeFi liquidity on Ethereum
Liquid constituents are crucial to ensure that the DeFi Pulse Index trades as close as possible to its net asset value. The ability to buy and sell at a fair market value gives investors fair entries and exits. Without liquidity, assets cannot be cashed out quickly, fairly and easily. This would interfere with the fundamental goal of allowing investors to control their exposure freely.
Passive holders cannot be disadvantaged
The token’s economics must not have locking, minting or other patterns that would significantly disadvantage passive holders. The DeFi Pulse Index is a spot index that, if implemented, must allow for the quick liquidation of a position. Being able to fully and immediately redeem ensures that any product tracking the index is priced close to net asset value. In addition, holding the unlocked or unstaked version of a token typically strictly underperforms due to constant dilution.
Project Traction Characteristics
The project must have a use-case that will benefit the DeFi space over time. The protocol must generate real economic activity and not contain ponzi-esque frameworks. Some of the more mature financial services that DeFi is offering are lending, trading and asset management.
The baseline measure of a protocol’s usage comes from the total value locked (TVL). TVL, according to DeFi Pulse, is the real value locked inside a protocol that generates economic activity. TVL must be examined in conjunction with qualitative examination to ensure the value is being used for the protocol’s service rather than an abstract ecosystem fund for example. Also, usage should not be concentrated in a small number of users or be limited by high barriers of entry.
Protocols may be launched and gain enormous traction within a short period of time. The DeFi Pulse Index aims to select projects that will retain traction and usage and are already battle tested. As a result, projects must be at least 180 days old. This also aids in any teething issues a protocol may experience from growing quickly.
The protocol or project must not be insolvent. The DeFi Pulse Index aims to track the DeFi space over a long period of time. As a result, selected projects should have a long, healthy life expectancy. Insolvent projects are unlikely to repay their debts and hence have a severely reduced longevity.
Protocol User Safety Characteristics
Security professionals must have reviewed the protocol to determine that security best practices have been followed in regards to user asset safety. Additionally, an audit is necessary to ensure there are no malicious intentions present within the smart contracts.
Security exploitation response
In the event of a safety incident, the team must have responded promptly and addressed the incident responsibly in the aftermath, providing users of the protocol with a reliable solution and the decentralized finance community with adequate documentation to provide transparency about the incident. Security issues happen to even the largest cryptocurrency projects, however if the team deals with them in a professional manner then they may still be included in the DeFi Pulse Index. Repeat exploitations will result in a removal of their product from the Index.
Sit back and relax
The ultimate purpose of the DeFi Pulse Index is to serve as a representation of the DeFi space as a whole. The criteria shown above are a culmination of standards aimed to curate DeFi protocols into a tradeable, user-friendly and efficient benchmark. The projects that comprise the index provide useful services whilst being well-known and reputable. Since exposure gained to them is via their tokens, the tokenomics may not put passive holders at a disadvantage. Making sure the index can be replicated by a token implementation has to be kept in mind of course. Scalara wants you to be able to sit back and relax when getting your DeFi exposure.
Find the complete index methodology here.