Polkadot Ecosystem Perpetual Index - PEPI - Market Proposal

Product

PEPI is a capitalization-weighted index that tracks the performance of the Polkadot Ecosystem projects via exposure to a basket of tokens. Denominated (cash-settled) in stablecoin.

The index is weighted based on the value of each token’s circulating supply. The PEPI Index aims to track projects in Polkadot ecosystem with significant usage, contribution to the interoperability/ multichain technology and that show a commitment to ongoing maintenance and development.

Motivation

In traditional finance, it has become increasingly popular, especially among millennials :yawning_face:, to seek pseudo-alpha while still pressing just one button and not tracking the candlesticks. By this I mean passive investment via ETFs and Index funds: baskets of securities chosen according to a published set of criteria. These filter criteria aggregate a group of stocks into a separate index united by industry, moral, speculative or some other overarching themes, for example would be Innovation ETFs by ARK Capital.

In the realm of decentralized finance, index funds have just started to increasingly gain momentum: current 24h volume for the Defi Perp Index on FTX is $25,341,559 in and for the recently launched Shitcoin Index, $5,926,970. The idea of aggregating tokens into ‘industry’ baskets and betting on or against their success, i.e. Defi tokens, is intuitive and reflects the nature of ecosystem development.

If you create an index for a specific ecosystem, such as Polkadot, such products naturally become mechanisms of “value driven investments” that allow participants to express their ‘bullishness’/‘bearishness’ on that ecosystem. I believe there is an untapped opportunity to satisfy the demand to get exposure to non-Ethereum tokens, bet on a multi-chain future of crypto as well as speculate on the ‘Layer 1’ wars.

As a rule of thumb, the first movers usually receive a huge advantage in the industry and I believe Injective could become the go-to-place for trading non-Ethereum Indices. I will provide my reasoning for why I think Polkadot Ecosystem could be a good first index, with possibility to extend the offering to Web3, Cosmos, Near and Solana ecosystem indices.

##Opportunity
Currently, there does not exist a mechanism for users to tap into the aggregated success of or express a view on the relative performance of separate blockchain ecosystems. Solutions that exist today are limited to Ethereum ecosystem and do not extend to a broader spectrum of projects. Moreover, it is difficult for exchanges to easily add new products based on new chains as easily as ERC20s. This has led to fragmentation of liquidity for ecosystems. For users to gain exposure to an index of Polkadot Projects, they have to use four or more exchanges, very high friction.

As a proxy for the future success of the product we can use the trading volume of perpetual indices on FTX ($25,341,559 in Defi Perp Index) and speculate that the attractiveness of derivatives vs index tokens can attract current capital from http://index.finance. Indeed, the protocol has gathered a total of ~$46m ‘TVL’ in its indices with a ~$7m daily trading volume since the beginning of the year.

Although the market caps of PEPI and Defi indices are comparable, we should discount our expectations of equivalent trading volume at the start due to the current ‘tulip /yield mania’ nature of Defi coins. In the long run, however, the launch of the index is indeed a bet on the demand for Polkadot ecosystem tokens, the reasoning for which I explain below.

Use Case

Why perpetual composite index:

  1. protection from smart contract exploitation risks
    • A synthetic perpetual product offers a way to ‘protect’ against smart contract exploitation risks or capital inefficiencies, rather than hold a basket of the underlying.
  2. hedging instrument
    • As outlined later, current composition of the index is 60% weighted towards DOT token, which is further correlated with other tokens in the basket, which might be a flaw in the diversification functionality. On the other hand, the instrument still offsets losses compared to 100% position in DOT: i.e. a 70% drop in DOT would lead to 50% drop in index (assuming other coins constant) .
  3. leverage (offered by Injective)
  4. elimination of gas fees
    • Eliminating the need to perform countless costly transactions manually saves users’ time and money. If one wants broad exposure to the basket of index assets
  5. diversification
    • Always less volatile than more concentrated portfolios. Downside protection due to holding a wider selection of tokens.

Why Polkadot:

The decision to take Polkadot ecosystem as a proxy for ‘interoperability index’ is motivated by several factors:
The decision to take Polkadot ecosystem as a proxy for ‘interoperability index’ is motivated by several factors:

  • Tight association within the ecosystem

    While IBC Protocol does serve the same function, the organizational structure of the ecosystem is such that each project is considered and developed independently > less association between the underling tokens

  • High volume expectations

    The ecosystem - together with all the projects building on substrate chains - is considered #4 in Top Cryptocurrency Categories By Market Capitalization according to CoinGecko:

  • ecosystem’s aggregate 24h volume of ~$7.4b (compared to $8.4b of Defi coins)

Basket and Weighting

Criteria for tokens:

  • Tokens Characteristics
    • The token must have sufficient liquidity across a variety of trading platforms
    • The token must be associated with an (announced) parachain in Polkadot ecosystem
    • The token must be a bearer instrument
    • It must be possible to reasonably predict the token’s supply over the next five years
    • At least 7.5% of the five year supply must be currently circulating (borrowed from the design of Defi Pulse Index)
    • Security professionals must have reviewed the protocol to determine that security best practices have been followed to maintain user assets safe under different circumstances

Current Tokens + Weights:

  • DOT
  • KSM
  • ONT
  • Clover Finance
  • Lina
  • Moonbeam
  • Centrifuge
  • Acala
  • Edgeware

Weight calculation:

The index divisor is an arbitrary number that is first defined when an index is first published. It’s initial use is to divide the total value of the index to produce an initial index value that is a number which is easy to handle, such as the number ‘1000’.

The current composition of PEPI index serves participants whom have a low risk appetite and and are looking to get exposure to a long term ecosystem position. However, the index could be altered to increase the weights of riskier tokens as well as including new tokens to capture the Xs in returns during bull markets.

Technical Specification

  • index price

    The index price is a weighted combination of token prices, all of which can be fetched from Binance API and fed into the following formula (not sure if the current infrastructure supports this, but should be easy to introduce).

    • fetching frequency

      Every 5 seconds (FTX standard)

** I know this may be difficult given current on-chain oracles. In-lieu, we can also use the traditional Chainlink % swing from last TWAP to calculate the spot price as well.

  • Market price: median of last, best bid, best offer

  • Mark price: middle of bid, ask and last for the future

  • Premium: MP - index

  • Funding rate:

    Unlike Bitmex 8-hour long epochs, I believe perpetual index futures should have funding payments every hour: while BTC and ETH are more liquid markets, lower liquidity and lower volume on exchange means that 1 hour TWAP pricing and funding is more appropriate at the current scale. This is the same rate used by FTX exchange. Specifically, every hour, we would measure the 1 hour TWAP (time weighted average price) of the perpetual future and the 1 hour TWAP of the underlying index:

    • Every long position pays position size * TWAP of ((future - index) / index) / 24
    • Every short position receives position size * TWAP of ((future - index) / index) / 24

    This scaling allows realization period of 24 hours → 24 funding cycles is able to mimic daily futures settlement.

  • PNL: position size * (sell price - buy price)

  • PNL for open position:

    • position size * (mark price - entry price) +/- funding fee (if bought)
    • position size * (entry price - mark price) +/- funding fee (if you sold)
  • Realized PNL: PNL - unrealized PNL

  • Unrealized PNL: position size * (mark price - mark price 30 seconds ago)

  • Collateral ratio:

    The ratio is determined by the risk-level of the collateral and volatility of the underlying asset. The multiplier on the margin required for a coin, IMF (inital margin factor) where the higher is riskier, could be borrowed from FTX, which lists IMF of 0.002 for a SHITCOIN Index, 0.004 for DEFI Index, 0.002 for DOT perpetual indices. Assuming that the risk factor of the PEPI Index is highly correlated with DOT and is less volatile than Defi Index, I suggest to 0.002 as an IMF factor. Which we can calculate by getting by current account balance / nominal position.

Rebalancing:

  • frequency

    Each token has their own token release schedule, which makes it pivotal for the contract to track the circulation supply changes and rebase appropriately. Similar to S&P500 quarterly rebalancing, I would suggest monthly rebalancing, since most protocols set milestones on a monthly basis.

  • mechanism

    Each month fetch new Circulating Supply values from CoinGecko (?) → update weights

    Each quarter fetch data of the new tokens in the ecosystem and their marketcap → remove or add tokens from the Index (this can be done via community voting)

Related Products:

  • Defi Perpetual Index on FTX
    • $25m 24h trading volume
  • DOTECO Index - Polkadot Ecosystem Index on Binance (recently delisted)
    • I believe the reason for delisting is not lack of liquidity, but rather an inaccurate choice of underlying tokens to represent the ecosystem, which limited demand among market participants
  • Defi Pulse Index (by Index Coop)
    • $112m market cap
  • Indexed Protocol
    • index fund
    • $10m locked since inception in January is a good indication of Proof-of-concept
  • Centralized alternatives
    • Bitwise: ~$800m?
    • Bitwise DeFi: $200m?

Risks

  • Oracle risk: This is the same risk that any DeFi protocol shares and would be shared with whomever Injective chooses to source data from, however sourcing from Binance, as it is the most liquid venue for the components of the basket, this risk is mitigated.
  • Volatility & liquidation: Right now, the IMF I’ve proposed is 0.002 , which is in line with FTX. While less capital efficient, we can increase the IMF to something like 0.01 and gradually lower this requirement as both liquidity on PEPI increases and the overall INJ insurance pool grows.
  • Slippage due to low volume: This can be somewhat mitigated by tapping into the Injective Ecosystem of market makers, incentives, and CLOB infrastructure provided by the Injective Derivatives Protocol.
2 Likes

All in for the proposal! DOT ecosystem will be big and important player in the future. Having the opportunity to bet on it on a decentralized manner is a must.

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