Index as a safe way to enter crypto market

Cryptocurrencies, and digital assets have been significantly influencing modern finance over the last few years, creating huge gains for the early believers in Bitcoin (BTC) and Ethereum (ETH) and striking losses for investors in OneCoin (ONE) or BitConnect (BCC). The multiples and almost immediate liquidity of the digital assets is creating scepticism, concern and yet strong interest, leaving no one indifferent.

Following the crypto winter, 2021 is returning everyone back to 2017–2018 with many hopes for the blockchain industry. It has now become increasingly popular for various traditional finance gurus and advisors to switch their investment mantra of “60/40” (allocation for stocks and bonds) to “60/37.5/2.5” advising 2.5% allocation to Bitcoin.

Cryptocurrencies are creating a niche in finance with many instruments to be developed. Futures contracts for Bitcoin and Ethereum, as well as existing Bitcoin ETF in Canada and much anticipated SEC approval for a US analogue makes it obvious: the gap between traditional finance and digital assets is shrinking.

So what is the best way to enter the booming crypto market? Is it investing in Mega Coins (BTC, ETH) or the variety of alt-coins? What is the difference between all the blockchains? Who is going to win on the long term horizon?

The question is similar to that of a tech enthusiast who in 1996 wanted to bet between the largest search engines: Yahoo!, Magellan, Lycos, Infoseek, and Excite. What was the right bet?

The prediction problem becomes simpler if being solved with an Index instrument. Then and only then one can be guaranteed to bet on “Google”.

Historical reference — DJI Index

The first stock index — the Dow Jones Industrial Average — was developed by Charles Dow in 1896. This index averaged the top 12 stocks in the market, and its level was calculated by taking all of the stock prices (which in retrospect was not ideal because different companies have different — and non-constant — numbers of shares). Yet, it has survived more than a century, growing from its first published value of 40.94 on May 26, 1896, to a staggering 34,529.45 on May 29, 2021. While the individual companies came and went, sky-rocketed and crashed, the index steadily moved up.

Crypto Indices

Bloomberg was among the first to launch their set of cryptocurrency indexes such as the Bloomberg Galaxy Crypto Index (BGCI) back in February 2018.

S&P and NASDAQ both introduced their crypto indices in 2021, offering traditional views on the new economy market.

Nasdaq Crypto Index (NCI) (launched in February 2021) consists of eight cryptocurrencies (as of June 1, 2021): Bitcoin and Ethereum (ETH) make ~94% of the index, with the remaining 6% shared between Litecoin (LTC), Chainlink (LINK), Bitcoin Cash (BCH), Uniswap (UNI), Stellar Lumens (XLM) and Filecoin (FIL).

It is quarterly rebalanced and dynamic by nature.

S&P Dow Jones launched their new series of digital asset indices in June 2021:

• The S&P Bitcoin Index (SPBTC) designed to track Bitcoin performance.
• S&P Ethereum Index (SPETH) tracking Ethereum performance — the second largest cryptocurrency by market cap.
• S&P Cryptocurrency MegaCap (SPCMC) tracking Bitcoin and Ethereum weighted by market cap.

This was followed by the July release expanding the index family:

• S&P Cryptocurrency Broad Digital Market (BDM) Index consisting of 240 cryptocurrencies
• S&P Cryptocurrency LargeCap Index — a subset of the BDM measuring the performance of the constituents with the largest market cap.
• S&P Cryptocurrency BDM Ex-MegaCap Index — a subset of the BDM that excludes the constituents of the S&P Cryptocurrency MegaCap Index (Bitcoin and Ethereum).
• S&P Cryptocurrency BDM Ex-LargeCap Index — a subset of the BDM that excludes constituents of the S&P Cryptocurrency LargeCap Index.
• S&P Cryptocurrency LargeCap Ex-MegaCap Index — a subset of the BDM that measures the performance of the constituents of the S&P Cryptocurrency LargeCap Index, excluding the constituents of the S&P Cryptocurrency MegaCap Index.

BDM family of indices are being quarterly rebalanced.

There are many other examples of indices such as: BitPanda CryptoIndex, CMC Markets with All Crypto Index, Major Crypto Index and the Emerging Crypto Index; or the one created by CBOE in collaboration with CoinRoutes.

Tradable instruments

In traditional financial markets, there are several types of tradable instruments that allow investors to track an index. These instruments can be active, such as mutual funds or hedge funds that are loosely based on an index, or passive, such as ETFs and futures contracts that are tied to an index by a set of rules.

There are no futures contracts or ETFs on any crypto indices currently. With the rising adoption of digital assets around the world and the greater comfort of regulators with such assets and their ability to protect ETFs and futures contracts buyers, such products will appear in many shapes and sizes.

It is not clear, however, when and if such products would be available and accessible for the global crypto enthusiasts. It is our belief that the digital asset index requires a digital instrument that is freely tradable and borderless — a blockchain-based token.

A blockchain-based token or an index coin is not a straightforward exercise, however. To be a tradable instrument representing an index, such a coin must possess the following properties:

• At any point in time, the coin has to be collateralized by the constituencies of the index. This ensures its creditworthiness.
• At any point in time, the coin could be exchanged for the corresponding collection of constituencies of the index and vice versa. This would ensure correct pricing.

Bottomline

The phenomenon of crypto is impossible to ignore, and suboptimal to miss. A strong interest in digital assets among investors, comes with a need of tradable solutions that minimize and manage risk. In the highly volatile crypto market, investors want instruments providing transparency and safety. Tradable coin that is collateralized by underlying tokens always matching the composition of a crypto index currently is the only way to go. This will serve as an efficient entry point to digital investments, inevitably leading to much broader crypto adoption.