Onchain-Traded Fund Endgame

Disclaimer: It's foolish to claim to know the future. Many of the following statements may be proven wrong over time as we learn more and grow. Instead, this is an exercise in long-term thinking to assist in path-finding, a starting point for discussion and experimentation rather than a definitive guide.

What's at the end of the rabbithole?

An Exchange-Traded Fund (ETF) as we know it today is a piece of technology invented in the era of paper accounting, that now enables transactions volumes of $45 trillion dollars annually¹.

At Alongside (opens in a new tab), we've been researching and developing ways to upgrade the system with Onchain-Traded Funds (OTFs), starting with the Alongside Crypto Market Index (AMKT) (opens in a new tab). So far, it's enabled 24/7, permissionless issuance and redemption of a basket of crypto assets across chains. During this process, we've discovered two truths about OTFs:

1. OTF technology is in its infancy. Existing products, including AMKT, all face the same technological challenges that inhibit adoption.
2. OTF technology will be superior to the ETF technology. OTFs can provide better pricing, deeper liquidity, increased accessibility and transparency compared to ETF's.

To illustrate where OTFs are going, we'll first showcase the current flaws of OTFs. Today, a typical OTF suffers from distinct categories of problems: Efficiency, and Trust.

1. Expensive gas cost, lack of liquidity for both the OTF and the underlying assets, and fragmented liquidity across chains result in inefficiency that inhibits iteration and adoption.
2. Lack of fully trustless management (e.g. methodology, inclusion/exclusion, pricing, supply, categorization data) results in trusted human intervention being necessary for safety and integrity of the product.

The Onchain-Traded Fund Endgame

The Endgame refers to a state in which the scope and complexity of a product or protocol no longer change. Below, the endgame models for each category are outlined.

Increasing Efficiency

OTFs could operate with zero secondary market liquidity requirements, and could be available on every chain with perfect pricing and liquidity.

Gas Cost

Limited OTF liquidity on any given chain creates a ceiling for short term demand and price instability for users. Bootstrapping of liquidity is required to take the OTF off the ground, and once live, LPs need to be constantly incentivized.

Upon further examination, it becomes apparent that this is actually a gas cost problem. If gas is free, buying or selling the OTF can be replaced with issuing or redeeming the OTF, removing the need for OTF liquidity entirely. For example, native OTF issuance and redemption on L2 or L3 could potentially achieve this.

Underlying Assets

If gas costs are free, and issuance and redemption is how users buy and sell the OTF, the next limitation will be the liquidity for the underlying assets. How will users buy the underlying assets for issuance? How will the index reconstitute? We face the same issues here as limited OTF liquidity.

If buying or selling underlying assets on the secondary markets can be replaced with issuing or redeeming the underlying assets, this removes the need for underlying asset liquidity on secondary markets. For example, being able to atomically wrap and unwrap any asset will enable OTF users to tap into the source of the underlying asset liquidity (e.g. issuers, custodians, exchanges) directly.

Multi-chain

Fragmented liquidity across chains creates inconsistent and subpar pricing for users across every chain. Expansion into a new chain requires bootstrapping that potentially siphons liquidity away from other chains and users.

Fast and free issuance and redemption of OTFs across chains removes the need for bridged assets, and liquidity flows seamlessly across chains to provide the same depth and pricing everywhere. For example, Circle's CCTP (opens in a new tab)-like service and architecture for OTFs and its underlying assets will enable users on any chain to tap into global liquidity directly.

Decreasing Trust

OTFs could be minimally governed, fully autonomous, and resistant to centralized control.

Rebalancer

Closed or trusted rebalance mechanisms are implemented for safety, usually in the form of a centralized manager, creating a substantial centralization and trust vector. How do we make this autonomous?

There are mechanisms that Indexed (opens in a new tab), Balancer (opens in a new tab), Index Coop (opens in a new tab), and Symmetry (opens in a new tab) have innovated on that we could learn from. An important insight is that to eliminate a centralized manager without enforcing a fixed portfolio, you need the following: trusted sources for price, supply, and assets to include. If you're able to acquire the trusted data, then an autonomous rebalance with a transparent methodology is possible through various market mechanisms.

Truth Machine

Lack of abundant trusted and quantifiable data limits the design space for alternative rebalance mechanisms, requiring most designs to require human intervention. How do we build a machine that we trust, whose purpose is to determine and deliver truth for relevant data?

Uniswap (opens in a new tab), Chainlink (opens in a new tab), Pyth (opens in a new tab), and UMA (opens in a new tab) offer unique ways to arbitrate truth onchain. Additionally, blockchains themselves are truth machines, designed to increment block by block as securely as possible. The room for exploration here is quite wide, as different solutions offer varying levels of decentralization and security.

Governance

Trusted humans play a large role in ensuring integrity and safety of the system. Today, they typically come in the form of multi-sigs and token holders. How do we minimize their role as much as possible?

Even after the Truth Machine is built, there may be room where Governance may have to intervene. The most obvious reason might be to upgrade a portion of the protocol, but there may be more nuanced reasons to need humans for safety. In case where humans are needed, we should aim to keep the powers from being immediate, unilateral, or overreaching.

How do we get there?

We've casually mentioned a number of the hardest problems in crypto today above. It's going to take a lot of researching, building, and experimentation to make significant progress towards the endgame. Unsurprisingly, the roadmap will be split into two parallel tracks: Increasing Efficiency, and Decreasing Trust. Over the next coming weeks and months, we'll tackle the problems in piecemeal and break down the endgame into consumable, testable chunks with visible roadmaps. They'll be integrated into AMKT, other products, or as PoC's, while always maintaining security as our top priority.

If you, your product, or your protocol are interested in similar problems, please don't hesitate to reach out.