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TradFi and Crypto’s Convergence: The Future of Index Products

By Yan POctober 24, 2024No Comments

This is the first of two articles exploring the convergence between crypto and traditional finance market structures, a trend that has accelerated this year. In this series of articles, we’ll take a high-level look at the topic, with the first focusing on index-tracking products that have become dominant in traditional finance (TradFi) markets, but have struggled to gain traction in crypto.

Introduction

2024 marks a pivotal year for the long-anticipated integration of TradFi and cryptocurrency ecosystems. The convergence is accelerating on two fronts: on-chain assets are being packaged into ETFs and listed on exchanges like the NYSE and Nasdaq, while institutional players like BlackRock are leveraging blockchains directly, exemplified by the firm’s deployment of $500 million worth of U.S. Treasury Bills on Ethereum.

“ETFs are step one in the technological revolution in the financial markets, … Step two is going to be the tokenization of every financial asset.”

Larry Fink, BlackRock CEO.

We think that the inevitable next step in this evolution is the integration of tokenized assets into the crypto ecosystem, which could drive unprecedented levels of liquidity on-chain. We’re already seeing the first signs of this shift: BlackRock reportedly aims to use BUIDL as collateral on crypto exchanges, and Hashnote’s recent launch of USYC as collateral on Deribit only reinforces the trajectory. These developments signal that institutional players are laying the groundwork for a deeper convergence of traditional and digital finance.

As institutional players flood into the space and the convergence of TradFi and crypto accelerates, we expect certain aspects of crypto to mirror traditional finance. However, one key difference will define the future: while index-linked products like index futures and index-tracking funds are already ubiquitous in TradFi, crypto is just beginning to unlock their potential. As crypto matures, these products will become foundational, reshaping how we invest and manage risk in a decentralized world.

Below, we examine the history and mechanics of index-linked products in TradFi, evaluate their current presence in the crypto market, assess potential investment opportunities, and outline why we’re bullish on the sector.

A brief history of equity index products

In 1982, the Chicago Mercantile Exchange (CME) launched S&P 500 futures, an innovation that quickly became a cornerstone of financial markets. These futures allowed investors to hedge portfolios and gain exposure to broad market movements efficiently, driving rapid adoption. Their success was so significant that by 1987, index futures had become integral to portfolio management strategies, including a technique called portfolio insurance.

In 1997, the introduction of E-mini futures, a smaller and more accessible version of the original S&P 500 futures, further expanded participation in the futures market. This product innovation fueled a surge in trading volumes, and today, equity index futures are the second most-traded category, with daily volumes exceeding one trillion dollars. Their evolution demonstrates how index-tracking instruments have become central to liquidity and risk management across global markets.

Source: CME Group

Futures traders, previously limited to commodities and forex markets, quickly embraced these new instruments as they provided deep liquidity, low margin requirements, and broad market exposure. The rise of the hedge fund industry, emerging alongside this financial innovation, provided additional tailwinds.

Eleven years later, the first ETF, the SPDR S&P 500 ETF (SPY), was launched. Much like S&P 500 futures, the SPDR S&P 500 ETF was an immediate success. Its lower fees and deeper liquidity compared to mutual funds made it highly attractive to investors. This success paved the way for exponential growth in the ETF industry. By 1998 and 1999, Dow Jones and Nasdaq 100 ETFs were launched, marking the entry of other major indices. From there, the ETF ecosystem expanded to include products that cater to every strategy: short and leveraged ETFs, option-based strategies, and even ESG-focused funds.

The rise of ETFs was largely driven by the widespread acceptance of the efficient market hypothesis (EMH), popularized by Fama’s groundbreaking 1970 paper. As algorithmic trading grew, market efficiency improved, supporting the EMH’s claim that active managers struggle to consistently beat the market. In this environment, ETFs offered the ideal solution—low-cost, liquid, and diversified exposure—tailored for an efficient market where outperformance is rare. The Global Financial Crisis further underscored active managers’ inability to outperform, accelerating the shift. By 2023, passive funds surpassed active ones in total assets managed for the first time.

Source: Morningstar Direct Asset Flows

Market structure & value chain

ETFs typically have low fees, yet their large assets under management (AUM) generate significant value for all parties involved in their structuring and operations. For example, the SPDR S&P 500 ETF (SPY), with an expense ratio of just 0.0945%, still generates over $500 million in annual fees.

In most ETFs, three key players are critical to their creation and operation: index providers, issuers, and authorized participants. As the crypto industry evolves toward a similar market structure, understanding how and where value is captured becomes increasingly important.

Index Providers

Index providers play a key role in maintaining index methodologies, selecting underlying assets and their weights, and publishing the index values that ETFs and other financial products track. Beyond traditional market-cap-weighted indices like the S&P 500, they offer a wide variety of indices.

To gauge the value creation potential of index providers, S&P Global’s 2023 10-K filing serves as a useful case study. The company reported an average AUM of $2.9 trillion for products tied to its indices, generating $859 million in asset-linked revenues—about 3 basis points. Additionally, it earned $277 million from indices-related data subscription services and $267 million from royalties on futures trading. When considering all revenue streams relative to AUM, the total revenue amounts to approximately 4.8 basis points.

Source: S&P Global 2023 10-K form

Issuers

Issuers create index-linked investment products and handle all operations, maintenance, and regulatory filings. Typically, they are asset management firms like BlackRock or State Street.

Fees vary substantially depending on the product type. For passive index funds, intense competition has driven total expense ratios down to the 3-10 basis points range. In contrast, smart beta, niche, and actively managed ETFs generally have higher expense ratios, typically ranging from 30 to 80 basis points.

Vanguard, known for its aggressive pricing, manages approximately $3 trillion in AUM across U.S.-listed ETFs. With an average expense ratio of 8 basis points, this generates about $2.4 billion in gross revenues, before payments to index providers and other operational costs. In contrast, the ARK family of funds, with around $10 billion in AUM and an expense ratio of 75 basis points, generates approximately $75 million in annual revenue.”

Authorized participants

Authorized Participants (APs) are institutions such as banks and market makers that have access to primary markets and can create or redeem ETF shares directly with issuers. Their primary role is to maintain the liquidity of investment products and ensure they trade close to NAV by facilitating the creation and redemption process.

APs mainly generate revenue through arbitrage opportunities, profiting from price discrepancies between the ETF and the underlying assets. However, there is limited transparency into their financials, making it difficult to fully assess their profitability.

TradFi Crypto products

While 2024 has drawn significant attention with the launch of Bitcoin and Ether ETFs in the U.S., the journey to this point has involved several key developments. Noteworthy milestones include Grayscale’s introduction of the Bitcoin Trust (GBTC) in 2013, the launch of CME Bitcoin futures in 2017, and the debut of ProShares’ Bitcoin Strategy ETF (BITO) in 2021.

Most popular crypto products today focus on single assets—primarily Bitcoin or Ether. However, there are also publicly traded crypto index funds available. The two largest are the Grayscale Digital Large Cap Fund (GDLC), managing around $520 million in AUM, and the Bitwise 10 Crypto Index Fund (BITW), with approximately $960 million in AUM. Both funds are structured as closed-end vehicles and trade at a substantial discount to their net asset values (NAV), reflecting some limitations in their current structure.

In contrast, Europe is years ahead of the U.S. in crypto product availability, thanks to clearer regulations. The first Bitcoin ETP, Bitcoin Tracker One, was launched in 2015 on Nasdaq Nordic in Sweden, followed by the first crypto index ETP, the 21Shares Crypto Basket Index ETP (HODL), introduced in 2018 on the SIX Swiss Exchange. Today, Europe offers over 40 crypto assets via ETPs, including diversified baskets and strategy-based products. This broad product range provides a more accurate proxy for gauging demand in crypto markets.

According to etfbook.com, there are currently 210 crypto ETPs traded in Europe, managing a combined $12.4 billion in assets. The largest categories by AUM are Bitcoin (54.8%), Ether (15.9%), and Solana (12.7%), while diversified products rank fourth with a 7% share. Notably, diversified products have experienced the strongest inflows over the past six months, nearly doubling their AUM during this period.

Source: etfbook.com

Notably, diversified products have seen the strongest inflows over the last six months, nearly doubling their AUM during this period. This trend indicates growing interest in broad-based exposure to multiple digital assets, signaling a maturing market where investors seek more diversified strategies beyond single-asset vehicles.

Crypto-native products

FTX pioneered both index futures and leveraged tokens, analogous to leveraged ETFs. These products were innovative and challenged the status quo in crypto trading, which is focused on individual assets. However, after FTX’s collapse, there were no serious attempts to reintroduce these products—until recently. This year has seen renewed efforts to develop and bring back these types of products, reflecting a gradual maturation of the crypto market.

Index futures

FTX’s foray into index futures began in 2019 with the launch of ALT-PERP, an altcoin index future, followed by SHIT-PERP and DEFI-PERP, which tracked the performance of low-cap coins and the DeFi sector, respectively. These products were reasonably successful, with ALT-PERP reaching eight figures in average daily volume during its peak in 2021. While they didn’t compete with the largest contracts, such as those based on BTC or high-cap altcoins, they carved out a solid niche among traders seeking broad exposure to altcoins. However, their growth was somewhat constrained by the amount of liquidity that Alameda Research, as a primary market maker, was able and willing to provide.

Binance introduced its own DeFi index futures ($DEFI) in 2020, but the product saw a significant decline in activity. Today, $DEFI has less than $1 million in daily trading volume, a 97% drop from its average daily volume (ADV) during the first six months of trading.

The early crypto index products didn’t have the market structure discussed earlier. Rather than relying on robust third-party indices, they were designed in-house with poor methodology and maintenance. Creation, redemption, and liquidity provision were managed through internal agreements with market makers. The primary market maker, Alameda Research, notoriously struggled with rebalancing, leaking value to frontrunners. Since then, no credible attempts to launch crypto index futures have succeeded.

Many index providers cover crypto markets, but most are TradFi companies extending their offerings to crypto. Traditional ETPs are often based on these indices, though they rarely include crypto-native exchanges. Notable exceptions are Coindesk Indices and GMCI, a new index provider launched by Wintermute and The Block.

In 2024, futures based on the Coindesk 20 index launched on Bullish, with an ADV of over $30 million, making it the most traded crypto index future today. GMCI’s indices have also gained some traction, with perpetual contracts listed on exchanges like Vertex, Woo X, and Bitget. Although these markets are still thin, with combined daily volumes below $100,000, this marks significant progress compared to previous years. Currently limited to smaller exchanges, we believe these products could gain broader adoption as the market evolves.

Spot products

FTX’s leveraged tokens were introduced at the launch of the exchange, providing 3x leveraged exposure to BTC and ETH. Later, FTX expanded into more niche products like BULLSHIT, which offered 3x exposure to an index of low-cap coins. These tokens initially gained traction, leading Binance to add them to its platform. However, within a few months, Binance delisted the tokens and introduced its own version of leveraged tokens. These, too, struggled due to issues with volatility decay, and in early 2024, Binance announced it would terminate its leveraged token services by April.

In the DeFi realm, several projects have experimented with on-chain structured products. One of the most notable is Index Coop, which enables the tokenization of structured products, including indices, leveraged/inverse products, and yield-generating strategies. The issuance, redemption, and rebalancing of these products are all managed through smart contracts, offering transparency and efficiency compared to their centralized counterparts. Index Coop’s most successful product has been the DeFi Pulse Index (DPI), which at its peak in September 2021 reached around boasted $220 million in total value locked (TVL), the highest figure for any on-chain index product so far. Unlike Binance’s DEFI index perp, DPI and other Index Coop products are based on a well-developed methodology and are still actively maintained.

Source: Coingecko

Leveraged tokens attracted more durable traction, accounting for over $65 million combined across Index Coop and dHEDGE products. Option-selling vaults gained popularity in 2022, with the leading project, Ribbon, reaching a peak of $300 million in TVL. However, interest waned, possibly as investors realized it wasn’t a traditional yield farming protocol.

A new category of index-tracking funds began to emerge this year, focusing on on-chain tokenized funds for institutional investors. Hashnote launched the first such product tracking the Coindesk 20 index in March.

Opportunity: A $650 Million Industry—and Growing

The equity market serves as the best proxy for understanding how the crypto market might evolve. Both asset classes include a wide range of assets, are growth-oriented, and exhibit high concentration in top assets. However, crypto is more extreme in this regard—Bitcoin accounts for 57% of the market, whereas Apple comprises only 7.3% of the U.S. equity market. Furthermore, the crypto market has historically lacked a broad base of high-quality, liquid assets, largely due to its relative novelty.

Despite this, the disparity in index-linked investments between crypto and equities is striking. While crypto’s total market cap is roughly 5% of U.S. equities, only 0.2% of crypto investments are allocated to diversified or strategy ETFs, compared to 13% in equities. This gap suggests that there might be an unmet demand for these products in the crypto market.

The maturation of the crypto market, fueled by institutional adoption through Bitcoin and Ether spot ETFs, as well as tokenization, is driving new demand for broader market exposure. European diversified ETPs, which now account for 7% of that market, support this view. However, outside of Europe, appetite for such products remains largely untapped, and the total market size remains relatively insignificant.

Source: etfdb.com, etfbook.com

There is a significant opportunity for on-chain index products to fill this gap, especially by leveraging the right distribution channels. Currently, these products exist almost exclusively on-chain, where users tend to prefer active management over passive strategies. To realize the full market potential, issuers need to overcome two key challenges: listing these products on retail-focused centralized exchanges and fintech platforms, and reaching institutional investors. Furthermore, to successfully onboard institutional investors, the products must also be designed to meet their specific needs, such as compliance, liquidity and custody. If these hurdles are addressed, the market could see substantial growth, creating a scalable and sustainable market for crypto index products.

We estimated the potential size of the crypto-index industry based on three scenarios for market growth over the next few years. In the pessimistic scenario, we forecast no growth, while the optimistic scenario projects 100% growth. The industry capture ranges from 1% to 5%, depending on the scenario. In the baseline scenario, we estimate the index-tracking funds to gain approximately as much traction as spot ETFs have today, even though the total market would grow by 40%.

Based on these projections, we assessed the industry’s revenue potential using ARK’s 75 basis points as the baseline for the average total expense ratio. Most of the revenue would remain with issuers, as is typical in traditional markets. In the baseline scenario, with a $3.5 trillion total market size and a 3% market capture, the industry has significant room for further growth, potentially generating more than $650 million in annual revenue.

Finally, we estimated the revenue potential of the market leader, assuming they capture a share similar to BlackRock’s 31% in the traditional ETF market. However, we believe the leading player in the emerging crypto market could initially command a substantially larger share.

In addition to ETF-like products, crypto issuers have a significant opportunity to structure offerings uniquely enabled by blockchain. A recent example gaining traction is Ethena’s delta-neutral perpetual position, packaged as a stablecoin (USDe).

Closing thoughts

Although index products have struggled to gain traction in the past, the tides have turned. Today’s market conditions are ripe for explosive growth. The launch of Bitcoin and Ether ETFs in the U.S., the rise of asset tokenization, and growing inflows into diversified ETPs are just the beginning. We are on the verge of a new era where crypto index funds, fueled by blockchain technology, will reshape the financial markets.

As traditional assets become tokenized, we envision a future where permissionless tokens will dominate, unlocking unparalleled efficiency, liquidity, and accessibility. Crypto index funds will serve as the backbone of a decentralized financial ecosystem, creating opportunities that are largely untapped by today’s market players.

While the reluctance of major exchanges to list these products has been a hurdle, history shows that when crypto products begin delivering clear competitive advantages—like those from FTX and Binance—the market moves quickly. We expect index futures and index funds to converge, driving a surge in trading volumes and generating powerful network effects that will transform the ecosystem.

The window of opportunity is wide open for innovators and investors alike. Those who act now will define the next decade of finance, laying the foundation for a future where decentralized markets rival, and ultimately surpass, their traditional counterparts.

In the next article, we will continue exploring the convergence of crypto and traditional finance, but from a different perspective—focusing on tokenization and the opportunities it creates for the crypto-native ecosystem and the projects operating within it.