Understanding the Diversified Staked ETH Index (dsETH)

The Diversified Staked ETH Index (dsETH) provides diversified exposure to the top liquid staking tokens in the Ethereum ecosystem and promotes decentralization amongst liquid staking protocols. It is important for users to understand dsETH’s methodology and functionality as well as its risks and returns.

What is the methodology for dsETH?

The objective of dsETH is to give token holders diversified exposure to liquid staking tokens, with weightings that favor decentralized liquid staking protocols. To be eligible for inclusion, liquid staking tokens must meet all inclusion criteria, which center around security, transparency, liquidity, and client diversity.

Tokens that meet these criteria are assigned equal weights before applying two factors: 1) the number of node operators supporting a protocol and 2) the distribution of stake across those node operators.

The number of node operators supporting a protocol is represented by the Node Operator Factor, which takes the square root of active node operators supporting a protocol and divides it by the sum of square roots for all protocols represented in the index. As a result, protocols that have more node operators receive a greater weight in the index, while protocols with fewer node operators receive lesser weight.

The distribution of stake across node operators is measured by the Herfindahl-Hirschman Index (or “HHI”) Factor, which measures validator concentration across active node operators. In the case of dsETH, HHI is calculated by squaring each node operator’s share of staked ETH relative to the rest of the protocol and then summing the resulting squares for all node operators.

Results can range from 0 to 10,000, with lower values indicating less concentration of stake within a protocol. Resulting HHI values are then subtracted from 10,000 and divided by the sum of all differences for the final HHI Factor, which ultimately benefits protocols with broader distribution of stake while protocols with greater concentration receive lesser weight.

Both Factors are then added to the equal initial weights of each liquid staking token for the ultimate weight, and subsequently divided by the sum of all ultimate weights to reach their final allocation percentage.

dsETH is designed to be an evergreen index, accounting for changes to the underlying protocols and allowing new tokens to be added over time. Meaningful changes to node operator or distribution of stake data will be factored into future rebalances, and additions to the index must meet all token inclusion criteria.

How does dsETH Work?

Diversified Staked ETH is the first index token to officially launch on Index Protocol, a good-faith fork of Set Protocol v2. The same security assumptions and audit coverage for Set Protocol apply to Index Protocol as no changes have been made to the core code. Therefore, dsETH will use the same battle-tested infrastructure as other Index Coop products like $DPI, $MVI, and $BED. More information on Index Protocol can be found in the docs here.

At launch, dsETH will be composed of rETH (Rocket Pool), wrapped stETH (Lido), and sETH2 (StakeWise). In order for dsETH to be a “re-pricing” token, its components must also be “re-pricing”. In other words, staking and execution layer rewards must accrue to the liquid staking token’s net asset value, with the token gradually appreciating in price relative to ETH over time. For this reason, stETH must be wrapped, and sETH2 rewards must be periodically reinvested so that the ultimate index token is “re-pricing”.

In the case of stETH, the innate rebasing mechanism creates composability issues for Index Protocol (as well as many other DeFi protocols). Wrapping stETH abstracts away the rebasing mechanism and results in a repricing token, with rewards accruing to the value of the wstETH token on a daily basis. As a result, wstETH becomes compatible with dsETH and enables the ultimate index token to be repriced as well.

StakeWise’s dual token model introduces complexity because sETH2 holders are rewarded with a separate token, rETH2. In order to enable a unified repricing token, rETH2 rewards will be periodically reinvested back into sETH2 via an extension to the token contract. At launch, rETH2 rewards will be reinvested on a weekly basis, resulting in a repricing effect after each reinvestment interval.

Like all Index Coop products, dsETH can always be minted or redeemed, in a permissionless fashion and at any time. At the most fundamental level, users can mint dsETH by supplying the individual components proportionally. When redeeming dsETH, users receive the individual components back.

Flash Mint will also be available for users that prefer to mint with a single token or redeem into a single token. When a user supplies ETH to the Flash Mint contract, it will swap that ETH for the individual components of dsETH and execute the standard issuance process atomically. Redemptions work in a similar way, with the user supplying dsETH to the Flash Mint contract and ultimately receiving their token of choice after the standard redemption and required swaps are executed.

Because of the implicit swaps and contract interactions, Flash Mint can be more expensive than simply buying dsETH on a DEX. However, for larger transactions, Flash Mint can be more economical than a DEX trade if price impact is significant. Gas costs and secondary market liquidity are key factors, so non-Restricted Persons are encouraged to test the Swap and Flash Mint paths on the Index Coop app in order to find the best price at the lowest cost!

What are the risks?

dsETH is subject to similar systemic and idiosyncratic risks as the rest of DeFi—like smart contract risk, oracle risk, and regulatory risk—but currency risk and liquidity risk are especially important for token holders to understand. Currency risk, in this case, refers to the inherent volatility of liquid staking token prices relative to ETH. Because withdrawals from the beacon chain are not yet enabled, there are no hard mechanisms, or “pegs”, in place to prevent liquid staking tokens from trading above or below their fair value in ETH terms. Therefore, the price of different liquid staking tokens is dictated by the market, often resulting in premiums or discounts to net asset value.

Because dsETH is effectively a basket of liquid staking tokens, its net asset value (NAV) is affected by these potential premiums and discounts. For example, if a user were to buy dsETH when several of the underlying tokens are trading at a premium relative to ETH, their position may be worth less if premiums dissolve or discounts appear after the fact. All the underlying tokens in the index will continue to accrue staking and execution layer rewards regardless of secondary market pricing, but the NAV of dsETH may fluctuate relative to ETH over time. These pricing issues will persist until withdrawals are enabled in the first half of 2023, at which point price parity between liquid staking tokens and ETH should track more closely due to effective arbitrage.

Favorably, dsETH token holders have less exposure to currency risk compared to holding a single liquid staking token because of the innate diversification of the index. A particularly aggressive premium or discount on one token will be balanced out by the others.

Liquidity risks for liquid staking tokens are also relevant for dsETH holders. Liquidity–or lack thereof–affects the price of a given liquid staking token if there is sustained and/or strong sell pressure. Because the value of dsETH is derived from the price of the tokens inside of it, low or mismanaged liquidity for a single liquid staking token can drag the value of the index down if prices are falling. For this reason, a minimum amount of secondary market liquidity is required for a liquid staking token to be part of dsETH. Liquidity for the underlying components of dsETH can also be monitored on the dsETH dune dashboard. This risk will also be mitigated once withdrawals from the beacon chain and, therefore, direct redemptions of liquid staking tokens are enabled.

What are the potential returns?

As an interest-bearing index token, dsETH provides a weighted aggregate APR of the liquid staking tokens inside. Staking and execution layer rewards earned by the components gradually add to the overall net asset value of dsETH, so token holders do not have to worry about claiming rewards or triggering taxable events. Based on backtest data since the Merge, the gross APR of dsETH would be approximately 5%.

Index Coop does not charge a commission or performance fee on staking or execution layer rewards on the index; rather, a static 0.25% annual streaming fee is in place. Using backtest data from above, the net APR for dsETH token holders since the merge would be approximately 4.75% (or the 5.10% Gross APR minus the 0.25% streaming fee).

Forward-looking returns depend on the core staking rate, execution layer rewards, and other variables controlled by liquid staking protocols like commission rates, MEV management, and slashing insurance. Conservatively, dsETH could potentially have a 4-6% Net APR in the future. More execution layer rewards and less protocol-level commission can contribute to a higher APR, while lower staking reward rates and protocol-level slashing penalties can contribute to a lower APR.

The Diversified Staked ETH Index (dsETH) Dashboard provided by the Index Coop monitors current and historical APRs for dsETH and its underlying components.

More Resources for dsETH

• Buy / Sell via Uniswap, Index Coop App, or DEX aggregator - CoW Swap or L2 zkSync - ZigZag Exchange & Argent (currently found in the Swap crypto section)

• Mint / Redeem via the Index Coop App

• Read the launch article

• Read the forum post

• Review the analytics dashboard on Dune

• Track the methodology transparently with Rated Network

For more information on Index Coop, please visit: Discord |Twitter | Website

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