Index providers have rules for every possible capital markets event to accurately represent the underlying economic reality. But how would a TradFi basket index handle a fork?

A group of developers and miners plan to fork the Ethereum blockchain after the Merge. This new chain would continue to run a proof of work (PoW) algorithm as part of its consensus mechanism. Such a fork will create a new chain on which users will have an amount of “PoW ETH” matching their balance on the Proof of Stake (PoS) chain.

The distribution of tokens through the fork closely resembles the TradFi corporate action of a spin-off.

According to MSCI’s Corporate Events Methodology, a spin-off is the free distribution of shares in a wholly-owned company to the parent company’s existing shareholders.

What happens next in the index? Usually an index methodology would not allow the holding of the newly added asset and remove it as soon as possible. In order to remove an asset from an index a price is required though. Effectively, the index “sells” the asset and reinvests the proceeds in the remaining assets proportionally. Therefore, most index providers’ rules would remove the spin-off company immediately if there is a price available on the effective date (“ex date”) of the spin-off. Otherwise, the index will hold the spin-off until the security starts trading.

Index adjustments

Since any index composition change has to be self-financing in total return indices, i.e. money is neither generated nor lost across the removal, the index divisor is adjusted (lowered) when the asset is removed:

\[Divisor^{post} = {\sum_{i}p_{i} \cdot s_{i} \over \sum_{i}{p_{i} \cdot s_{i}} + \text{spin-off value}} \cdot Divisor^{pre}\]

Divisor adjustments implicitly distribute the proceeds proportionally across the index.

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