Treasury Management In The Age of DeFi
On the need for protocol treasury to be better managed
Today we have our first contributor piece written in collaboration with Siddharth Jain. He was an early member of the team at Polygon and has been steadily building DeFi Dollar over the past year.
The internet has likely done more in the past decade to change the nature of our jobs than any technology at any point in time in history. It used to be unheard of to sit at home, work with other pseudonymous characters and make a meaningful living. Growing up, I kept hearing about how being in San Francisco would give a sea of opportunity for the average individual. Since 2017, I have slowly been seeing the trend shift towards being present on-chain. We have discussed in abundance how on-chain reputation is increasingly becoming instrumental to working with protocols in the past. But to coordinate and control resources in these protocols, you need infrastructure that can help make decisions and allocate resources. This is where DAOs come.
At its crux, a DAO is a headless organization that runs on the basis of instruction given by code, governed through on-chain interaction. What used to be corporate governance in the traditional realm could be conducted entirely on-chain. Today DAOs are used for coordinating everything ranging from buying NFTs (e.g.: PleasrDAO) to making venture-style investments (Metacartel, SyndicateDAO). In other words, they are on-chain primitives that redirect resources on a need-by-need basis. They are upending traditional notions of how institutions are built and run to pave ways for equitable ownership and transparent governance. We won't be going in-depth on how DAOs are transforming culture today, but if you are curious to learn more about DAOs, I recommend reading this piece explaining the pre-history of DAOs.
Billion Dollar Protocols Are The New Cool
Market frenzy in the public markets could mean protocols reach billion-dollar valuations much faster. Most teams in the digital asset space keep a fraction of the supply for themselves. This could be a variable depending on the nature of the firm. Anything between 10-20% is not unheard of. If a team hits a multi-billion dollar valuation, the venture now has to find new ways to allocate the newfound wealth to further the protocol's interest. In many instances, these tokens are locked in a DAO and managed by the community.
DAOs doing protocol treasury management find themselves in a unique spot.
1. Selling assets in the public markets may signal a lack of confidence and cause a collapse in the asset price. Some protocols get around this through reaching private agreements with venture capital firms. However, this may not be genuinely fitting in the ethos of community-based governance.
2. The other angle they may take is to make a public announcement on which the community votes. These could get rather messy as we recently saw with Sushi. The community may not form the consensus needed to initiate such an agreement meaningfully fast enough.
More importantly, many large organisations would rather avoid the scrutiny altogether and buy the asset from the public markets. Due to a mix of the two, some of the largest DAO treasuries remain concentrated on very few assets with directional exposure. The graph below shows the percentage distribution of prominent DAO treasuries in dollar terms.
Protocol treasuries need to liquidate their holdings routinely as crypto markets are largely cyclical. Selling part of the treasury during a bull run extends the team's runway and gives resources to make strategic acquisitions in the case of a market pullback. In this article, we briefly look at capital allocation for University endowments and then evaluate a few solutions for protocols treasuries to hedge their risk. The raison d'être - for DAO treasuries is the same as that for University Endowments. The goal is to optimize for longevity and be anti-fragile to ensure operational deployment and development funds even in bear markets.
Assets that are liquid form a significant part of the endowment: Bond + Cash + Absolute Return numbers target a whopping 31% of the total size of the Yale endowment in 2020. By design, endowments have allocations reserved for non-risky assets to avoid liquidity crunches during critical times- this allows the returns for the long-term holdings like equity & venture to compound as they stay untouched. If endowments consider their sworn enemy as inflation, its counterpart for DAO treasuries is market downturns. As shared above, a majority of DAO holdings consist of the protocols' token. While this may be great to capture value from the protocol's growth but can also be detrimental as market movements hamper the 'cash at hand' or results in severe opportunity costs for expansionary spending, responding to economic exploits or hacks. Many protocols have native tokens as backstops. This form of risk could be better managed if protocols had more than just their token to fall back on. Let's take a look at one of the largest treasury of them all - Uniswap
The UNI treasury has seen a drawdown of over 50%. Due to the price dip since an ATH all in the course of ~2 Months. With the recent resurgence in the markets, the treasury has recouped some of the lost value. This fluctuation is a nightmare for any fund manager and highlights the need for improving asset allocations for treasuries. Keeping protocol treasury in its token without managing risk means that protocols may not have enough runway to keep the heat on in long crypto winters. Projects need to actively mould the treasury as a competitive lever to deploy and not just depend on their original fundraising. We delve into some potential solutions to address the liquidity at hand problem for treasuries and their related trade-offs:
Scenario: Treasury funding puts by selling covered calls to protect the protocol in case of a sharp market correction/ Simply buying puts to hedge downside risk
A put is a financial instrument betting on an asset going lower in price within a pre-determined period of time, while a call is used to bet a higher price. Selling a covered call would mean the treasury sells the right to buy a token at a specific price above current levels while holding the underlying asset. Since the underlying asset rises in price, selling the calls would not incur heavy losses on the protocol's treasury itself. You can read this article for more on covered calls. I found this hilarious video helpful. The premium thus earned from selling these calls can be used to pay the premium for purchasing put options. This effectively offsets the cost for the treasury to fund puts.
Ideally, Protocols will be buyers of put options to derisk a part of the treasury. This would generate a profit in case the assets they hold go lower in price and effectively act as a floor price at which the protocol would convert into stables than hold onto the token. The challenge here is that on-chain liquidity for options isn't sufficient to enable a transaction of this size -assuming protocols would likely want to hedge at least 10 % of their treasury. This means the volume of upwards of $100 Million for the Uniswap treasury alone. Compare this with the Opyn - the leading on-chain options protocol that has a TVL of ~82 Million. There isn't enough liquidity in the on-chain markets to execute this in a capital-efficient manner. We consider on-chain avenues as DAO treasuries are likely to avoid off-chain management. However, the current pricing is prohibitive as compared to centralised alternatives and for this to become cost-efficient on-chain volume for Options has to scale considerably. The other here might be the recurring costs of rolling over the puts - repurchasing put options close to their expiry to ensure continued protection. With the on-chain options landscape maturing with time, this would be a plausible alternative for treasuries to effectively manage risk while adhering to complete transparency which is DAO's value.
Stablecoins and Indices
Scenario: Treasuries holding stablecoins, diversified indices, and other on-chain structured yield products to provide operating capital without having a distress sale in an already weakened market.
One proposal that has been discussed at length for treasuries to guarantee runway is to diversify into stablecoins. This might not get voted for as it will mean selling the native token. Although indices aren't the equivalents of stablecoins in preserving value, they can be a better way to hedge risk than holding a single token. More importantly, DAOs can choose different themes from what the protocol does to ensure proper diversification. The interesting bit here is that indices to enable this transition already exist. As mentioned in a previous article - thematic index-based diversification is well within what is possible on-chain today. A market-maker could also be commissioned to enable the transaction for a pre-set fee. In such an instance, individual market-makers would propose the rates at which a portion of the DAO's treasury can be gradually converted to other assets over a while. This would ensure that a better price can be obtained for purchasing the index constituents.
Borrowing Against Treasury
Scenario: Treasuries availing on-chain loans against token collateral to provide operational capital without needing to sell tokens upfront.
Protocols can borrow from on-chain lenders to access funds for operational expenses without selling any native tokens. It protects the network from a short-term sale of the assets. If deployed as intended, the funds will lead to positive outcomes and justify the repayment even with a sale of tokens down the line. The underlying idea here is that if one genuinely believes a protocol will rise in price over time, it makes more sense to take a loan against it. The challenge is with relation to collateral ratios. If a lending protocol (or venture) sees the asset trending lower in price, they have good reason to sell the tokens to maintain the necessary collateral ratio. More importantly, if a hack takes down the protocol and price slips fast, any entity that has offered the loan could find itself in the red. Protocols could also use off-chain lending to generate yield. DAOs could liquidate part of their treasury to stablecoins and offer to projects like Centrifuge to do real-life lending. This still requires them liquidating an amount of the tokens they hold.
Scenario: Treasuries leveraging range tokens to avail debt that can be settled later with the native token.
UMA Protocol's range tokens get a special mention given how they were proposed as a solution during the recent Sushi treasury sale. So I strongly suggest reading up on them here. A range token is a debt instrument that is backed by protocol treasury. So instead of selling an asset to get stablecoins, they sell the right to buy the underlying within a range of price. The example given in the launch blog post is as explained below.
The range token enables a DAO to use its native token as collateral to borrow funds. At maturity, if the debt is not paid, the range token holder is instead compensated with an equivalent amount of the collateral (the native token) using the settlement price of the native token to determine the number of tokens. For example, if the native token is trading at $25 at settlement, a 100 USDC debt would be settled with 4 tokens (100 / 25)
This keeps the protocol from selling tokens at a low price while having the option of settling in dollars if need be. However, this requires investors with a particular risk appetite. For instance, if a range of tokens trend towards a ratio where they are undercollateralized, the risk is on the investor's books. Similarly, if they are trading at a price above the pre-set range, the protocol loses the upside. For now, they are a complex instrument that may take a while to find a product-market fit at scale but are one of the many forays that are innovating to help manage risk for DAO treasuries. ( I understand this was confusing. I will try and get someone from the team to explain this better than I could, soon).
Where Do We Go From Here
There will be at least $10 billion in assets looking for treasury management within the next six months by conservative estimates. The infrastructure to cater for its optimal control is still under development. Centralised service providers are slowly waking up to the opportunity, and startups have capitalised on the narrative. Given the large-scale coordination necessary to make decisions on these large pools of capital, it may be a while before we trend towards efficient management. In our opinion, we will likely see specialist protocol fund managers emerging within the next few quarters. They will be individuals who understand the complexities of the CeFi world and bridge it to a DeFi market. In the interim, communities and protocol developers will likely continue to bring new instruments like UMA's range tokens to assist with the transition. One of the angles we did not mention in this piece today is the possibility of specialist fund managers running portfolios entirely on-chain. We will dive into how a hedge fund or a venture fund will transition towards running on-chain in a future piece. For now, all that can be said is that protocol treasuries are a sleeping giant waiting to be used optimally to push the industry forward. If you are building for this - drop me an email (by replying to this) or hop on our telegram here.
I will see you guys on Friday with lots of analytics on a gaming venture.
1. I may have commercial exposure to some of the ventures mentioned above.
2. Not investment advice.
A fairly large DeFi protocol is looking to hire a NFT designer in the short future for a paid engagement. The protocol has one of the largest userbases in crypto. If you are an artist with an understanding of how to design NFTs, drop me an email with your portfolio and I would be open to introducing you to members of the team