How does the DAO Treasury manage assets in the DeFi era?

Over the past decade, the internet has dramatically changed the nature of our work, more than any other technology in human history. It was unheard of for people to live decent lives remotely, working with a group of anonymous people from the comfort of their own homes. Growing up, I’d always heard that San Francisco was a place for ordinary people to find opportunities. Since 2017, I’ve seen this trend shift to the blockchain industry. We’ve discussed many times how on-chain reputation will play an increasingly important role in enabling cooperation between protocols. However, in order to facilitate the regulation of the resources of these protocols, we need infrastructure to facilitate decision-making and resource allocation. This is where DAOs come in.

A DAO is essentially a “headless” organization (i.e., an organization without a leader) that runs based on instructions given in code and is managed through on-chain interactions. Traditional corporate governance models can be implemented entirely on-chain. Today, DAOs are widely used for everything from purchasing NFTs (such as PleasrDAO) to venture capital (such as Metacartel and SyndicateDAO) that requires coordinated on-chain interactions. In other words, DAOs are blockchain-native modules that redirect resources based on demand, subverting traditional ideas about how to build and run institutions to achieve equal ownership and transparent governance. This article will not delve into the impact of DAOs on culture. If you want to understand DAOs more deeply, I recommend reading this article about the history before the birth of DAOs.

DeFi “unicorns” lead the new trend

The amount of funds locked in the top 12 DAO treasuries (in USD)

The frenzy in the public markets means that DeFi protocols will reach billion-dollar valuations much faster. In the digital asset space, most teams will keep a portion of the liquidity supply for themselves. Exactly how much is a variable, depending on the nature of the company, and anywhere between 10% and 20% is possible. If a team reaches a multi-billion dollar valuation, it will have to find new ways to distribute the new wealth and increase the yield of the protocol. In many cases, these tokens are locked in a DAO and managed by the community.

The DAO that manages the protocol treasury has a special status.

1. Selling assets on the open market may send a bearish signal, causing asset prices to plummet. Some DeFi protocols will privately sign buy-sell agreements with venture capital institutions to avoid this risk. However, this practice may go against the spirit of community governance.

2. Another approach is to publicly announce the community’s vote. However, this can cause great confusion, as Sushi has shown. The community may not be able to reach a consensus and reach an agreement within the effective time.

More importantly, many large organizations prefer to purchase assets from the open market to avoid scrutiny. As a result, the wealth of some large DAO treasuries is mainly concentrated in a few types of assets, resulting in directional risk exposure. The following figure shows the distribution ratio of mainstream DAO treasuries (in US dollars).

Data source: Deepdao.io

Due to the highly cyclical nature of the cryptocurrency market, the DAO Treasury needs to regularly recalculate its assets. Selling assets during a bull market allows the DAO Treasury team to operate longer and have sufficient resources to make strategic acquisitions when the market turns down. In this article, we outline the allocation of funds for university endowments and then evaluate some solutions for how the DAO Treasury can hedge risks. In this regard, the DAO Treasury is no different from a university endowment fund. The goal of both is to achieve long-term and stable development and ensure that there is sufficient funds for operation and deployment in a bear market.

Liquid assets account for a large proportion of university endowments: taking Yale University's endowment fund allocation in 2020 as an example, bonds + cash + absolute return products account for as much as 31%. By design, endowments reserve some funds for risk-free assets to avoid illiquidity during economic crises. This allows endowments to hold assets such as equity and venture capital for a long time and enjoy compound returns. If inflation is the enemy of endowments, then market downturns are the enemy of DAO treasuries. As mentioned above, the assets held by the DAO treasury are mainly composed of the tokens of the protocol. It is certainly a good thing to be able to capture value from the growth of the protocol, but there are also drawbacks, because market turmoil affects cash flow or causes high opportunity costs due to spending expansion, economic exploitation, or hacker attacks. Many protocols have native tokens to rely on. If they rely on more than just native tokens, they can better manage this risk. Let's take a look at the top DAO treasury, Uniswap.

Uniswap Treasury Value in USD

The dollar value of the UNI treasury has shrunk by more than 50% as the price of the coin has fallen from a record high in the past two months. As the market has begun to recover, the UNI treasury has recovered some of its losses. Such violent market fluctuations are a nightmare for fund managers, highlighting the need to improve the allocation of treasury assets. If the treasury concentrates its wealth on tokens and ignores risk management, it will be difficult for the protocol to survive the long winter of the cryptocurrency industry. Projects need to turn the treasury into their own competitive advantage, rather than just relying on initial financing. We have delved into some potential solutions to treasury liquidity problems and trade-offs.

Options

Scenario: The treasury sells covered calls to finance put options during periods of extreme market volatility, or simply buys put options to hedge against the risk of falling prices.

Puts and calls are both financial instruments, with the former betting that the price of an asset will fall at some time in the future, and the latter betting that the price will rise. Selling a covered call means that the treasury sells the right to buy the asset at a price higher than the current price (i.e., a call option) while holding the underlying asset. If the price of the underlying asset rises, selling the call option will not cause a big loss to the treasury of the agreement. If you want to learn more about covered calls, read this article, or watch this funny video. The premium earned from selling the call option can be used to pay the premium for buying the put option. This effectively offsets the cost of the treasury buying the put option.

In an ideal world, the protocol would buy put options to hedge a portion of the treasury. If the price of the asset held by the protocol decreases, it will bring profit to the protocol. In addition, this move actually sets a price floor, below which the protocol will convert the underlying asset into a stablecoin instead of continuing to hold the underlying asset. The problem is that the on-chain liquidity of options may not be enough to enable trading of this scale. Assuming that the protocol wants to hedge the risk of at least 10% of the assets in the treasury, the Uniswap treasury alone needs to hedge more than $100 million in assets. Compare this to the leading on-chain options protocol Opyn, which has a total locked amount of $82 million. This shows that there is not enough liquidity in the on-chain market to execute hedging transactions in a capital-efficient manner. We consider on-chain options trading platforms because the DAO treasury is likely to avoid off-chain management. However, the prices of on-chain platforms are prohibitive compared to centralized platforms. In order to achieve cost-effectiveness, on-chain options trading volume must increase significantly. Another problem is that this could make rolling puts — buying puts again near expiration to extend the duration of the risk hedge — a recurring cost. As the on-chain options trading space matures, this could become an alternative that helps the treasury manage risk efficiently while ensuring full transparency (one of the DAO’s values).

Stablecoins and Indices

Scenario: The treasury holds stablecoins, diversified index funds, and other on-chain structured income products as a source of operating funds to avoid selling assets at low prices when the market is sluggish.

One proposal that has been discussed at length is to invest in multiple stablecoins to ensure the longevity of the treasury. This proposal is unlikely to gain traction, as it would mean selling the protocol’s native token. While index funds are not as good as stablecoins in terms of value preservation, they are a better hedge than holding a single token. More importantly, DAOs can choose different sectors to invest in based on the functionality of the protocol, ensuring proper diversification. Interestingly, there are already index funds that can facilitate this trend. As we mentioned in a previous article, diversified sector index funds can be implemented entirely on-chain. The protocol can entrust market makers to trade at a preset fee, that is, gradually convert a portion of the DAO treasury assets into other assets at the exchange rate proposed by individual market makers. This allows the protocol to purchase the constituent tokens of the index at a more favorable price.

Borrowing

Scenario: The Treasury uses its assets as collateral to obtain operating funds through on-chain lending without selling tokens in advance.

Protocols can borrow funds from on-chain lenders to cover operating costs without having to sell any native tokens. This can save the network from having to sell assets in the short term. If deployed as intended, the funds will have a positive impact, and even if the tokens are sold later, the loan will be well paid back. The underlying logic here is that if one truly believes that the native token of a protocol will increase in price, it makes sense to use it to pledge loans. The problem is the collateralization ratio. If the lending protocol (or venture capital firm) sees the price of the asset fall, there is a good reason to sell the token to maintain the collateralization ratio at the necessary level. More importantly, if the protocol is hacked and the asset price plummets, the lender will face the risk of losing money. Protocols can also use off-chain lending to generate income. DAOs can liquidate part of their treasury into stablecoins and provide them to projects such as Centrifuge for lending. This requires the DAO to liquidate some of its tokens.

Range Token

Scenario: Treasury uses range token

A special mention here is the UMA protocol’s range token. It was proposed as a solution to the recent Sushi token sale proposal. I highly recommend reading this article to understand what range tokens are. Range tokens are debt instruments backed by the protocol’s treasury that sell the right to purchase an underlying asset within a certain price range, rather than exchanging the native asset for a stablecoin. For more details, read this blog post.

Range tokens allow DAOs to collateralize their native tokens to take out loans. At maturity, if the borrower does not repay the debt, the range token holder will receive an equal amount of collateral (native tokens) as compensation (the specific amount depends on the settlement price of the native token). For example, if the native token settles at $25, a debt of 100 USDC will be settled with 4 native tokens (100/25).

This prevents the protocol from selling tokens at low prices and allows it to settle in USD if necessary. However, this requires investors with specific risk appetite. For example, if the token price drops so that it is undercollateralized, the risk is borne by the investor. Similarly, if the trading price is above the preset range, the protocol will miss out on the profits of the increase. At present, range tokens are a complex tool and it may take some time for the market to truly adapt, but it is one of many innovative attempts to help DAO treasuries manage risks. (I know this is a bit confusing. I will ask someone else on the team to write a clearer article soon.)

Where to go?

Conservative estimates suggest that at least $10 billion worth of treasury assets will be sought for management in the next 6 months. The infrastructure to best manage these assets is still under development. Centralized service providers are already waking up to this opportunity, and startups are also capitalizing on this narrative. Since large pools of funds require large-scale coordination for decision making, we are still a ways off from efficient management. We believe that professional protocol fund managers will emerge in the coming quarters. They understand the complexities of centralized finance and aim to bridge them with the decentralized finance world. Meanwhile, the community and protocol developers will continue to introduce new financial instruments like UMA’s range tokens to drive the transformation of the financial industry. Alternatively, there is the possibility that fund managers will run their portfolios entirely on-chain. In a future post, we will dive deeper into how hedge funds or venture funds can run on-chain. For now, all we can say is that protocol treasuries are still sleeping beasts waiting for someone to wake them up and harness them to drive the financial industry forward. If you are building a project related to this, please send me an email or join our Telegram group chat.