Like traditional companies, on-chain agreements face the dilemma of difficulty in generating their own blood in the early stages of development. A constant cash flow is the key to maintain the sustainability of any system, however, a reserve of assets is the key to determine whether it can survive better before entering maturity. Of course, the difference between a protocol built on top of a system and a traditional company is that the fixed operating costs of the protocol are negligible when iterative updates are not considered.
This article from Blockchain Capital details the operating model and strategy of a protocol vault that can make the protocol sustainable.
This guide and recommendations address the various tools that can be used to manage the balance sheet and vaults of a DeFi protocol DAO.
While this is a heavily abridged version, it contains many of the key elements of the report, and a more detailed assessment of the tools available and their risks can be found in the full report.
The purpose of any protocol DAO is to manage and govern the protocol in a sustainable manner. As such, an agreement DAO needs to capitalize to ensure that it can not only continue to operate sustainably, but that it can continue to invest in its future growth – no different than how a traditional company would consider itself capitalized. In the same way that a traditional company uses retained earnings, equity and debt to finance itself, an agreement DAO has similar options.
-Retained earnings from the agreement and non-operating income from the agreement’s vault assets
-Sell the protocol’s native assets in exchange for stablecoin/ETH/BTC
As the chart below shows, many DeFi protocol DAOs hold nearly all of their vault assets in their native tokens. Since the protocol’s operating expenses are denominated in USD/Fiat, a bear market may force DAOs to sell their native tokens at extremely low “dump” prices to keep their operations up and running. Therefore, a protocol DAO should have multiple ways to generate revenue cash flow (i.e., protocol revenue and investment income) to support its operating expenses; however, since the vault needs to have an asset base to generate revenue/non-operating income, the DAO should consider conducting token sales or issuing debt to obtain this asset base.
Figure I. Data as of June 11, 2021
DAOs have two ways to generate retainable revenue: protocol revenue and non-operational revenue (i.e., return on investment).
While many DeFi projects now understand the importance of accruing value as part of the token economy, not all DAOs are retaining the fees/revenue generated by their agreements. For example, Aave, Yearn, BadgerDAO and Index Coop all keep protocol revenue in the vaults of their DAOs, but Sushi, Compound, Uniswap and Maker do not currently do so. Similar to any high-growth company (indeed, any company since the ‘Great Discovery Era’), it does not make sense to pay ‘dividends’ to shareholders when the return on investment in the core business is higher than the cost of capital. In addition, DAOs should also carefully consider the composition of their revenues: Aave and Yearn derive most of their revenues from interest-bearing stablecoins, while Index Coop derives most of its revenues from their high-risk products (e.g. DPI and leveraged ‘ETFs’ of ETH/BTC). Therefore, DAOs should retain at least a portion of their protocol revenue and carefully consider the composition of that revenue.
Particularly when considering the size of the vaults of many DAOs, it is likely that a significant portion of some DAOs’ revenues will come from non-operational income/returns on investments (at least until the agreement matures). Much like traditional companies that invest in a variety of assets with different levels of risk (from risk-free Treasuries and highly rated bonds to high-risk M&A and venture capital), DAOs can reference similarly different on-chain asset classes to diversify the vault’s balance sheet into.
See the full report for more details
Currently, even some of the headline protocols do not generate enough revenue to cover the operating costs of the protocol (audits, salaries/payments to contributors, marketing, etc.). For example, even if non-operating revenues like liquidity mining are credited, Yearn is still in the red. Therefore, retaining protocol revenue alone may not be sufficient to fund protocol operations (at least until these protocols mature). This means that DAO may need to raise additional capital to acquire a large enough asset base to generate a revenue return – which also provides guidance on how much vault assets should be divested: assuming a reasonable and low-risk ROI scenario, we can invert the volume of non-primary assets needed as investment principal . Once DAOs have built their position in reserve assets, they can evaluate multiple investment vehicles based on their risk appetite and decide on an asset allocation strategy that minimizes asset correlation and risk across different dimensions.
Raising capital through token sales.
Token sales are the best way to diversify your balance sheet and build a reserve asset position. However, there are only a few ways DAOs can sell tokens.
-Sales in the open market at market price; however, this can be very detrimental to the token price.
OTC sales to strategically aligned investors (with negotiable discounts, lockup periods, etc.); however, the final sale terms of such transactions may be objectionable to other holders, and it can be difficult to select strategic investors who can become long-term partners with DAO.
-Auctions (either by whitelisting a group of buyers and implementing a lock-in mechanism, or by invoking the KPI option model); however, the auction mechanism needs to be carefully designed, but if it is too complex it may be detrimental to the promotion of the auction.
-Financial engineering (e.g., buying covered calls, limiting float, taking short positions in futures/forwards/permanent); however, these options will still end up having an impact on token prices at some point, and generally the more “clean” the strategy, the higher the fees paid to the OTC (at least until the DeFi derivatives circuit really matures).
Therefore, DAOs should carefully evaluate their specific needs to determine which option is best for them. For example, a DAO may ultimately decide to use a combination of 2 and 3 to bring in a group of investors who add value to the protocol while incentivizing existing holders.
Raising debt to finance.
As with traditional finance, raising debt is another alternative and may be a lower cost form of financing than diluting token sales. Therefore, for DAOs with strong vault cash flow solvency, debt raising can be considered an alternative financing option to token sales.
Currently, borrowing in DeFi is only available as an overcollateralization. Nevertheless, the vast majority of DAOs open debt positions directly with Compound/Aave/Maker – even if a DAO’s native token can be found on platforms such as CREAM or Unit Protocol, the token’s borrowing capacity/debt The token’s borrowing capacity/debt ceiling may not be sufficient to fund the DAO’s needs. As a result, most DAOs looking to raise debt can only do so by issuing bonds (zero-coupon and over-collateralized; e.g., UMA’s yield-dollars) or convertible bonds (e.g., UMA’s Range Tokens), which are subsequently auctioned and liquidated into stablecoins.
While there are options for unsecured lending on the market (e.g., CREAM’s Iron Bank), this is not an option for most DeFi protocols. Even for those few Iron Bank eligible borrowers approved for CREAM, these loans have lines of credit and are only intended for short-term liquidity mining and not for long-term operating/capital expenditures for DAO. While there is nothing stopping the agreement from issuing unsecured bonds and auctioning them off with the promise of airdropping interest to bondholders, it is unlikely that such credits issued under no guarantee of repayment will become the norm. For example, while TradFi creditors can initiate foreclosure proceedings against a debtor company, as provided for in the U.S. 7/11 Bankruptcy Act, there is no provision in the DeFi agreement for such an act. Therefore, unless there is a robust on-chain ‘bankruptcy’ process or a formal set of measures to protect the interests of creditors, DAOs may not be able to achieve partially secured/unsecured lending.
Given that DeFi’s DAOs need to support their protocols in perpetuity, managing their balance sheets based on income/expenses is a critical task. Most protocol DAOs currently only hold their native tokens on their balance sheets. Given the volatility of cryptocurrencies, this may mean that DAOs will need to be forced to sell their native tokens (at unsuitable prices) during bear markets in order to maintain their operations. Therefore, DAOs should first ensure that they have an income cash flow anchored in reserve assets, and if the income is not sufficient to cover operating expenses, DAOs should consider using token sales/debt raising, etc. to raise additional reserve assets. Doing so will provide the agreed DAO with a substantial reserve asset base on its balance sheet to secure sufficient additional non-operating revenue and investment returns to act as a ‘cushion’ in extreme cases. By following such a playbook, any DAO will be in a better financial position to maintain its agreement’s normal operations even during a multi-year bear market.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/insights-how-to-run-a-sustainable-dao/
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