The Defi bull market triggered by COMP liquidity mining in the summer of 2020 has turned many Defi protocols into fast-growing revenue “monsters”. You would think that this puts them in a comfortable financial situation, which seems to be confirmed by the following superficial observation of the DAO Treasury. For example, OpenOrgs.info data shows that some top Defi protocols have already been sitting on hundreds of millions of dollars, even in the case of Uniswap, even billions of dollars.
However, almost all of these assumed treasury values come from the project’s native tokens, such as UNI , COMP, and LDO, as shown in the figure below:
Although we agree that the native tokens in project funds can be used as financial resources, treating them as assets on the balance sheet does more harm than good, and is often used as an excuse for poor fund management.
To clarify this point, let us quickly deal with traditional accounting.
Native tokens are not assets
Although Defi tokens are not considered equity in the legal sense, we can still learn from how traditional companies account for their shares. To put it simply, tradable shares (all stocks available for public trading) and restricted stocks (employee shares currently in exercise) together constitute the company’s tradable shares.
These outstanding shares are a subset of authorized shares-a soft cap on the total issuance. It is essential that the authorized but unissued shares are not included in the company’s balance sheet. How are they possible? Calculating unissued shares will allow the company to arbitrarily exaggerate its assets by authorizing more shares without selling them.
We hope you see the link to native tokens in the DAO Treasury: these are the cryptographic equivalents of authorized but unissued shares. They are not the assets of the agreement, but only report the number of tokens that the DAO can “legally” issue and sell to the market.
Therefore, whether the DAO authorizes a small or large amount of tokens to enter its treasury is meaningless: it does not state its actual purchasing power. To illustrate this point, imagine Uniswap trying to sell as little as 2% of the treasury tokens. When this transaction is executed through 1inch, the order is routed to many on-chain and off-chain markets, and the price impact on UNI will be close to 80%.
Real Defi Treasury
Ignoring the authorized but unissued stocks, we can have a different and more accurate understanding of the Defi Treasury. In this article, we further subdivide non-native assets into three categories: (1) stable coins, (2) blue chip encrypted assets, and (3) other non-stable encrypted assets. Using this new classification, Uniswap’s assets are about 0, and only Lido and Maker’s assets exceed 50 million U.S. dollars.
But why is there a problem with a treasury of this size?
First, we see that issuing new shares is not enough, you must also sell them on the market. This price impact quickly became a constraint on greater sales. But further, the price the market pays for your native token is uncertain and highly volatile.
Second, the price depends on the overall market conditions. The crypto market has gone through several speculative cycles in which tokens can reach an encouraging valuation, but they can also collapse by more than 90% and stay there for a long time.
Third, when the Defi project urgently needs liquidity, it may be related to project-specific risks: For example, when a project encounters a large bankruptcy due to a bug or hacking and wants to keep users complete, the token price will often be affected. Drive down—especially if the holder expects a dilution event.
Case study: Black Thursday exposes MakerDAO’s treasury issues
The risk of insufficient treasury reserves is not just theoretical, because MakerDAO experienced it firsthand during the market crash on March 12, 2020 (commonly referred to as “Black Thursday”). The lack of liquid assets puts the MakerDAO credit system at risk of collapse. Although the crisis was eventually alleviated, it led to a significant decline in the value of token holders. Let’s see how it works:
From the launch of MakerDAO in 2018 to March 2020, DAO has been using net proceeds to repurchase and burn MKR tokens (return capital to the token holders). A total of 14,600 MKRs have been burned at a cost of more than 7 million DAI . During this period, the average price of MKR tokens was approximately $500.
Then came Black Thursday, due to the sharp decline in prices and Ethernet Square, network congestion, Maker underwater failed to liquidate positions, resulting in a loss of $ 6 million to the protocol. After deducting the 500,000 DAI in the MakerDAO vault at the time, it had to make up for the remaining 5.5 million losses by auctioning MKR tokens on the market. Maker eventually sold a total of 20,600 MKR at an average price of approximately $275.
Until December 2020, Maker’s cumulative revenue reduced the supply of tokens back to the original 1 million MKR through repurchase, at a total cost of more than 3 million DAI (the average purchase price of MKR is about US$500).
Image: The Makerburn website shows that the Black Thursday crash caused a significant dilution of the tokens.
To sum up the financial impact, the $6 million credit loss caused by Black Thursday erased the $10 million accumulated in three years. If Maker held more treasury reserves in stable assets such as DAI, they could have avoided an additional loss of $4 million, because they could have used these funds to repay insolvent loans without having to sell MKR at a low price. Or in other words, Maker can obtain up to $4 million in additional value by holding a larger treasury.
Although it is difficult to assess funding needs in advance, as of Black Thursday, the holdings of 500,000 DAI Makers are almost certainly too small. For the 140 million outstanding loans of the agreement, it only has a capital buffer of 0.35%, while most traditional financial institutions hold at least 3-4% of venture capital. And this does not take into account operating expenses and wages, if they are not covered by non-local treasury assets, this may lead to further forced selling during the market downturn.
Understanding repurchase and dividends
Many Defi projects naively treat their tokens as a treasury asset and may have to sell it at the worst possible time. This is the result of a lack of a framework for how to do better. Although there are many ways to run the agreement, practitioners may benefit from the following guidelines.
Rule 1: The goal of DAO is to maximize the value of long-term token holders.
Rule 2: When put into practice, Rule 1 recommends that every dollar that the agreement owns or receives as income should be allocated to its most profitable use, discounted to today. Options usually include depositing funds in the national treasury, reinvesting them in growth or new products, or paying token holders through token buybacks or dividends.
Only when the money is outside the agreement (after taxes) has a higher return to the token holders, the money is paid correctly instead of saving or reinvesting it. In practice, we see that many of the funds paid by the Defi agreement can be used for growth or deposited in the national treasury for future expenditures. According to our framework, this is a big mistake. As far as Maker is concerned, we have seen how it sells cash in tokens, but then has to buy back tokens with the same cash at a higher cost of capital.
In general, we recommend giving up the idea that paying dividends or repurchasing tokens will “reward” token holders to some extent, while internal reinvestment is not. For token holders, the most valuable decision is to maximize the return of every dollar, whether internal or external.
Rule 3: When following the above rules, DAO will become a non-cyclical trader of its own tokens. If the DAO believes that its tokens are overvalued and internal reinvestment has a good return, it should sell the tokens in exchange for cash and reinvest that cash into the agreement. It is almost certain that this is true of all bull markets. When the DAO sees that the price of its tokens is lower than the fair value, and it has excess cash without high internal returns, then it can buy back the tokens. Almost certainly, this is true of all bear markets.
Achieve better money management
Finally, we want to share our views on how the DAO should manage its funds. We propose the following rules:
Rule 4: DAOs should immediately discount native tokens from their treasury-they are cryptocurrencies equivalent to authorized but unissued stocks.
Rule 5: The DAO Treasury needs to survive the next bear market. This may not happen next week or next month, or even next year. But in a speculative-driven market like cryptocurrency, it will happen. Build a treasury that can last for 2-4 years, even if the entire market collapses by 90% and stays at the bottom for a while.
We especially recommend 2 to 4 years, because you want enough time to survive the longest crypto winter according to known standards, but it won’t make you rich and lazy, or like a hedge fund. Distracted by running your agreement.
Considering the known operating expenses of major DAOs with large development teams and liquid mining plans, few people today meet this condition. This means that most or all of them should use the bull market to sell tokens and build a real treasury with stable assets, which will not only enable them to survive the upcoming bear market, but also hopefully put them ahead of their competitors.
Rule 6: The DAO Treasury should understand and hedge its application-specific liabilities. For example, the loan market may plan that a portion of the loan position will fail each year. Although they did not say so clearly, people implicitly understood that the loan market would take this risk. Therefore, underwriting becomes a regular cost on the balance sheet and can be hedged accordingly. At the same time, a more streamlined agreement like Uniswap may not take additional risks, so it can be completed with smaller funds.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/what-kind-of-defi-treasury-strategy-can-cross-bears-and-bulls/
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