How should DeFi protocols design treasury strategies?

Original Title: "The Path of DeFi | What Kind of DeFi Treasury Strategy Can Survive Bull and Bear Markets?"

Written by: Kyle

Compiled by: The Path of DeFi

The DeFi bull market triggered by COMP liquidity mining in the summer of 2020 has turned many DeFi protocols into rapidly growing income "monsters." You might think this puts them in a comfortable financial position, and the superficial observations of DAO treasuries below seem to confirm this. For example, data from OpenOrgs.info shows that some top DeFi protocols have already amassed hundreds of millions, and in the case of Uniswap, even billions of dollars.

However, almost all of this assumed treasury value comes from the project's native tokens, such as UNI, COMP, and LDO, as shown in the following images:

While we agree that native tokens in project funds can serve as financial resources, viewing them as assets on the balance sheet is more harmful than beneficial and is often used as an excuse for poor fund management.

To clarify this, let’s quickly review traditional accounting.

Native Tokens Are Not Assets

While DeFi tokens are not considered equity in a legal sense, we can still learn from how traditional companies account for their shares. Simply put, outstanding shares (all shares available for public trading) and restricted stock (employee shares currently being exercised) together constitute a company's outstanding shares.

These outstanding shares are a subset of authorized shares—setting a soft cap on the total issuance. Crucially, authorized but unissued shares do not count as assets on the company's balance sheet. How could they? Counting unissued stock would allow a company to arbitrarily inflate its assets by authorizing more shares without selling them.

We hope you see the connection with native tokens in the DAO treasury: these are the crypto equivalents of authorized but unissued shares. They are not assets of the protocol but merely report the number of tokens the DAO can "legally" issue and sell to the market.

Thus, it makes no sense whether the DAO authorizes a small or large number of tokens into its treasury: it does not indicate its actual purchasing power. To illustrate, imagine Uniswap trying to sell as little as 2% of its treasury tokens. When executing this transaction through 1inch, routing orders to many on-chain and off-chain markets, the price impact on UNI would be close to 80%.

A Real DeFi Treasury

By ignoring authorized but unissued shares, we can have a different, more accurate understanding of DeFi treasuries. In this article, we will further categorize non-native assets into three types: (1) stablecoins, (2) blue-chip crypto assets, and (3) other non-stable crypto assets. Using this new classification, Uniswap's assets are approximately zero, with only Lido and Maker having assets exceeding $50 million.

But why would a treasury of this scale pose a problem?

First, we see that issuing new shares is not enough; you must also sell them in the market. This price impact quickly becomes a constraint on larger sales. Furthermore, the price the market pays for your native tokens is uncertain and highly volatile.

Second, that price depends on overall market conditions. The crypto market has gone through several speculative cycles, during which tokens can reach euphoric valuations but can also crash by over 90% and stay there for a long time.

Third, when DeFi projects urgently need liquidity, it may be related to project-specific risks: for example, when a project encounters a major bankruptcy event due to a bug or hack and wants to make users whole, the token price often gets depressed—especially if holders expect a dilution event.

Case Study: Black Thursday Exposed MakerDAO's Treasury Issues

The risk of insufficient treasury reserves is not just theoretical, as MakerDAO experienced firsthand during the market crash on March 12, 2020 (commonly referred to as "Black Thursday"). The lack of liquid assets put MakerDAO's credit system at risk of collapse, and although the crisis was ultimately mitigated, it led to a significant decline in the value of token holders. Let’s see how it played out:

From MakerDAO's launch in 2018 until March 2020, the DAO had been using net income to buy back and burn MKR tokens (returning capital to token holders), destroying a total of 14,600 MKR at a cost of over 7 million DAI. During this period, the average price of MKR tokens was around $500.

Then came Black Thursday, when due to a significant price drop and congestion on the Ethereum network, Maker failed to liquidate underwater positions in time, resulting in a loss of $6 million for the protocol. After deducting the 500,000 DAI in MakerDAO's treasury at the time, it had to auction MKR tokens on the market to cover the remaining $5.5 million loss. Maker ultimately sold a total of 20,600 MKR at an average price of about $275.

It wasn't until December 2020 that Maker's accumulated earnings were used to reduce the token supply back to the original 1 million MKR, at a total cost of over 3 million DAI (with an average purchase price of MKR around $500).

Image: Makerburn website shows that the Black Thursday crash led to significant dilution of tokens

To summarize the financial impact, the $6 million credit loss from Black Thursday wiped out three years of accumulated earnings of $10 million. If Maker had held more treasury reserves in stable assets like DAI, it could have avoided an additional loss of $4 million, as they could have used those funds to repay non-performing loans without having to sell MKR at a low price. In other words, Maker could have gained up to $4 million in additional value by holding a larger treasury.

While it is difficult to assess funding needs in advance, it is almost certain that the 500,000 DAI held by Maker before Black Thursday was far too little. For the protocol's $140 million in outstanding loans, it had only a 0.35% capital buffer, while most traditional financial institutions hold at least 3-4% in risk capital. Moreover, this does not account for operational expenses and salaries, which, if not covered by non-native treasury assets, could lead to further forced selling during market downturns.

Understanding Buybacks and Dividends

Many DeFi projects naively view their tokens as treasury assets and may have to sell them at the worst possible times, a result of lacking a framework for doing better. While there are many ways to run a protocol, practitioners may benefit from the following guidelines.

Rule 1: The goal of the DAO is to maximize the long-term value for token holders.

Rule 2: When implemented, Rule 1 suggests that every dollar the protocol owns or receives as income should be allocated to its most profitable use, discounted to today. Options typically include depositing funds into the treasury, reinvesting them for growth or new products, or paying token holders through buybacks or dividends.

It is only correct to pay this money when it has a higher return for token holders outside the protocol (after tax), rather than saving or reinvesting it. In practice, we see that many DeFi protocols pay out funds that could be used for growth or deposited into the treasury for future expenses. According to our framework, this is a significant mistake. In the case of Maker, we have seen how it sold cash in tokens but then had to buy back tokens at a higher capital cost with the same cash.

In general, we recommend abandoning the idea that paying dividends or buying back tokens somehow "rewards" token holders while internal reinvestment does not. For token holders, the most valuable decision is to maximize the return on every dollar, whether internally or externally.

Rule 3: When adhering to the above rules, the DAO will become a non-cyclical trader of its own tokens. If the DAO believes its tokens are overvalued and internal reinvestment has good returns, it should sell tokens for cash and reinvest that cash into the protocol. This is almost certainly the case in all bull markets. When the DAO sees its token price below fair value and it has excess cash without high internal returns, it can buy back tokens. This is almost certainly the case in all bear markets.

Achieving Better Fund Management

Finally, we want to share our views on how DAOs should manage their funds. We propose the following rules:

Rule 4: DAOs should immediately discount native tokens from their treasury—they are the crypto equivalent of authorized but unissued shares.

Rule 5: DAO treasuries need 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 2-4 years, even if the entire market crashes by 90% and stays at the bottom for a while.

We specifically recommend 2 to 4 years because you want enough time to survive even the longest crypto winter by known standards, but not so much that you become wealthy and lazy, or run your protocol like a hedge fund and get distracted.

Given the known operating costs of major DAOs with large development teams and liquidity mining programs, few meet this condition today. This means that most or all of them should take advantage of bull markets to sell tokens and build a real treasury with stable assets, which can not only help them survive the upcoming bear market but also position them ahead of competitors.

Rule 6: DAO treasuries should understand their application-specific liabilities and hedge against them. For example, a lending market may plan for a portion of loan positions to fail each year. While they may not state this explicitly, it is implicitly understood that lending markets will take on this risk. Thus, underwriting becomes a regular cost on the balance sheet that can be hedged accordingly. Meanwhile, more streamlined protocols like Uniswap may not take on additional risks and can operate with smaller funds.