DAO Treasury Management
Reminiscences of a DeFi Operator
From an asset class perspective, DeFi yield is a very unique strategy.
It allows for liquid capital deployment into yield strategies in exchange for taking on smart contract risk. Often, this can even be done without taking on the market price risk. DeFi also doesn’t carry duration risk - this means that when interest rates go up (and crypto goes down), this has no impact on blockchain protocols and stablecoin values. The yield might suffer but the underlying capital should not be affected - some DeFi funds are still earning double digit yields in 2022. In the meantime, US treasuries are down 20%+ this year.
Such nuances make treasury management for DAOs a very exciting undertaking. Crypto projects (for a change) are positioned better than traditional companies who need to manage their cash as they are onchain natives and understand what it takes to be a successful DeFi operator.
What are DAOs sitting on?
DAO treasuries hold billions of dollars in liquid assets.The largest DAOs like Uniswap, hold much of their assets in their protocol tokens. Others like GnosisDAO, mix that in with stables and blue chips like ETH. Even smaller DAOs can hold millions of dollars in their treasuries. Most of this is held in volatile assets, either the project’s native token or crypto assets like ETH. A very small percentage of DAO treasuries is held in stablecoins.
For DAOs with such large warchests, the options for deploying and managing this money are sparse. Projects that don’t have enough stables may look to sell their treasury tokens to raise money. But unloading tokens from the DAO treasury is almost always going to have a negative impact on the market. Further, selling tokens during a bear market means depressing the project’s price even further while not getting as much value for the sale. So instead the treasuries sit idle in mutlsigs on chain, waiting for some productive use. In this article we will review some considerations for DAO treasury management and how our portfolio management methodology can help DAOs deploy their funds productively.
Diversification, Risk and Return
In traditional portfolio management, the goal is to get the best risk-adjusted return. Portfolio management is a well-studied discipline in finance schools across the world.
Modern portfolio theory is one example of a method for picking assets. By starting with a defined risk tolerance or target return, a portfolio manager can construct a portfolio of assets that meet the risk-return profile of their client. Typically, these assets are chosen to have diversified returns that are not correlated. This means that even if one position does not perform as expected, the portfolio won't experience large drawdowns as the other positions can be expected to continue providing returns.
Traditional companies go to great lengths to manage their cash and financial positions. For example, an oil company that expects to sell 1 million barrels within the year may enter into hedging agreements to maintain a fixed price for the barrels that they will sell. Other companies will enter into similar contracts to manage their income and cash balances. Companies like Apple will hedge their foreign currency earnings with FX swaps. Others that have lots of cash for operations will work with banks to invest in fixed income or other short-term cash instruments.
Many of these strategies are similar to the ones that DAOs will contemplate when managing their treasuries. For a DAO that expects certain amounts of revenue, they may want to enter into agreements that can give them current assets to hedge these future cash flows. For DAOs that have lots of native tokens or other crypto like ETH, swaps and other yield opportunities may be ideal. A coherent strategy will take these risks into account in order to craft a diversified strategy that weighs the returns against the chance of drawdowns.
But in DeFi, finding uncorrelated returns while managing risk is a full-time job.
Despite the clamour on crypto twitter about #realyield, there are precious few opportunities for meaningful returns in DeFi. Even fewer of these can scale to the amount of capital that a typical DAO is looking to deploy.
The top 10 yielding pools from DeFi Llama yields: all in the single digits:
As the bear market continues, yields in DeFi have compressed. Yields in blue chip protocols like Aave or Curve have fallen from the cycle highs to only a few percent. Once an attractive yield opportunity is identified, it takes ever more effort to monitor the yields and rebalance the portfolio when sands are shifting. Keeping an eye on stablecoin pegs and oracle stability is also a must for anyone engaging with DeFi.
This is a considerable investment - it took Re7 a lot of time to deploy data infrastructure that would track onchain data from hundreds of pools and send out yield and risk signals.
On top of this there is the expected challenge that higher yields come from more exotic opportunities. In some cases, tech and trading infrastructure is required to capture an attractive yield spread; and sometimes it simply comes from taking on a higher smart contract risk, which needs to be measured, quantified and analysed. Checking audits, on-chain activity, and incorporating third-party risk scores are all options available to develop a view on the smart contract risk for a project. It takes a full time team of analysts, quants and engineers to manage this.
Constructing a DAO portfolio
For DAOs looking to manage their treasuries, here is a bit about how a professional portfolio manager would construct a portfolio.
First, consider the entire universe of yield opportunities available at the moment (~500 pools by now). To keep this up to date, you need to be constantly reviewing new protocols and getting introductions to projects in the space. Often the best opportunities in DeFi are for those who jump in early and are efficient in their due diligence process. Being able to quickly triage new opportunities and decide whether they merit further research is an important first step.
From there, promising new opportunities will get further review and go to a short list. These go through a lengthy research and security review process. Vetted projects will get rated for risk across a wide range of factors to provide a normalised score that can be used to compare opportunities and inform the maximum allocation for each in the portfolio.
The job doesn’t stop when you deploy capital. For each position you will want dedicated monitoring, alerts and tracking for important variables that will influence the risk/return of the position. This includes basic information like real-time yield tracking, but also price alerts, governance votes and other market information to keep a steady stream of alpha flowing. This will allow the portfolio manager to react to events both good and bad, making quick, but informed, decisions.
This entire system is scaled across the many protocols and allows for the management of a diversified portfolio of many positions. The diversification improves risk-adjusted returns and works to minimise smart contract risk from a concentrated portfolio.
Dedicated Portfolio Management for DAOs
For DAOs that are looking to manage their own treasuries, this process could be daunting and require additional resources that might not be available. One other option is to turn to professional portfolio managers whose job is to manage the risk and provide good returns.
Protecting and stewarding a portfolio is a difficult task in the best of times. When this money is the treasury nest-egg of a growing DAO, it can be even more difficult to decide on a deployment strategy.
To manage this well, one has to focus completely on the deployment and management of such a portfolio and risks and opportunities that come with it. This can be a useful tool for DAOs looking for exposure to yield-generating opportunities, who do not have the time or expertise to set up their own portfolio management team.
We are also of the opinion that governance matters. Deploying capital via a regulated investment vehicle brings in discipline, oversight and clarity of thinking. As our industry matures, we hope that professional money management expertise will help DAOs optimise their balance sheets and extend their runway.
Re7 Capital - DeFi treasury management for stablecoins and ETH