https://uncommoncore.co/a-new-mental-model-for-defi-treasuries/
The Defi bull market, started by COMP liquidity mining in Summer 2020, has turned many Defi protocols into rapidly growing revenue monsters. You would assume that this puts them in a comfortable financial position, and a superficial look at DAO treasuries seems to confirm that. For example, OpenOrgs.info suggests that the top Defi protocols are sitting on many hundreds of millions or – in Uniswap’s case – even billions of dollars.
However, almost all of this supposed treasury value comes from the projects’ native tokens such as UNI, COMP, and LDO, as the following charts show:
While we agree that native tokens inside a project’s treasury may be financial resources, counting them as assets on their balance sheet does much more harm than good and is often used as an excuse for poor treasury management.
To elucidate that point, allow us to take a quick detour into traditional accounting.
While Defi tokens are not considered equity in the legal sense, we can still learn from how traditional companies account for their shares. Simply speaking, the float (all shares available for public trading) and restricted shares (employee shares that are currently vesting) together make up a company’s outstanding shares.
These outstanding shares are a subset of authorized shares – a self-imposed soft cap on total issuance. Crucially, shares that have been authorized but not issued are not counted to the company’s balance sheet. And how could they? Counting unissued shares would allow a company to arbitrarily inflate their assets just by authorizing more shares without ever selling them.
We hope you see the connection to native tokens in DAO treasuries: these are the crypto-equivalent of authorized but unissued shares. They are not assets of the protocol but merely report how many tokens the DAO could “legally” issue and sell to the market.
Whether a DAO authorizes a small or very large number of tokens into its treasury is hence meaningless: it says nothing about its real purchasing power. To illustrate that point, imagine that Uniswap tried to sell as little as 2% of its treasury. When executing this trade via 1inch, which routes the order to many on- and off-chain markets, the price impact on UNI would be almost 80%.
Ignoring authorized but unissued shares allows us to get a different, much more accurate picture of Defi treasuries. For this exercise, we broke the non-native down further into the three categories of (1) stablecoins, (2) blue chip crypto assets, and (3) other non-stable crypto assets. Using this new categorization, Uniswap has ~0 assets in its treasury and only Lido and Maker have >$50m.
But why are treasuries of this size problematic?
First, we have seen that it’s not enough to issue new shares, you also have to sell them on the market. This causes price impact, which quickly becomes a constraint for larger sales. But further, the price the market is paying for your native token is not guaranteed but highly volatile.
Second, that price depends on the overall market conditions. The crypto market has gone through several speculative cycles in which tokens can reach euphoric valuations but can also collapse 90%+ and stay there for a long time.
Third, times when Defi projects urgently need liquidity can correlate with project-specific risk: for example, when a project experiences a large insolvency event due to a bug or hack and wants to make users whole, the token price tends to be depressed as well – especially if holders expect a dilution event.
The risk of holding 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”). A lack of liquid assets put the MakerDAO credit system at risk of collapse, and although the crisis was eventually defused it has led to a significant erosion of token holder value. Let’s see how it played out: