Longtime crypto denizens can see the future: Winter is coming (it always is).
“I think there’s scars left over from the bear market. While I think there’s a mentality of ‘up only,’ that’s more among the smaller teams. The bigger ones have been through it,” said Accelerated Capital, a pseudonymous founder who uses the name of his fund as his handle.
A lot of new people have gotten into investing in cryptocurrency over the last few months. Some may be so new they won’t remember the last “crypto winter,” which started with the regulatory crackdown in 2018 and continued at least into very late 2019. When it first hit, many crypto startups were laying off staff by the dozens.
Lots of those companies survived and new ones launched regardless. All those survivors have started to get ready for the inevitable downturn in this market.
This has always been an industry that could print “money” at will. During the last long bearish period, select projects conceived of a new form of money from nothing: governance tokens (which we at times have called “growth tokens” because early on they do more to drive volume than to distribute authority).
The craze for governance tokens began with the launch of Compound’s COMP token in 2020.
That innovation has given teams more latitude this time around to prepare for slow days ahead.
Those preparations look quite different than they did in the 2017 cycle, when token-powered projects created large treasuries of a protocol’s native token and allowed it to be controlled by the founding team. That approach has become passé. Today, it’s more common for a new crypto endeavor to create a decentralized autonomous organization (DAO) to manage its assets.
That is, many people are given a chance to hold a governance token and those holders collectively control the protocol’s codebase and its treasury.
Aaron Wright, the founder of a startup for making legal agreements on Ethereum, OpenLaw, spoke to this new arrangement during a panel at Consensus 2021 last week. “The internet is building a native structure. We’ve all lived in those structures in different ways,” he said. “And if you think about how the internet works, it doesn’t work in a hierarchical way. It works in a swarm-like manner, and DAOs are trying to capture that energy productively and deploy people’s thoughts, ideas and capital for higher purposes. And it’s working.”
DAOs often sit on a large quantity of their governance tokens (UNI on Uniswap or YFI on Yearn, for two examples). These hoards are worth a lot now, which makes it look like the projects have a very long runway. But what if a governance token goes through a long downturn? What if precisely when it needs to invest to drive value back to its core asset, a company’s treasury isn’t worth enough on the open market to do so?
Every reasonably experienced investor knows what to do when they have too much of a highly volatile asset at a high point in a cycle: diversify that portfolio.
Artem Gramma is a core contributor to Index Coop, a project that makes investable crypto indices on Ethereum, such as the DeFi Pulse Index and the Flexible Leverage Index. “I think treasury diversification is extremely important to a project’s ability to survive and execute through the bear market,” he said.
Diversification
DAO members are now deciding to unload portions of those governance hoards for … something else. Usually, the teams want stablecoins, or something that generates some revenue. That way, the project’s fate is not completely dependent on its native token’s price.
“I think there’s a general sense in the space right now of, ‘What’s going to break projects if we have a bear market?'” Gramma said.
For one very recent example, in early spring the lossless lottery startup PoolTogether wrapped up a vote on a diversification deal it has been discussing since early May. Several funds, including ParaFi Capital, Galaxy Digital and Dragonfly Capital will buy 7.2% of the treasury of its POOL tokens for $5.95 million in USDC. The vote closed with all the POOL tokens that voted backing the proposal.
“Obviously, the main idea behind it is we have on paper a very large treasury, but it’s almost exclusively in the POOL token,” PoolTogether founder Leighton Cusack said. POOL launched in mid-February.
According to Cusack, none of the PoolTogether staff voted their own holdings.
But this is just the latest recent example of a project taking tokens it allocated to the treasury and selling them or otherwise unloading them in exchange for something whose value is unlikely to go south if the crypto market does.
How it started, how it's going
Right now, the form this is taking is fairly straightforward. Venture capital firms with fairly deep pockets propose a deal to the community. They offer a fairly decent discount on the market price in exchange for treasury tokens, usually with some kind of lockup. The PoolTogether lockup is fairly typical: none unlock for a year and then they go through another year of vesting.
“Obviously, there is a deal component,” Accelerated Capital said. These investors want to get the best price they can with the most flexibility, but DAOs want to avoid a sudden supply shock as well. So, the two parties have to negotiate price, lockups and other such terms.
But we’re already starting to see hints of other crypto-native approaches to diversification that work less like a traditional deal and rely more on the open market, potentially creating interesting new dynamics in the market.
Further, DAO members are beginning to appreciate that their rights as holders of a governance token may be more multifaceted than they had previously realized.
“Owners of the governance tokens from these DAOs not only have a right to the cash flow on these networks, they also have claim to some of the assets in the DAO,” Ben Forman of ParaFi Capital said. In other words, it is in their interest to mitigate risk in a treasury’s assets.
“I feel like every treasury DAO is thinking about this now,” Forman said. To that end, Shreyas Hariharan, founder of treasury consultancy Llama, wrote about best practices for diversification on crypto blogging platform Mirror in March.
Step by step
The trend started with Synthetix in February, when its sDAO announced that it had sold $12 million in its SNX token to Paradigm, Coinbase Ventures and IOSG.
Synthetix founder Kain Warwick explained via email it did not need to take a full DAO vote to make the deal because Synthetix has a multisig of three people empowered to make deals along these lines.
Synthetix has been around longer than the newer DAOs, a product of the initial coin offering era that preceded this one, so Synthetix is still in the middle of evolving into a fully decentralized mode of operations. “I am working on an SIP [Synthetix Improvement Proposal] that will remove this discretionary power soon,” Warwick wrote in an email.
After that, treasury diversification went from a best practice to a full-on trend at crypto speed.
Then the Bitcoin-oriented BadgerDAO began discussions to create a similar structure to Synthetix, where a team voted on by the DAO could make deals to diversify its treasury. A proposal was passed and the DAO announced its first sale on March 3: $21 million to ParaFi, Polygon and Ethereum’s mega-wallet, 0xb1.
On April 2, the SushiSwap community voted through sushiHOUSE, a treasury management partnership run by Yam Finance.
On April 28, Lido, the protocol for derivatives on Ethereum, best known for making stETH that tracks ETH committed to an Ethereum 2 node, approved a vote to sell 100 million of its LDO governance token for 21,600 ETH in a deal led by Paradigm but including lots of other investors as well, including Three Arrows, Jump Trading, Alameda Research and many more.
On May 5, Decentral Games, which enables gambling inside virtual worlds, considered exchanging $200,000 worth of MANA held by its treasury for a Metaverse Index token created by Index Coop, thereby better aligning it with the sort of projects that are likely to host its games.
(This deal is a little different because Decentral earns a lot of tokens for its treasury through its operations; MANA is not the Decentral governance token, but many users who play in Decentraland play with MANA.)
As mentioned above, PoolTogether just finalized its deal for a sale of POOL tokens, in a discussion that started April 30.
Hugh Karp, the CEO of Nexus Mutual, the smart contract risk management project, told CoinDesk that its community is actively looking at diversification right now (most likely going for an interest-earning form of ETH, such as StETH), as is Index Coop.
So far, this process has been one initiated by funds. “The investors really came to us. We didn’t actually search them out,” Cusack, PoolTogether’s founder, said.
Earning a large discount on a protocol’s governance token may sound like a very attractive deal, but it’s worth noting they tend to come with pretty aggressive lockup terms, restricting reselling. Cusack called the prices “illiquidity discounts.”
“It’s a good way for investors to acquire large positions,” Forman said, but the “jury’s still out on whether these are good deals.”
“Now governance has optionality,” Cusack said. For PoolTogether, the USDC allows the DAO to immediately make its lossless lottery more attractive. It can add the funds to a sponsored pool, which increases the payout to players but doesn’t reduce their chances of winning.
“One of the core takeaways is it was more about getting the right contributors on board,” Kasper Rasmussen from the Lido team said.
While the tokens are not liquid, they can usually vote in governance, giving the protocol new active (but also large) voting blocks.
Forman argued that this is a good thing, because investment firms have the bandwidth and the motivation to improve these projects. “We’re oftentimes users in these networks as well as investors in them,” Forman said.
Automated BFF
The era of sweet deals to VCs might soon give way to a new era of projects diversifying on the open market.
Index Coop’s Gramma expects a VC-oriented deal in the works now will help seed a larger deal with the general public (if everything goes according to plan).
It’s possible to leverage automation to diversify a treasury’s portfolio. For example, Gramma said, a treasury could set up a smart pool on Balancer, one with rules built into it to, say, start with a 10% USDC and 90% INDEX (The Coop’s governance token) allocation.
That pool would immediately begin earning trading fees on Balancer, but beyond that it could be set up with rules that might say, for example, over a 12-week period, increase the allocation of USDC to 25% gradually.
These are just hypothetical parameters but they help to illuminate Gramma’s point. “The main concern there is: Do you communicate this to the market, that you’re going to be selling into it? How transparent do you want to be?”
“In the spirit of the space, if there’s less private capital formation in the token world, I think that’s a good thing,” Forman said.
And the opportunity for fostering greater resiliency is huge.
“If you think about a lot of these treasuries that have a lot of capital, if they just convert a little to stablecoin they can cover all of their expenses,” Gramma said.
In other words, a treasury could take DAI or USDC and yield-farm it on Compound or Yearn and potentially earn enough each year to pay for developers, designers and business development without touching the principal.
“My goal would be a lot of these treasuries are relatively diversified so they have income to sustain operations,” Accelerated Capital said. “Hopefully, we get them all sorted out before the next bear market.”
Accelerated has been actively working with projects, such as Decentral Games, to look for opportunities to mix up their holdings to foster resiliency.
Not everyone is rushing to diversify, however. The founder of Swiss Stake, the company behind Curve Finance, the DEX for stablecoins, wrote in an email, “The best way to prepare for bear market is building something which will be useful in the bear market.”
Curve’s Mikhail Egorov said if his project needs funds, he prefers to borrow against holdings, earn yield that beats the interest on the loan and put the difference to work in operations.
“I am a crypto maximalist who survived two bear markets (2014-2016 and 2018-2020), so I think I am not panicking at [the] slightest,” Egorov wrote via email.
Danger, danger
It is hoped that one threat has been obvious to everyone throughout this entire discussion: silent but deep pockets.
There would really be no way to stop an extremely large fund from buying up a significant position in a governance token, holding it in several different wallets, proposing a sweetheart deal to a DAO and then using its holdings to vote it through.
Of course, the worse a deal was the more tokens they would have to hold. But for a decent but maybe somewhat questionable deal, a whale wouldn’t need to hold enough tokens for a majority of the vote. They would only need enough to sway it. No one would likely ever know.
“That’s a potential vector,” Cusack granted. “There could be something down the road that goes a nefarious way.”
Forman agreed, but without a lot of concern. “I think there are these governance edge cases that aren’t fully mitigated that make something like that possible – but not probable.”
So it’s something to watch out for but not worry over.
Meanwhile, as DAOs diversify their treasuries, their members are also giving more people access to power over the direction the projects take. This will inevitably yield unforeseeable consequences, the most likely of which will be further consolidation of power by large holders over each project.
Assets have a way of gravitating to a few well-resourced hands. The more tokens that find their way out onto the market, the fewer holders there are likely to be over time. Somehow that just seems to be the way of the world.