How should a protocol like Uniswap or Compound structure its treasury? This post covers the principles of protocol treasury management, fiscal policy, asset allocation, ways to diversify the treasury, and responsibilities of a treasury committee.
Principles of treasury management
Infinite time horizon
- The treasury should be structured to exist in perpetuity.
- There should be no time preference, i.e. no preference given to funding present projects over future ones.
Inflows should exceed outflows
- Over the long-run, the returns of the treasury (inflows) should be greater than the spending rate (expenses/value of treasury) + inflation rate.
- The treasury’s purchasing power should be maintained or grown after accounting for expenses.
Diversified asset allocation
- The assets in the treasury should be diversified and aligned with the goals of the community.
- Besides the protocol's governance token, there should be a portion of the treasury in liquid blue chip assets (e.g. ETH, BTC), stablecoins (e.g. DAI, USDC), and other assets.
A protocol treasury could have a different approach: be dissolved after a certain number of years like the Gates Foundation. Arguably, dissolving a treasury is a sign of even greater decentralization than having a community treasury. It means that the protocol is self-sustaining and does not depend on a single treasury.
But having a diversified treasury that exists in perpetuity can be effective, especially in bear markets. If markets are down 40% but you still need to solve an important technical problem, a diversified treasury can fund that without relying on broader public goods funding. I lean towards structuring a treasury with an infinite time horizon.
The annual budget for a treasury should be decided based on the protocol’s needs and its treasury size. Ideally, a protocol’s annual budget should be less than its expected revenue (e.g. Uniswap fee revenue) and treasury investment income.
One of the most valuable things a protocol can fund is ecosystem development, which can eventually serve as a competitive edge. Pilot programs by Uniswap and Compound have proposed $750,000 per quarter in grants that might be reduced or expanded based on their effectiveness.
As the recent Compound proposal states, the main needs of a protocol are:
- Protocol and parameter development
- Code audits
- Business development and integrations
- Advertising and sponsorships
- Miscellaneous improvements
It is risky for protocols to only have their own governance tokens in their treasury. If Uniswap has only UNI in its treasury and the token price falls by 40%, its balance sheet would also shrink by 40%. This is dangerous because it occurs at a time when the protocol needs to ramp up spending, whether it is LP subsidies, token buybacks, or core development. This could lead to a further downward spiral for the token.
A protocol's treasury should be diversified over time. Diversification should be planned based on the treasury’s expected annual outflows, liquidity needs, and risk-return of assets.
Here is a sample allocation (without knowing the numbers above):
- Protocol’s token
- Stablecoins (DAI, USDC, etc.), a portion of which earn yield. Stablecoin allocation depends on the liquidity needs and treasury budget.
- Blue chip crypto assets (BTC, ETH)
- DeFi index (DPI)
- Early-stage token investments and M&A that improve the protocol's competitive positioning. The discussion between Keep and NuCyphur is an example of what an on-chain merger could look like.
- Insurance cover and options. Example: rolling buys of smart contract cover or short-dated puts on the protocol’s tokens. This could benefit the protocol during Black Swan events like contract hacks, economic exploits, and market drawdowns.
Protocols can also allocate a portion of the treasury for token buybacks when the token is highly undervalued and there aren't other effective ways to deploy capital.
There can be ways to diversify a treasury that are trust-minimized and does not require a group of people to have multisig access. Protocols can leverage the existing on-chain asset management stack:
- TokenSets for customized index-like ERC20 portfolios
- Enzyme and dHedge for on-chain funds
- Potion Labs for risk management architecture
- Yearn for yield optimization
How can protocols diversify their treasuries?
The simplest method to diversify is to sell some of the protocol's tokens to buy other assets (e.g. ETH, DAI, etc.). Treasuries can’t be diversified overnight. But plans can be made to reach a steady-state allocation over several years.
There is currently a negative perception associated with selling the protocol's token because it could signal that the treasury has lost confidence in the protocol. This has a short-term impact on price. Selling large amounts of the protocol’s tokens would involve slippage, especially if it’s not done thoughtfully. However, this can be avoided if the treasury has a stated target policy allocation and dollar cost averages into other assets over several months or years.
The treasury could also receive other crypto assets as inflows. Few methods include:
- Earn fee revenue in other assets that accrues to the treasury.
- Earn other tokens in exchange for value added by the protocol in other cryptonetworks.
- Set up yield delegation vaults: i.e. pay the protocol’s tokens (e.g. UNI) to Yearn users for them to delegate a portion of their yield in ETH and stablecoins to the protocol treasury. Rally experimented with yield delegation vaults.
- Invest in early-stage projects or do M&A that improves the protocol’s competitive positioning.
Index Coop is a good case study. They recently published a thoughtful treasury report and made a proposal to purchase ETH with INDEX and DPI in its treasury. Index aims to implement a smart treasury at Balancer with INDEX / ETH at 80/20.
Protocols should set up a 5-7 member treasury management committee, which will work on the following:
- Propose treasury budget to discuss and vote on
- Define liquidity requirements based on budget
- Decide asset allocation policy and review this policy allocation every month
- Define policy for liquidity mining, token buybacks, salaries and vesting schedule of core contributors
- Publish monthly / quarterly financial statements
- Publish monthly / quarterly reports on how treasury is spent
The treasury committee can be voted on and removed by token holders.
We will increasingly see specialization emerge for protocols. Token holders will approve big decisions and elect or nominate managerial stakeholders with expertise (individuals, DAOs). Managerial stakeholders will make smaller, more frequent decisions and be held accountable by token holders.
We will have several experiments to figure out the right balance between managerial effectiveness and community control. In both cases, clear processes and useful transparency is critical.
Protocol treasuries need to be structured with an infinite time horizon. This requires thinking effectively about:
- Fiscal policy: how much to spend and what to spend on
- Asset allocation: how the treasury should be diversified to fund key protocol development irrespective of the market environment
- Reporting: financial statements of the treasury and summary of key transactions