Mapping DeFi Guardrails

In the face of undeniable inflation, TradFi yields are on the rise as the US Fed has started quantitative tightening. The one year Treasury yield is at 2.79% as of this writing. This compares to USDC’s anemic 0.50% APY on AAVE, and 0.18% in the Curve 3pool, two of DeFi’s “bluechip” dApps.

Most people would agree that US government bonds are safer assets than DeFi liquidity yields, so wouldn’t it follow that in order for capital to flow into DeFi, returns to investors must be higher to compensate for the additional risks? This is currently not the case, and in market backwardation, it would be hard to provide on-chain yields that can compensate investors for the additional risks that are unique to DeFi.

But what if you choose to stay on chain? This is a dilemma that DAOs are facing right now. In order to provide transparency to users and investors, many protocols must manage their treasuries on-chain even though returns are less than ideal.

While there are protocols promising higher yields, the associated risks have increased in the current market regime. For projects looking at treasury management options in this less-than-ideal environment, the focus right now should not be on juicing up returns, but rather on establishing the risk guardrails to ensure that your project survives and thrives.

In that framework, I’d venture the following suggestions:

Stop obsessing about growing treasury; focus on protecting runway so you can obsessively build. There are no risk-free yields in DeFi, period. Stable returns are not risk free. Getting mid-to-high single digit returns is difficult to maintain and would require disproportionate risk that it might not be worthwhile. This is not the time to experiment with high-octane tokens, and yield farm into high APYs. This is the time maximize liquidity, protect notional, and minimize volatility. This means a deep dive to…

Map out your risk appetite. It’s important to understand the % drawdown to your treasury that would require a change in your roadmap. This could be reducing marketing spend, third-party services, or team size. Plan out where your milestones are to the next raise or liquidity event, so there is no doubt about your runway. If your treasury needs to grow at a return that is beyond what is safe in reliable stable yields, then it might be wiser to look at a strategic raise instead of reaching for more risk for returns. If your protocol cannot survive without treasury returns, then it is time to examine your business model. A combination of external growth capital and internal revenue drivers should be the main capital engines of a startup. If a project is matured and cannot generate profit to self-sustain and must rely on an internal fund (treasury), then it is a fund with a storefront…(ahem, Celsius, Nexo, BlockFi…). Beyond your own risk profile, it’s crucial to…

Clarify risks that are out of your control but will affect your treasury. What is your current value-at-risk and what risk vectors can alter that? How much are you holding in algo stables vs collateralized ones? In a depegging event, what are your a) monitors, b) alerts, and c) action plans? How much of treasury assets is illiquid? What % of runway is that and can those assets materially depreciate without recourse? How reliant is your treasury on dexes and oracles? Would a liquidity lockdown cut short your runway? What exogenous event could put your project in jeopardy? No, it’s not always possible to provision for black swan or contagion, but assigning sobering probabilities and calculating expected outcomes is a healthy exercise for holistic treasury management.

Finally, question all assumptions. There are numerous narratives about the valuation of projects and their tokens, and discussions about “where yields come from.” It’s now clear that yields that depend on contango price action for tokens have crashed. But even if returns come from transaction fees and staking rewards, how dependable are those income streams? Question and monitor the sustainability of transaction volumes in the current market regime. Quoted APYs are backwards looking, which means that the headline number will disappoint if market slows down, as it has recently. What is the liquidity cost of the APY? In the current market, where there are daily exploits, the longer the lockup, the higher the risk. There has never been low-risk APYs in DeFi, but risk discussions were not sexy in a bull market.

In a bear market, protecting your team’s ability to build is paramount. This is the time to put guardrails around your treasury. That means clarifying risk vectors and creating monitors and alerts. That means taking risk off because it is already risky to build in DeFi.

We, at Exponent, are doing the unsexy work for charting DeFi risks, and providing the tools necessary to help builders truly focus on building.