1. Use hedging strategies to limit a treasury’s exposure to the crypto market’s volatility, using financial instruments known as derivatives, like:
a. Put Options
b. Futures Contracts
c. Perpetual Futures
2. Evaluate the effectiveness of hedging strategies using IAS 39. A hedge is considered highly effective under IAS 39 if the following two conditions are met:
a.0.80 ≤|βˆ|≤ 1.25
3. The assets in a DAO, or company’s crypto treasury in excess of a 12-to-18-month operating budget can be invested in:
a. Strategic projects
b. Venture capital
d. Token buybacks
f. Direct market investments (e.g. buying ETH)
4. When allocating investable surplus from the treasury to different avenues and asset classes, consider:
a. Tiers of investable surplus
b. Risk return profile
d. Capital efficiency
5. Have a documented investment policy that is constantly being evaluated against performance, and market developments.
6. Use crypto portfolio management and tracking tools
In the previous section, we covered the first, and most important pillar of how to manage a crypto treasury: liquidity management. The priority of every Web3 CFO is to ensure that a DAO, Foundation, or crypto company has the money to do what it needs to do, and manage the crypto payments related to collections and disbursements.
Now, we turn to the second of three pillars of managing a crypto treasury: funding management. This domain can be divided into two categories: getting external funding, and deploying idle assets from the treasury.
Raising external funding is particularly important for many DAOs, and crypto companies as they are in their early stages of growth, and typically require continued flows of capital from external sources in order to finance their operations.
However, this is a subject that has been explored extensively elsewhere - from token sales, to various staking and yield farming mechanics. Given that there is likely little added value here, we will leave this topic here without further elaboration.
There are two subdomains to investing a crypto treasury: (i) hedging, and (ii) portfolio management. The former is focused on capital preservation, while the latter is more focused on generating yield or capital appreciation.
Cryptocurrency markets are incredibly volatile. The Chainalysis State of Web3 Report noted that the average DAO with assets over $1 million suffered a maximum drawdown of 51% in the value of their treasury’s assets over 2021, compared to Bitcoin’s drawdown of 72%. The responsibilities of hedging a crypto treasury’s exposure to these currency exchange risks sits with the Web3 CFO.
Goals. Hedging aims to mitigate potential drawdowns in the crypto treasury’s net asset value, by taking a position expected to perform in the opposite direction of an existing position. Hedging helps Web3 CFOs to moderate their treasury’s exposure to the crypto market’s volatility, by using financial instruments known as derivatives. It is important to note, however, that most hedging instruments can only be accessed through stablecoins. Therefore, to employ this strategy, you will need to have already built up a stablecoin reserve.
Instruments. The two most common derivatives used to hedge a crypto treasury’s exposure are futures and options. Both allow investors to go long and profit when an underlying asset goes up in price, or to go short and profit when it declines. Perpetual futures are also another instrument Web3 CFOs can consider for hedging.
Web3 CFOs should take note of key differences between these instruments. The downsides of using derivatives such as futures contracts and options, is that they are more complicated and require more management than perpetual futures. Both futures and options contracts have expiration dates, so these contracts have to be rolled over to keep a hedge in place. In contrast, a perpetual position is basically equivalent to a continuous hedge over time.
A second factor to consider is the funding rate. A short position may receive funding payments from, or pay funding fees to, traders who are long. The funding rate mechanism is in place to keep the price of the perpetual futures contract in line with the price of the underlying asset.
When the funding rate is consistently negative, short positions incur fees that are paid to traders who are long, where the fees are proportional to position size. Under these conditions, there’s a small additional cost associated with using perpetuals to short as a hedging strategy.
Funding fees can accrue over time, which have an impact on the effectiveness of using perpetuals as a hedge, especially if you have a very large position. To get around this, you can split up a large position across multiple perpetual futures exchanges, which may vary in their respective funding rates.
The third factor to consider is liquidation risk. If the price of ETH rises by around 20%, then a short perpetual futures position with 5x leverage will face liquidation. However, for a short that’s only leveraged 2x, the price needs to rise 50%, so there’s a lot more breathing room for this hedge. Use an appropriate amount of leverage and manage the position over time to avoid blowing up the hedge.
Evaluation. Web3 CFOs should assess the effectiveness of various hedging strategies, not just the relative costs. This should be done prior to adopting a strategy, as well as to monitor the effectiveness of a hedge throughout a given period.
International accounting standards offer a simple and widely used test to assess the effectiveness of a hedging relationship between a hedged item – and the associated hedging instruments (e.g., futures and options).
IAS 39 deems a hedge highly effective if two conditions are met:
1. The offset is in the range of 80-125%, meaning the slope parameter (Beta) of the regression of the returns of the hedging instrument against the hedged item’s returns is within the range of 0.80-1.25;
2. The coefficient of determination of the regression (the R-squared parameter) is equal to or greater than 0.80. R-squared is a statistical measure that in this case represents the proportion of the variance of the hedging instrument’s returns that is explained by the variance of the hedged item’s returns.
In summary, a hedge is considered highly effective under IAS 39 if the following two conditions are met: (i) 0.80 ≤|βˆ|≤ 1.25 and (ii) R2 ≥0.80
While the International Accounting Standards Board (IASB) has recently replaced the IAS 39 quantitative criterion with a principles-based approach, the quantitative hedge effectiveness test remains widely used by financial institutions to determine the effectiveness of a hedging relationship.
Web3 CFOs are also financial asset managers for their DAO or company, investing idle crypto assets that sit on the balance sheet to generate a return.
But what exactly are considered idle assets? Web3 CFOs must first ensure that their organization maintains a strong balance sheet. As explored in the section under liquidity management, Web3 CFOs should aim to achieve a cash ratio of at least 1.
This gives the treasury sufficient liquidity to meet its projected cash needs for at least 12 months. More cautious Web3 CFOs could even consider ensuring sufficient liquidity for up to 18 months, or whenever they expect to be able to raise additional funding.
The assets in a DAO, or company’s crypto treasury in excess of this 12-to-18-month operating budget can be considered idle, investable surplus that can be allocated to opportunities that generate returns to grow the business.
When it comes to allocating this investable surplus, Web3 CFOs can either deploy it externally, or plow it back into developing the organization’s internal capacity. While much attention has been given to external investments, more attention should be paid to reinvesting capital towards the latter. Hasu et. al. explained this best in their 2021 article:
“In general, we recommend divorcing the idea that paying dividends or buying back tokens is somehow “rewarding” token holders while internal reinvestment is not. The most rewarding decision for token holders is the one that maximizes the return on each dollar, whether internally or externally.”
Each of the above asset classes or capital allocation avenues has different risk, yield, and liquidity profiles. Before allocating among them, it can be useful to develop an investment policy to guide the overall approach of how to deploy the investible surplus from your crypto treasury.
For reference, a16z provides their portfolio companies with a sample investment policy. These are largely focused on traditional asset classes like money market mutual funds, and corporate bonds. However, it remains relevant as many of these are increasingly being tokenized, and thus accessible to Web3 CFOs managing on-chain treasuries. For a more Web3-native approach, asset management guideline proposals from other protocols such as AAVE can serve as a starting point.
The CFA institute also has published a 16-step guide that identifies the key elements of drafting an Investment Policy Statement (IPS) for institutional investors. It is an instructive, actionable guide for DAOs, or crypto treasury managers at Foundations, and crypto companies.
Even for Web3 CFOs looking to invest only in crypto-native assets, the underlying principles are an incredibly helpful starting point from which to develop your own treasury’s DeFi investment policy.
When developing such an investment policy, consider the following factors:
- Tiers of investible surplus
- Risk return profile
- Capital efficiency
The guide to crypto treasury management published by a16z crypto explains:
“The diagram below provides a high-level look at various products and when they might become appropriate to consider. In general, products offering greater yield become more appropriate as a project moves from operating cash (for meeting day-to-day needs) towards strategic cash (for pursuing growth and other opportunities).
In general, traditional companies allocate excess cash toward safe holdings. These include products such as money market instruments and investment-grade fixed income securities (rated BBB or higher). In a given portfolio, these companies typically diversify assets across maturities, credit quality, sectors, and issuers…
While we’ve seen some corporate treasurers take on additional risk in recent years, a more conservative strategy is often advisable. This is particularly true in the current rate environment, where yield is beginning to return to many traditional credit and banking products. For example, yields on certain money market instruments are beginning to approach 150 or 200 basis points in some cases, making them an attractive option for managing cash. A portfolio anchored around these types of assets is likely to be well-suited for many companies.
Meanwhile, for DAOs managing on-chain treasuries, a variety of money market and fixed-income products have emerged in recent years that may be appropriate to consider. These include products such as Compound, Element Finance, and Goldfinch, among others. For longer-term cash, it may make sense to explore staking with high-quality protocols like Lido and others.
As with more traditional products, however, it’s important to consider the risk, yield, and liquidity profiles of these options before allocating to them. It’s also important to evaluate any technical or operational risks that may arise when interacting with assets or protocols on-chain to ensure a project isn’t exposing assets to risk of loss.”
Web3 CFOs investing surplus capital from their DAO treasuries should consider implementing regular monitoring and evaluation regimes for their investments. For instance, some digital asset managers have weekly reviews of their investment portfolio to ensure that it continues to be comfortable with their liquidity profile, diversification requirements, and to gather general industry and regulatory updates that may have a material impact on those investments.
Fortunately, the availability and quality of the systems Web3 CFOs can use to manage their portfolio assets have also advanced. Over the past three years, there has been an acceleration in the development of crypto treasury management, and portfolio tracking tools that make the deployment of capital more of a well-thought-out process and less of a gut reaction, or back-of-the-envelope calculation.
For example, protocols that we discussed earlier (like Fyde) can allow Web3 CFOs to put more of a DAO’s native governance tokens to work, thereby increasing the amount of working capital that can be deployed. Other more centralized solutions like institutional digital asset prime brokers or custodians such as Copper, are also available for larger more TradFi-native organizations.
These platforms can also allow crypto treasury managers to embed their investment policy rules into the portal, preventing moves—whether deliberate or inadvertent—that would violate their policies.
But when it comes to investing spare capital, the name of the game is still capital preservation—not returns. Especially in a post-FTX environment, Web3 CFOs are paying ever more attention to risk assessment. The single biggest theme since the collapse of lenders like Genesis, BlockFi, and venture capital funds like Multicoin Capital has been an increased focus on counterparty risk.
While many companies’ investment policies already limit the percentage of funds that could be invested with any single counterparty, asset allocation has become more critical to an organization’s investment strategy following FTX’s demise.
Having clear investment policies is critical for Web3 CFOs. Investors expect organizations to take risks in order to deliver returns. But investors do not generally expect organizations to take risks beyond their circle of competence.
For example, a Foundation that is charged with research and technical innovations around a Layer 1 blockchain has engineering competencies, so investors would expect it to take relevant business risks like re-investing surplus capital into enhancing the protocol and its ecosystem. They would not expect the firm to speculate in exotic options (a financial risk), or run a prop trading desk.
This brings us to the third, and last pillar of managing a crypto treasury: risk management.
In this chapter, you will learn to identify and understand the three key pillars of managing a crypto treasury, map out key areas of responsibility, and identify what the key goals are for crypto treasury managers.
If money is to organizations what blood is to our bodies, liquidity management is about ensuring that there is sufficient blood in the system, and that it flows efficiently.
Ensuring liquidity is the primary goal of good crypto treasury management. Especially in bear markets, when token prices and company valuations tank, the distinction between liquidity and solvency becomes sharper.
Crypto treasury risk management is the practice of mitigating money-related risks in DAOs, Foundations, or any organization using crypto in its operations, or holding substantial amounts of crypto assets on their balance sheet.
This chapter will focus on how Web3 CFOs can identify and assess the different risks they may be exposed to from various treasury activities, and develop appropriate response plans ahead of time to reduce potential downsides.
Understand the key features and benefits of a good crypto treasury management system and how it can offer visibility into organization-wide positions, automate manual processes, facilitate decision-making for internal management teams, and simplify financial reporting in crypto.
Many of the principles and best practices of crypto treasury management discussed in previous chapters are equally relevant for DAOs.
However, there are key organizational features of DAOs that require special attention. You’ll learn how to apply these in the context of DAOs.