DAOs and the Art of Risk Mitigation: The Importance of Hedging | Deyeon Kim | ETHTaipei 2023

[Music] all right well good afternoon everybody uh so yes my name is Dion Kim I'm the growth lead at Potts Finance so today I'm going to be presenting on Dows and the Art of risk mitigation uh the importance of hedging okay so just a little background about me I've spent about 17 years in Trad 5 from institutional sales trading to private wealth management at JPMorgan which is the largest bank in the United States uh back in 2013 I bought Bitcoin for under 300 per token at that time all my colleagues made fun of me they said I threw money away my mother was crying like oh I raised the d-gen and now a few years uh fast forward a few years and all my colleagues are asking me oh when do I buy Bitcoin when do I buy ethereum and now my mother says that she raised a good man so uh Who's laughing now right so that is yes that's my uh background there um so today the uh my presentation is really about treasury management challenges uh what is hedging why hedge how do we hedge and some hypothetical scenarios and best practices so what is a dow for those that don't know a dow is a decentralized autonomous organization there's a lot of them um you have ones like optimism and bit Dao that have billions of dollars in their Treasury and then you have some that don't even have a million dollars in them and you know you see weaker Dows get uh you fail every day and you see new Dows get formed almost every day as well too one of the benefits uh that dowels have is the inclusivity of their membership all you have to do is own one of their governance tokens that they issue or an nft and then you are a dow member so you know there potentially they could have a global reach in their membership um but as organizations are they always organized you know that inclusive is actually partially uh you know the source of some of their problems so one of the problems that are is often uh the case you know we we talk to a lot of dows at pods I've conducted lots of Treasury interviews with treasury heads so oftentimes there's no designated well-defined treasury team especially amongst uh the smaller Dows it's usually just like a volunteer or somebody who's deemed to be trustworthy uh and usually they do not have professional financial management experience and also too you have key people that can change often you know they have uh voting every three to six months that wear leadership and treasury members can get replaced so sometimes there is a big challenge in planning these longer term initiatives especially when you have new leadership changes every three to six months um and so that's uh that's why you know the finances can be actually quite difficult also too even if they do have Financial initial that they do want to pass oftentimes especially in the newer Dows you see a concentration of votes around Wales so if some of these whales are not on board or if they're AFK away from their keyboard and are non-responsive you know you may not be able to reach a quorum in order to get any initiatives passed uh Financial challenges uh so a lot of these uh Dow treasuries a big percentage of their treasuries are and their own native tokens or their nfts um and uh and there is a deep hesitancy within Dow members to vote for selling this native token right um you know as a down member if you're holding all these native tokens it's very unlikely that you're going to vote for the treasury to sell that and put selling pressure in and downward pricing pressure on the token that you're holding and some doubts have some Provisions where without a vote they can sell some parts of their native token to raise additional funds but still even though it's allowed to do that there's this Optics and and politics around that because if they do sell within their mandate and they are blamed for the downward price and their native token because of the selling pressure they can get easily replaced in next three to six months in the vote so there's uh there's a lot of politics involved in Dows and sometimes uh the assets may not even be liquid they may not be able to sell uh and then obviously there's price volatility as well we all know crypto can be extremely volatile these native tokens and nfts oftentimes have way more volatility than ethereum or Bitcoin so and when ethereum or Bitcoin is going down 10 20 these native tokens are going down 30 40 uh and some native tokens actually haven't even started their rally yet so you know Ethan a Bitcoin they bottomed out in Q3 of 2022. some of these governance tokens and nfts they they're still going down since then so uh they oftentimes they have a leveraged downward uh price capture but then sometimes none of the upward capture uh which also you know poses its own set of challenges so these are actual real Dao scenarios the only thing that I cut out are the name of the Dows because I just didn't want to put anybody on blast but uh you can go to deepdow.io and you can actually take a look at all the treasuries and these are like just take a look at any one of them most of them look like this uh in 2022 a lot of these dials lost uh 80 to 90 percent of their treasury value um there are very few that maintained uh their treasury values usually it's because they were always in stable coins uh but those but most have you know a governance token or an nft or are an eighth and if that's the case their treasuries kind of look like this all right so this is a hypothetical Dow treasury scenario so in this scenario I have um a dow you know with a hundred million dollars um you know just to make the math easy uh and then I put the monthly ethereum performance and then we have the uh each column represents the number of uh years in the runway or how much they can spend without you know without going to zero um and so in the five year for example this means that they're spending about one and a half percent of their treasury on a monthly basis on this side here one year they're spending about eight percent of their treasury on a monthly basis and as you can see too um as their treasury value goes down that nominal value of that cash burn per month also goes down so for some of these Dows uh if they had kept their costs fixed in 2022 and if they had less than four years of Runway they wouldn't have made it they would have been at zero so in 2022 we actually saw that we actually see a lot of these walking wounded dials basically they're still open and they're still members but they can't do anything because they don't have any funds um and so a lot of these Dows did a lot of cost cutting so this kind of uh it it gives that a fair representation of that spending okay so hedging what is hedging hedging is taking an offsetting position to protect against price risk in another position so a hedge is very comparable to Insurance let's just go over an example here let's say you buy a house all right you want to protect it from bad weather disaster so you buy flood insurance let's say if there is no flood well you have to still pay for that flood insurance right and so it eats away at the return of your house however if there is a huge flood and your house just gets wiped out and you know in a Mudslide or whatever and there's flooding then your insurance policy will pay out and you get to recoup some of that value that you put into your house so there is a risk reward trade-off in hedging it reduces risk but also reduces your potential rewards especially in prolonged bull markets there are instances where hedging will actually get you ahead rather than you know going just straight into an asset and that's what we call like a choppy Market we call that a price Discovery Market where it has big upswings and downswings but then in this uh period of time it stays relatively flat so in that one instance you know hedging will actually put you ahead but in these prolonged bull markets yes there is definitely a risk reward trade-off uh in hedging all right so how can we hedge there's many ways to hedge these are the three uh most popular ways of hedging that that you know I uh heard of when when I spoke to the treasury heads there's some doubt treasuries that actually do have legal entities and so there's some of them that mentioned uh uh expressed interest in getting some CME Futures you know the Chicago Mercantile Exchange futures you see the S P 500 futures on there oil uh gold silver Commodities they're all traded on the CME uh and also Bitcoin and ethereum but again you have to have a legal entity you got to go through kycaml um and usually though they've uh participants in the Bitcoin and ethereum CME Futures are tradfi institutions most of them were trading S P 500 crude oil gold and silver like all these other CME Futures before they started trading uh Bitcoin ethereum Futures so it's mostly favored by Trad fire institutions there's also Perpetual Futures too and like the CME Futures it uses leverage so you could put potentially be Force liquidated or it could be extremely costly if that hedge goes against you and actually I have one example here this is a Friday to a Friday in ethereum okay one week all right so let's say at the end of day Friday right here on the first vertical black line right there you decide hey you know what by next week I think ethereum is going to be down by next Friday well you were right but on Friday not the Saturday you saw a 180 Point rise in ethereum before it started falling so depending on how much leverage you're employing that could have been your liquidation event right there you could have been Force liquidated or if you actually exercised some good risk management you might have gotten stopped out okay even though you were right for that week um you know your timing has to be impeccable if you're using that leverage so another uh way that you could hedge is with the options market now the challenge with options and the reason why most people are turned off by options is because you got to be right in three aspects for a payout you got to be right on Direction timing and the volatility expectation okay most people are thinking you know when you buy a put option which is a bear bearish bet on the uh on the market hey the market went down but I still didn't get my payout well maybe it's because your timing was off maybe uh it expired before the actual price movement went in your favor or maybe the volatility expectation uh was wrong all right so you have to be right in those three aspects however there is a benefit to using options which is buying options is a defined risk position okay defined risk what does defined risk mean it means that you know what your worst outcome is going to be on that trade the worst thing that can happen when you buy options is that your options go worthless it goes to zero right so it's defined risk it can also be very Capital efficient because it has a convex return profile what does convex return profile mean so it's this curved line right here that parabolic curved line all right convex return means as the position goes in your favor your profit grows exponentially on that trade all right and that is how we can have uh Capital efficiency you just don't need as much to get a large payout on a very large move in the market all right and as you can see I have a little red line right here that's your cost that's your defined risk right there you know the worst outcome is that cost and even though it keeps going against you that's still the worst outcome that can happen Okay and then obviously as price goes more and more in your favor you start getting that exponential payoff we call this like a gamma explosion uh uh in options trading all right uh this uh straight slanted line that's more of a return profile for holding an asset or maybe perhaps holding a Futures Contract or a Perpetual Futures position the slope of this line is dependent uh is is based on how much leverage you're employing so the more leverage you're employing the more the the slope of this line is going to be vertical all right the less leverage you're using it's going to become more horizontal all right so here is the unhedge hypothetical treasury scenario I just showed you this from before the only difference is now I put some colorful circles down there so you can now track uh what it would look like in April uh which is this month uh so these all have been updated so this is what it looks like when you are unhedged on unhedged uh now the benefits of hedging let's say you take 20 of your uh treasury uh portfolio all right and you put it into let's say a stable coin usdc all right you take that usdc you put it into Ave right now Ave is yielding around 2.7 percent you take that 2.7 percent on a weekly basis uh you know it's a 2.

7 annualized and they pay you you know little bits on a weekly basis you take that Weekly yield and you buy out the money puts which are bearish bets on the market with that yield okay this is the results you get so if you had a five-year Runway if you spent less if you were spending less if you were only spending one and a half percent of your treasury every month you would have around 70 million dollars left over after April in the previous example you had about 45 million so you have a a good 20 million extra your your opportunity cost for not hedging costs you about 20 million dollars now if you had less of a Runway if you were spending more if you had two years or one year and most styles that we talked to are in this Camp right here they have one to two years of Runway um you would have about 56 million or about 41 million dollars if you had hedged with 20 of that portfolio without it 30 million and 15 million okay so for those with especially in the one year segment we're at 15 million um that is about a 25 million dollar difference so more than double okay almost tripled right so that's a huge opportunity cost and one thing I want you to notice too here is that you see that with the hedging performance uh you know since you're only using the yield portion when the market is going up you're not really losing all that much but it doesn't really pay out unless there's a quick movement basically this will pay out when you need it the most all right that's usually how uh hedging with options works and as you can see here we have a risk event that happened in May June does every anybody remember what happened in May June of 2022 anybody remember 3ac all that systemic risk one firm borrows money to uh lends money to another firm and that firm lends money to another firm one firm fails and then all of a sudden all these firms can't meet their obligations and remember we had a huge sell-off in the market then uh we had a you know 30 down in one month and another 45 percent in the next also too this strategy paid out in uh in November and December as well November in 2022 as well does anybody remember what happened in November of 2022 FTX that's right FTX right so when FTX failed there was a huge sell-off in the market and boom uh this uh strategy would have paid out so let's talk about a little bit more what if we hedged with 40 of the portfolio all right now some of you may be asking you know maybe telling yourself well gee 40 of the portfolio to hedge that seems like a little bit too much to use for hedging well in traditional Finance uh when we did um asset management for a lot of Foundations and for high wealth uh High net worth individuals we call the 60 40 portfolio a balanced portfolio basically 60 in Risk assets like uh like stocks or you know other risk assets and then 40 and short-term treasury bonds uh cash equivalents things of that nature so in in traditional finance and professional money management forty percent of a portfolio being used as a hedging uh or a something to counteract a risk asset is actually not so far-fetched and again in this example we would have had if you had a five-year Runway you'd be left with about 90 million dollars in your treasury whereas unhedged again about 45 million dollars and also if we go here on this side uh I if you had a one year or two year uh uh if you had one year or two you're in your in your Runway you'd be left with 64 or 78 million dollars after hedging but if you didn't hedge again 30 or 15 million that's a huge opportunity cost imagine you are the head of a treasury you did not hedge and now your 100 million dollar uh treasury is now at 15 million dollars but if you hedged it could be a 64 million dollars so somebody needs to answer some questions about 50 million dollars that is missing right that is a very uncomfortable conversation to have to your Dow members all right so the key takeaways here is that hedging is beneficial in preserving the value of a portfolio or treasury especially if you have less of a runway in your Dow and also it makes potentially larger losses into smaller ones one thing I also want to point out too is in the unhedged one I don't know if you can see because of this table right here but right here as you can see from January till now we've had actually decent rally in crypto right we've had a decent rally but here if you were unhedged you started at the end of December you had about 14 million dollars but now uh you only have about 15 million uh even after this large rally why why is that well you know who here knows Warren Buffett and Warren Buffett's rule to investing anybody what's rule number one don't lose money that's rule number ones don't lose money what's rule number two that Warren Buffett says always remember rule number one there's a reason for that it's basic math if you lose ten percent you need to make 11 to break even if you lose fifty percent of your portfolio you need to double your portfolio to break even if you lose 75 of your portfolio you need to quadruple your portfolio to break even all right you basically when you take these large losses you dig yourself in a hole and you takes all this time and effort to dig yourself out of it the the the the the you know to you have to keep your losses small so that you can recoup quickly and then uh start making new money again all right so again benefit of hedging uh you do not take those large losses all right and then options provide a convex return profile with defined risk so that is why uh you know especially with me and uh you know those in tradfi also and uh at pods we prefer an option strategy in order to use that for that convex return profile and Define risk all right now anybody have any questions I know I put a lot of numbers up on the chart a lot of people have stuff to say whenever I do that if you have any feedback or questions or comments you would like to share with me I'd be more than happy to answer you guys online as well if you take a picture of this QR code it links to pods it links to my personal uh Twitter and Telegram and my email as well and I'm open to answering questions or having a discussion with you online about this anytime thank you [Applause] okay questions hey hey um so I think a question that I have is um a big problem with uh with obviously hedging on chain purely as you expose yourself to a bit of smart contract risk when you're doing that and uh that's something when I've spoken to Towers before about this problem they are typically uncomfortable with um so I remember even when we were at risk uh planning on you know allocating our treasury or something we were saying oh why don't we deposit an Oiler and if we had done that we'd have lost our treasury so um I think that it may be something that is sort of mispriced a lot when you're thinking about these heading strategies and they're wondering sort of what your thoughts are on that tail risk so yeah you know for tail risk and and definitely you know with if you if something happens to a Smart contract um you know you're it's not going to provide you might end up losing everything right and so that is a very interesting problem uh I don't know if there is an answer to that right um if you look at any type of uh on-chain solution you're always going to going to have that smart contract risk so I think to hedge or to protect yourself from that tail risk we probably need to look at some Security Solutions or things of that nature like you know like in that uh a home insurance example you buy you're buying home insurance you know to protect yourself from your home getting flooded right perhaps what we also need is some type of smart contract Insurance um and you know perhaps that might be a way to hedge against that or from an attack or you know of that nature yeah I think that'd be quite an interesting start to add to this model you made I mean sure thing yeah thanks for the feedback thank you um I have a quick question I feel like a lot of times in defy you don't really have hedging options like like I I would like to hedge a lot of the things that I'm exposed to but either the options or volatility is too expensive or there's not enough liquidity to like get out of a position let's say you're a doubt and you know your treasury is like primarily in your own token and there's no actual liquidity to move it into stable coins um so in these kinds of situations like what do you think is the best thing that a project can do to like hedge to the best of their ability given you know the market conditions you know I I didn't want to really bring this up I wanted to make this as educational as possible but you know I am at pods um and so since you ask uh we do have some products that we are about to launch where you can get a hedging structure a payout structure with a vault actually this strategy that I just described to you is going to get launched pretty soon at pods and so um this is something that we developed after having a conversation with multiple dials just like what you said they said exactly the same thing we would like to hedge for the next bear Market we just don't know how so um stay tuned and pretty soon we're going to have something for you guys great thank you hey great talk I have a question if um if many dials are piling into these kinds of hedging strategies does that not uh dilute like the or does it not make it more expensive for any tail Dows coming in like the first one is obviously going to get better pricing on the hedging options that they buy but anyone coming after will be it'll slowly degrade is that true no that's necessarily true because we're also in the well at least in the example that I and the back test that I did we used weekly options so every week it's an option that expires one week later and then you you take the next week's yield and you buy the next week's options with it okay so we're using WOW one week weekly options to do this so it's not like we're buying something like you know a year out or something like that and then you know yeah everybody that's coming afterwards piling on it gets more and more expensive it's not like that the the scenario that I ran was for weekly options okay thank you let's maybe take one last question what do you think about protocol on liquidity to diversify the treasury out of its own native token providing liquidity to diversify the treasury out of its own native token using protocol owned liquidity and permanent loss um and so yes diversification is also key but again from the Dow from what I presented about Dallas you know a lot of these dowels have about 50 or 60 even higher percentage of their treasury in their native tokens and the Optics around selling that it's just you know it just won't pass the initiatives uh and if they if they even do a little bit that's within their mandate they make it they might get voted out so they have limited Capital to use for this and they would rather have direct what we call negative Delta exposure as the market drops this has a positive payout they want something like that because they want it to be capital capital efficient because they just don't have that much Capital to allocate toward a hedging portfolio because most of their portfolio is in uh stable coins and in their own nfts okay uh that's round of playoffs again per day on [Music]