Today, the majority of DAOs in DeFi hold only their native tokens in their treasuries. Many others have as much as 96–99% of their treasuries in their native tokens while only few have up to, and above, 5% diversified into other assets and/or asset classes. This leaves them massively exposed to the price volatility of their native tokens.
In a long crypto bear market, they could easily see more than half of their treasuries wiped off if their native tokens lose more than 50% of their value. As we have witnessed in previous bear markets, it’s totally possible for the price of these tokens to fall by more than 80%. As a result, there is an urgent need for DAOs to diversify a portion of their treasuries and balance sheets out of their native tokens into other assets. This will be crucial to funding the operations of the DAOs and ensuring that they can survive and thrive long-term regardless of the state of the broader DeFi or crypto market.
In order to optimally diversify their treasuries, DAOs should consider their current and future liquidity obligations for sustaining their operations as well as their existing and expected sources of income.
What are Range Tokens?
Range Tokens are financial instruments developed on the UMA derivatives protocol that enable DAOs to diversify their treasuries away from their native tokens without having to sell them immediately. Similar to convertible debt in traditional finance, range tokens allow DAOs to raise debt capital in stablecoins (e.g. USDC) without liquidation risk by using their native tokens as collateral. Upon settlement at maturity, if the debt is not paid up, the range tokens are convertible to an equivalent amount of the collateral (native tokens) using the settlement price of the native tokens.
However, there are some added benefits with range tokens. The range token seller (in this case, a DAO) cannot be liquidated and as a result, the number of native tokens given to the range token buyer/holder is capped. Basically, the range token seller has a put option to convert at a minimum price. The investor is compensated for taking on the risk of default with a call option that guarantees a minimum number of native tokens regardless of how high the price goes.
In general, there is a spectrum of financial instruments that can be used to fund a venture:
To raise money, a DAO can sell their native token directly. This is comparable to classic equity financing which gives a 1:1 exposure to the investor. Especially in the beginning, this might not be desirable as the price of the token might be very low. Additionally, it could create an immediate selling pressure on the native token. In general, equity financing has a higher cost to the seller than debt financing and thus, should only be done when necessary .
On the other side of the financing spectrum there is debt. One way to generate debt is by issuing a bond. The most basic bond is the zero-coupon bond which means that it doesn’t pay anything during its runtime and only pays out the notional value on maturity. These bonds are sold at a discount which then results in a yield over time. Thus, the investor gets a predictable return as long as the issuer doesn’t default completely.
A convertible bond is the same as a bond with the addition of a call option at a particular strike price. Beyond that price the investor would have exposure to the underlying asset. Thus, it behaves sometimes like debt and sometimes like equity.
The Range Token ultimately adds a put option for a lower end strike price. Now the investor has exposure to the volatility of the underlying token outside of a given range, and inside that range, yields a stable return. Looking at the graphs for Bonds & Convertibles, one immediately sees that at the lowest range, the amount of tokens needed to collateralize the loan becomes exponentially more. In practice this means starting with a certain amount of tokens as collateral and then having to add more collateral if the price goes down.
A Range Token is much simpler because it limits the collateral at risk to a fixed amount. There is a fixed amount of tokens you need to fully collateralize the instrument without having to worry about being liquidated due to price fluctuations .
Why should DAOs issue Range Tokens?
The main reason why a DAO would issue a range token is to diversify its balance sheet and reduce the cost of capital compared to simple equity financing (via selling of native tokens).
Relying solely on selling its native token can become a costly way to raise capital, especially if the native token appreciates a lot in the future. In the end, by issuing a range token, the DAO will be reducing their average cost of capital as well as decreasing the impact of price volatility on their balance sheet .
Why should an Investor purchase Range Tokens?
Investors who purchase range tokens are essentially lending funds to the DAO and could earn a decent yield on the capital (e.g. USDC) provided. Also, by holding a call option which gives them the right to convert the debt at a maximum price per native token (the high price range), they are also guaranteed a certain amount of the DAO native tokens at maturity regardless of the price action.
This limits downside exposure to the price of the native tokens because they would always receive at least the equivalent of the notional value of the debt unless the price eventually goes below the low price range. In addition, if the price exceeds the agreed call option strike price at settlement, the investors (i.e. range token holders) would have positive exposure to the native tokens.
A Range Token is a less risky version of the underlying asset. If the project is still emerging & high risk, the yield will tend to be higher to compensate for that. If the project has little risk/volatility, the yield will tend to be lower as well.
Should DAOs purchase Range Tokens from other DAOs?
Ultimately, the decision to issue range tokens will depend on the treasury position and strategy of a DAO at any given time. They could also pursue range token investment opportunities to further diversify their balance sheet and asset base. However, this would depend on their overall goals and objectives.
For example, a DAO that primarily builds and invests in other DAOs (like Open DeFi DAO) might consider purchasing range tokens from portfolio DAOs as opposed to solely investing in their native tokens. In addition to diversifying its own Treasury, the venture DAO could also be helping the projects they invest in to diversify theirs as well and preserve the long-term value of their native tokens.
How can DAOs issue Range Tokens?
Range Tokens can be built and issued on UMA using its Long Short Pair (LSP) contract which enables anyone to deposit collateral and mint a long and short token. In this case, the collateral deposited would be the native token of the DAO while the long and short tokens would represent the call and put options. The DAO would keep the short token and sell the long token to the range token buyer/investor. At the maturity date, the collateral is shared between the DAO and the investor through a payout function using UMA’s Optimistic Oracle which provides a settlement price to the LSP contract on-chain.
Risks of Issuing Range Tokens
With every financial contract, there are several risks to consider and manage. Range Tokens are no different. However, because they are on-chain smart contracts, new risks are potentially introduced as well. The major ones are:
- Smart Contract Risk
- Oracle Risk
- Market Manipulation Risk
While the first two are technical risks, the last one refers to an economic attack vector. The lower the size of a native token’s market, the easier and cheaper it is to manipulate the price. Discussing this risk in detail is out of scope for this article, though one measure that could increase the cost and thus reduce the attack surface is time weighted average price. This is because it is much more costly to keep a price at a desired level for a prolonged amount of time instead of just spiking it for one moment.
This is a mechanism that shouldn’t be used with something like an algorithmic stablecoin as it invites arbitrage attacks that arise out of the delay between real price & perceived price in times of high market volatility. Though in the case of a range token this seems to make sense as every token is a self-contained contract and can only be redeemed once, so there is no repeatable arbitrage opportunity that would arise out of a weighted but lagging price oracle.
Range Tokens for Open DeFi DAO Treasury
On day one, the Open DeFi DAO treasury and balance sheet would be made up of only native ODEFI tokens. In order to properly fund our operations, we would need to diversify out of ODEFI into other assets like stablecoins (e.g. USDC and DAI) and reserve currencies (e.g. ETH and BTC). The obvious way to achieve this would be to raise funds by selling some of the ODEFI tokens to investors via a private sale, public sale, IDO, or some other token sale mechanism.
Selling ODEFI could invite direct sell pressure on the token in the market which in turn could hamper its price growth potential and subsequently reduce the long-term value of the ODEFI tokens left in our Treasury. In addition to that, selling ODEFI tokens could be one of the most expensive ways to raise capital (assuming its price goes up substantially afterwards). To avoid this, it is sensible to make use of debt instruments like range tokens to capitalize our operations and business activities.
As a venture DAO that incubates and invests in other DAOs, the Open DeFi DAO could also explore opportunities for purchasing range tokens as part of our treasury diversification strategy. That is, in addition to purchasing and holding native tokens of incubated projects, we could hedge our exposure by providing debt capital to them and receiving range tokens in return. The capital we provide would be earning yield while we still have upside exposure to the prices of the native project tokens. Given how composable DeFi primitives are, we see a future where range tokens have more utilities for the holders. For example, they could be deployed on lending protocols to earn more yield or used as collateral to finance new loans.
A good balance for the management of our treasury would be to pursue opportunities for issuing as well as purchasing range tokens wherever the contract terms are ideal.
Next Steps
As we move closer to the launch of our DAO and ODEFI token, we will be monitoring the developments and applications of range tokens as a potential tool for diversifying our treasury. The UMA team will soon be issuing the first ever range token collateralized by the UMA token which should hopefully shed more light on the range token issuance process.
Conclusion
In conclusion, range tokens are innovative financial instruments that could help DAOs to stay liquid, capitalize their operations, diversify their treasuries and bring down their cost of capital. We believe they could be a real game changer for the rapidly growing DeFi and crypto economy.
References
https://medium.com/uma-project/treasury-diversification-with-range-tokens-145d4b12614e
https://umaproject.org/range-tokens.html
https://medium.com/uma-project/ulabs-range-tokens-in-detail-f24ceffdf90b
https://medium.com/uma-project/introducing-umas-long-short-pair-lsp-financial-primitive-84596803864f
https://medium.com/uma-project/the-yield-dollar-on-uma-3a492e79069f
