As 2022 continues its bear market correction on the back of a cascade of staggering systemic failures, many Layer 1 and Layer 2 foundations are starting to wonder how they will address their working capital requirements going forward. Some have lent a significant amount of their treasuries to counterparties that have abruptly ceased to exist, others were expecting to raise liquidity via discounted token sales only to see demand drop and valuations plummet. Regardless of why a cryptonative institution may need to raise funds, sources are less abundant and options are limited.
Token sales function similarly to an equity raise where the seller parts with a financial asset of intrinsic value and the buyer purchases with a potential future economic upside in mind (i.e. the token) in exchange for cash in the short term. Hedge funds and venture funds were typical buyers of such offerings and many hedged these purchases using perpetual futures (also known as ‘perps’) which is similar to traditional futures contract which many readers will be familiar with except it deals with digital assets. The sheer size of these transactions pushed the perpetual futures price on many tokens below spot trading prices, which is an unnatural state for any market.
Buyers of perps should be willing to enter long positions in perps at a premium because perps carry implied leverage which comes with a cost. The fact that perps have been trading negatively for so long is primarily due to the imbalance in the market as described above.
This imbalance has created a ripple effect. Perps were used by hedge funds and other investors to hedge discounted token sales. Now that perps are trading below the spot price, sellers of perps (i.e. the hedger) have to pay higher funding costs to keep the hedge. Incredulously, on some tokens, the hedging costs are now larger than the discount on which they bought the tokens!
This shift in market structure has made discounted token deals less attractive as there is no longer an economical way to hedge them. The impact of higher funding costs has manifested itself in lower demand for token sales, thus making it harder for foundations to raise money.
Another major source of funds came from venture capitalists, which typically approach the market from a buy-and-hold perspective. With many of the most popular tokens in the last cycle down 60-90%, the appetite from this community has become suppressed.
So what options are left for projects with good prospects and believe in their future?
We believe the answer is to raise debt. The simplest form of debt financing is via a collateralized loan structure. However, this has not been a popular means of financing projects as it faces two major challenges:
- The borrower needs to post collateral, typically in their native token. Posting collateral is a heavy operational lift as margin collateral needs to be adjusted frequently, especially in periods of high volatility.
- Most projects don’t naturally generate USD revenue while almost all their costs are in USD. So if they borrow in USD and don’t generate USD, it creates the situtation where the borrower struggles to pay back the loan.
Therein lies the problem with the current forms of debt financing. The only real way to pay the loan back is to fund raise again through the sale of more tokens. So if that’s the case why not just sell the tokens in the first place?
Where Do We Go from Here?
There have been some recent attempts to bring debt financing to the market via DeFi bonds issued on chain. Typically, a borrower will use a bond issuance site to both structure and distribute their bonds.
A more common structure is for the foundation to pledge 3x collateral vs the USD notional of the bond and pay a high single-digit interest rate. A protocol called Porter Finance issued a similar structure back in late Q2 2022.
Unfortunately, while the ability to raise money via an on-chain debt vehicle seems cool it doesn’t solve any of the problems of the collateralized loan. Furthermore, since the collateral amount for these bonds is fixed at issuance, the credit quality of the bonds drops with the price thus making it riskier than a collateralized loan for lenders.
To make it easier to compare highlighted below are the challenges of both collateralized loans and on-chain bonds.
- Since the collateral of the loan is native to the borrower, this type of lending is considered wrong-way risk
- Example – Alameda collateralized a number of their loans in FTT tokens but the moment the FTT price began dropping at speed it started the doom-loop which led to the loans becoming insolvent
- Risk reward is skewed against the lender
- If the token goes to zero and the borrower does not fulfill their repayment obligation, the lender loses on the loan
- If the token rallies materially the lender only earns the set interest rate and does not participate in the rally
- The payoff of the loan is in fiat (USD), so eventually, the borrower will have to sell tokens to pay back the loan
- Have the same challenges as collateralized loans but faces the additional challenge of:
- Providing less protection than a collateralized loan as bonds don’t allow for dynamic margining
- Bonds are securities subject to licenses and regulations while loans are not
- Sites offering bonds would need to have a broker-dealer license to offer them legally
- A foundation engaging in such activity be exposed to legal or regulatory risk
Thus, current debt offerings have not gained meaningful traction. While on-chain bonds have been touted as an innovation, we strongly believe that the reasons demonstrated above show that they are in fact sub-optimal even when compared to a vanilla collateralized loan.
There is a better way.
Matrixport has crafted a handful of new solutions for clients to raise debt in a sustainable way. These solutions are designed to retain the upside of projects, such that when a project performs better than anticipated, the founders stand to gain while making it attractive for investors to lend. We also have tailored approaches for projects to earn dollar yields on their treasury, including safe US government backed yields on excess cash. These new offerings are now available via Matrixport Institutional Capital Management Services.
If you are a foundation, DAO VC or any other large holder of tokens looking for help managing your financial resources, please contact us for more information.