TheDAO Should Perform Arbitrage By Buying Back Tokens

TheDAO should programmatically buyback DAO tokens at 90% of their ETH value. DTHs should be able to send their DAO tokens to an address and receive 90% of the underlying ETH in return instantly.

Situation

DAO token holders are selling their tokens below their underlying value. This presents an arbitrage opportunity that market participants are exploiting. I wrote about this DAO/ETH arbitrage on Reddit and encouraged savvy ETH participants to go for it. But what if TheDAO itself could programmatically perform this arbitrage for its own benefit?

Solution

TheDAO should programmatically buyback DAO tokens at 90% of their ETH value. DTHs should be able to send their DAO tokens to an address and receive 90% of the underlying ETH in return instantly.

TLDR

DAO tokens are trading in a range of 90-95% of the value of the ETH that back them. This has been as low as 80%. This evidences that there is value to be had for TheDAO to offer instant ETH liquidity to DAO token holders (DTHs). If the TheDAO was buying back tokens at a rate of 110 DAO tokens : 1 ETH, TheDAO and its ongoing DTHs would benefit. It would be instantly and risklessly accretive, i.e. all remaining DTHs will get a small return. This design offers several other benefits to both redeemers and TheDAO. Redeemers get anonymity (don't have to touch an exchange), immediacy, and liquidity. TheDAO gets the arbitrage, removes participants that aren't invested in the concept, and likely slows down the rate of outflows (so-called "Jentzsch Radiation").

Bonus. This would be a clear example of TheDao solving a real-world agency problem at which real-world funds and governance structures fail. So when someone says, "Yeah but like TheDAO is dumb there is no advantage to it over a VC fund or any other fund and you’re all idiots trying to recreate the wheel," here's an advantage.

Background to discounts in Closed Investment Funds

A closed investment fund is a of capital raised by a manager. That manager then invests that capital on the behalf of the fund's shareholders. The closed part means that investors can't just call up and get their original capital back directly from the manager. The capital is locked up perhaps forever or perhaps for 10 years. The underlying value of a closed investment fund's assets that is attributable to their shareholders is referred to as their Net Asset Value, or NAV.

Like TheDAO today, closed investment funds often trade at discount to NAV. Fidelity's screening tool lists the median discount for closed-end funds (CEFs) as 6.48%. CEFs are only one type of closed investment fund. Discounts to NAV for closed investment funds can happen for many reasons: the NAV is not reliable; an imbalance of liquidity demand/supply; people are bearish on the fund’s particular niche. The solution seems simple. Such funds should buy back their shares when they trade at market prices that are below NAV per share. The fund will instantly recognize a riskless return for its continuing shareholders. It is considered industry best practice for discounted buybacks to happen programmatically/automatically upon the occurrence of a set level of discount that occurs in the market (10%, 15%, and so on).

But this happens rarely, if ever. Why not? Agency problems.

The managers of closed investment funds earn fees based on the size of assets they manage. Every share they buyback and retire is a reduction in the size of the assets they manage. If a manager chooses to buyback shares, that manager is choosing to reduce the manager’s own income. Managers are rarely selfless, so what is best for the underlying shareholders is not what happens . And so the discounts to NAV persist.

Here's an example from normal finance of substantial (20% as an asset class) discounts to NAV persisting: Buybacks New Best Practice

Proposal for TheDAO and How It Works

TheDAO (and all future DAOs) should offer instantaneous liquidity for a price. TheDAO should programmatically buyback all tokens at a 10% discount or simply a 110 token : 1 ETH rate today. An open question for further inquiry is whether this rate should be dynamic as TheDAO spends its ETH on projects.

The Contractor would get nothing from this. All the benefits will go to TheDAO.

What do Redeemers get?

This proposal gives redeemers value:
• Anonymity (no need to touch an exchange -- this is key)
• Immediacy
• Liquidity

Closed investment funds, to which TheDAO bears the most resemblance, only offer liquidity to shareholders by means of irregular, infrequent, and small discounted buybacks or when they unwind and go into liquidation. Otherwise, shareholders can only get liquidity on secondary markets and often only at substantial discounts to NAV. Using programmatic buybacks, TheDAO would be able to demonstrate an innovation on traditional funds that adds clear value.

What does TheDAO get?

This proposal gives ongoing DTHs value:
• Instantly value accretive. More ETH inside TheDAO per DAO token. A small riskless return for long-term DTHs.
• Removes DTHs who are not suitably invested in the concept of TheDAO.
• Example of TheDAO’s governance being advantaged over the real world.
• Slow down the rate of Jentzsch Radiation.

Why is this especially great?

This is a real world example of a governance problem that TheDAO can solve. This has been a common critique of TheDAO -- there's no point, it's a mess, existing governance designs work just great.

Why should there be a cost to redeem one's DAO tokens?

To offset the costs redeemers impose on TheDAO (and any DAO). Redeemers impose several costs, including, but not limited to:
• The cost of having an uncommitted participant. Uncommitted participants undermine the decision-making process of a collective entity. It’s an unfortunate cost given that many people participated just as a free option.
• The cost of uncertainty about how much capital TheDAO actually has to invest. It’s hard to evaluate how much to spend on structural issues for TheDAO when we don’t know if it’s really a 12 million ETH entity or a 3 million ETH entity. It’s hard to know how to choose between productive projects and what the relevant opportunity costs are when you don’t know your capital constraints.

Why do real world investment funds have gates?

Real world investment funds have gates. Gates are size and timing limitations on investor redemptions of capital. The reason is that a fund manager can't properly plan and make investment decisions if they don't know how much capital they will have to deploy in in 1 week or 1 month or 3 months. When funds don't have effective gates, dealing with redemptions requires that a manager make sub-optimal capital allocations to account for potential redemptions. This may mean an overallocation to cash and liquid securities like treasuries; it may mean an underallocation into particularly illiquid assets that are otherwise attractive investments. Redemptions make it more difficult to make the optimal long term decisions. They impair the ability to be patient.

For funds that have only daily gates (daily redemption mutual funds), the uncertainty caused by redemptions is a significant drag. Beyond the uncertainty and the indirect costs it imposes on a fund manager, there is an actual direct financial cost for these redemptions. Namely the bid/ask spread that exist in the markets for the underlying assets of the funds. Many daily redemption funds have sales charges that apply to subscribing or redeeming investments in the fund. They do that as another way to discourage churn.

Links et Cetera

This is an adaptation of psdev’s buyback proposal. It grew out of a conversation with him and the guys at CoinFund.
psdev's original Consider.it. proposal

DTHs were not in favor of this 100:1 buyback proposal because DTHs want patient capital in TheDAO and they don’t want uncommitted DTHs fleeing en masse. This new proposal allows uncommitted DTHs that wish to leave with their ETH to do so but in a way that creates value for everyone that does stay. Win-win.

psdev's preliminary code adapted from Attores' DGD swap contract: http://testnet.etherscan.io/address/0x40D6F648F67d00A514d759f4fAbE4eCce925b266#code

Problems Unsolved

Q: Should the rate be dynamic and adjust to reflect ETH spent?

My gut would say “maybe.” I ginned up a model I can share with anyone in the CoinFund slack. It would only value the ETH still held by TheDAO and not spent, with no value ascribed to any DAO reward tokens. Reward tokens don't exist yet and will be difficult to programmatically value.

Q: What ETH pool should be used to fund these buybacks? How much should be set aside? For how long? When is that ETH returned to TheDAO?

My strawman would be that the buyback should be perpetual and the ETH should automatically be send to the Contract as needed. The easiest way to do it is probably to set aside X amount for some duration Y into the relevant contract and have everything returned to TheDAO after Y expires.

Q: Should the token be destroyed or held by TheDAO?

Held by TheDAO or in a TheDAO controlled contract might mechanically be the simplest. In the real world, when shares are bought back they are destroyed and thus the denominator in the earnings/share calculation decreases.

Q: Should there be an automatic SELLback that perpetually raises more ETH at a crooked price?

I.e. 1 ETH for 50 DAO tokens. This is instantly value accretive, so I would say yes but reasonable people can disagree about this. Such issuance would not benefit from any past reward tokens created but would benefit from any prospective reward tokens.

Q: Are there exploits that can take advantage of this complexity?

Maybe. Nothing is obvious. The buyback structure is something that exists in the real world. There could be social attacks that are used to scare people about liability associated with TheDAO or the inability to splits and thus stimulate interest in selling DAO tokens below NAV. Socially, I’d say to all DTHs that care about the value of their tokens, you should avoid being scared, you should do your due diligence on every proposal and you should be sure to vote.

Q: Are costless splits dumb in a DAO fundraising model?

Yes. They give people a free option and gum up a democratic, collective process with flippers and people who are not actually invested -- in all senses of the word -- in the given DAO. It’s a misalignment of incentives.

How to Help

This idea needs to be refined but I wanted to get it out there to the community. You can help by giving your feedback on all the issues at hand. Economic and technical feedback are needed in equal measure.

Inspiration/DAO superstar: /u/paleovanguard aka psdev
Author: /u/eeksskee
Review/Feedback: CoinFund Community Slack