This work was funded by the AADAO.
Author: Noam Cohen / Binary Builders
Dynamic Community Pool Tax & Reserve Management
Blockchain protocols are micronations, each with their own citizens, culture and goals. With the Cosmos Hub we are currently participating in one of the most interesting decentralized governance experiments in Web3. Every ATOM holder is part of this journey where we’re figuring out how to steer the ship together.
Nations and corporations alike practice rational financial management; when times are good we (hopefully) put money aside, and when times are bad, we ideally make sure we use those reserves to cover our costs.
With this post, I’d like to start a discussion on how, by partially transitioning to a USD-based expense model, the Cosmos Hub can practice automated rational financial management to increase the available resources to cover its operational expenses in the long term.
The Problem
While kickstarted at Tendermint and maintained by the ICF, the Hub is transitioning to an independent, ATOM-led community that’s now able to fund it’s own future path. With the AADAO in full motion, research & development being funded directly through the Community Pool, and liquidity deployment a common occurrence, we need to start gearing up to guarantee the necessary funds for the years to come.
With over $100m worth of ATOM and NTRN sitting in the community pool, things are looking relatively bright, but we must remember that not long ago this was a very different scenario. Most protocol foundations actually practice some form of asset management: in bull markets they tend to spend more to accelerate growth and convert some of their assets to fiat to guarantee resources during bear markets.
It’s time for the ATOM community to consider the same. There are two complementary approaches to this:
- Create a variable Community Pool tax based on the price of ATOM: If ATOM does well, a higher percentage goes to the CP. If ATOM is performing badly, a lower amount is taxed.
- Design mechanisms to convert some tokens to stablecoins: This does not have to be a huge percentage at all, and we must take care not to affect the price of AEZ tokens. But a combination of manual & automated conversions can help us achieve longevity. Potentially, these stablecoins could be used to buy back ATOM when some conditions are triggered during a bear market, driving the price up when needed most.
A significant amount of our expenses can actually be expressed in fiat. Developers can’t pay their rent with ATOM and funding requests from Informal/Hypha & the AADAO took a fiat-first approach to assessing how much was needed. Partially transitioning to a USD-based cost model allows us to offer more long term stability in operational expenses while still offering a reasonable amount of ATOM upside to incentivize developers.
How would we go about doing this? First we need to address the problem of trying to time the market. Because:
You Can’t Time The Market…
That’s correct, but let’s use an analogy to understand how we can still optimize for longevity:
Imagine a fisherman who fishes to feed his family. The amount of fish he catches each day varies because of circumstances beyond his control, such as the weather and seasonal migration. There are days of abundance and days when he won’t have enough to feed his family. Without knowing what will happen in the next few months, the fisherman is incentivized to keep some amount of fish in storage for bad days. As such, on a day where he catches more than his family can eat, he keeps some of the fish and preserves it through freezing. In days of unexpected abundance, he might even sell some to the open market so that he can buy other foods to feed his family in times of need.
The fisherman cannot “time” the sea, but he can assess daily whether his catch was sufficient to keep some in stock. There is no guarantee this will work forever, but he keeps his family well-fed for longer while also learning how much to ration over time. Similarly, the Cosmos Hub can assess daily whether its “catch” (i.e. inflation + revenue) was more than usual over a certain period and potentially set some ATOM aside for later, or even convert some to stablecoins if the excess was overwhelming.
So what would this Fisherman’s Protocol look like?
Part 1: Dynamic Community Pool Tax
If we read the price of ATOM through an oracle, we can calculate a moving average (MA) of the price over the last several hundred days (I’m using a 655-day MA). Based on the distance between the current price and the MA, we can calculate whether today was a good day or not.
If we then take a minimum tax percentage that goes to the CP (let’s say 5%), and a maximum in case of peak bull market (20%), we can calculate a dynamic CP tax that depends on the delta between the price and the MA like this, where the blue area in the bottom indicates the CP tax rate:
Note: to illustrate my point, all my examples assume this model has been running since genesis.
Approaching it this way should guarantee two things:
- There is slightly more ATOM available for validators and delegators in the bear market.
- There is a higher total of ATOM available in the CP during bear markets. For example: based on the above parameters and my calculations that you can check in the interactive chart below, there would have been a 33% increase of available ATOM in the CP during the market low in June 2022.
While this does mean that ATOM rewards decrease slightly during a sustained market rally, the USD income is still increasing because the price of ATOM is going up. This is particularly relevant for validators who need to make sure they can pay their operational bills in fiat.
Part 2: CP Reserve Management
Converting some of the CP’s assets to stablecoins would guarantee that we have more assets available in the long term, although we obviously should only convert when ATOM is performing well. We can consider two approaches:
Manual Conversion
Through a governance proposal, a certain amount of tokens can be transferred to a multisig that is tasked to convert them to a basket of stablecoins. This can be done through OTC deals, trade on the open market over an extended period of time, or by providing collateral for algorithmic stablecoins like IST (and actively managing that position to prevent liquidation), the latter of which could be automated to some extent using protocol covenants.
Organizations like the AADAO or similar minded groups are well positioned to execute on the above. For example, the AADAO has already managed the deployment of the Stride POL request in prop 800.
While manual conversion require trust assumptions that we’d all be keen to avoid, they are a stepping stone towards a fully automated and decentralized future.
Automatic Conversion
There are two parts to converting some amount of the CP automatically to stablecoins:
How much and how often to convert
Two parameters are needed here:
- The token / stablecoin ratio for each asset: E.g. for ATOM we could say, we’d like a maximum of 15% to be available in stables.
- The maximum percentage of tokens that can be converted on a single day: E.g. setting the parameter to 1% would mean that of the 15% that we want allocated to stablecoins in the long term, we’re converting up to 1% per day. I.e. 1% of the 15%, not 1% of the total CP! This number is modified by how well the ATOM price is doing.
We can use the same performance indicator we use to calculate the dynamic CP tax. If the price of ATOM is above the moving average, the Hub attempts to convert up to its maximum allowed percentage on that day (anywhere between 0 and 1%). If the price is below the MA, we assume it’s a bad time to convert ATOM.
If we assume the above suggested parameters, the treasury would accumulate stablecoins like this, where the light green color indicates the USD in the treasury:
If we compare that to not converting at all, we can see that the total available funds expressed in USD during a bear market is considerably lower:
The difference is very significant. If we again take the bottom of the bear market on June 19th, 2022, we see that 15% conversion leads to a total of $123m USD being available in the CP, compared to $61m USD at 0% conversion. The general outcome of this mechanism is that the volatility of the CP stabilizes over time.
You can experiment with this spreadsheet and the charts here. I encourage you to duplicate the document and change the parameters on the first sheet to test out various outcomes.
Please note that this spreadsheet is a simple approximation to this mechanism to illustrate the point. There are a few details to mention:
- It only covers ATOM, there is no NTRN in this example.
- There is no outflow from the CP. I.e. the money isn’t being spent.
- It assumes this mechanism was in place since genesis.
- There is some historical data missing about inflation rates and I’ve made several assumptions before 02/17/2021 and after 07/17/2023 that are noted in the document.
Where and how to convert
This is the tricky part. There are several approaches possible and they all have their pro’s and cons:
- Interfacing with DEXes and selling on the open market: While simple in theory, there’s significant complexity around connecting to a multitude of exchanges and managing the trading across them based on the available liquidity. It’s also extremely easy to be front-run and likely has the largest price impact, which is something we want to avoid.
- Automated stablecoin minting through posting AEZ tokens as collateral: This is not the most capital efficient method because we’d need to overcollateralize the position. Additionally, there’s significant complexity involved in making sure we reduce the position in the case of price volatility. It won’t allow us to maintain the reserves during a bear market.
- Using an auction-based system: By offering a daily auction that operates within certain bounds, we can significantly reduce the complexity of converting tokens as we can leave it to the arbitrageurs in the open market to find the most capital efficient way to convert. This secondary market enables us to indirectly access both centralized and decentralized exchanges. Furthermore, it offers an attractive location for traders to accumulate ATOM. This is the least complex solution with the lowest price impact while still enabling long term USD reserves. This mechanism could also be used if the community decides it would be preferable to convert some of the USD back to ATOM during a bear market.
Timewave is building out an auction based system that could accommodate our goals of maintaining a USD reserve. This would mean the Hub would contain some logic that automatically sends the desired amount of ATOM to convert to a contract on Neutron, on a daily basis. The auction has a starting price and a minimum price, below which no ATOM would be sold. If the auction does not completely convert all the funds, it will be returned to the Hub and we try again the next day.
I encourage the Timewave team to elaborate on the workings of their model to illustrate how this can be achieved.
Conclusion
By enabling a dynamic Community Pool tax rate, and converting some amount of the CP’s assets to stablecoins, we can assure that the Cosmos Hub will be able to maintain funding longevity for our core development teams, grants and protocol owned liquidity deployments in the many years to come.
As the financial markets are recovering, I believe now more than ever is the time to open the debate around this topic. We are at a critical point in time where the ATOM community can decide whether the Hub is ready to mature to a sustainable token-based economy that can set a standard for the hundreds of autonomous decentralized communities in the Interchain and beyond. My hope is that we can get a governance proposal going in the near term and that Binary Builders and Timewave can build out the required logic for this as soon as possible.
I appreciate your time in reading this post made in collaboration between Binary Builders and the AADAO, and look forward to discussing this with our community 
