Optimizing FIP-77's TWAMM Parameters

Governance Proposals FIPs
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This is Ouroboros Capital. We are a liquid crypto fund that prides ourselves as vocal hands-on investors of our bags (FXS included).

The protocol has recently resumed its TWAMM FXS Buyback program again, kicking it off with a $2mn buyback over 6 months. I’m writing this proposal for us to consider parameters to which we can optimize for to design a much better buyback program.

Objective of Buyback
To start, we have to first understand what the buybacks are attempting to achieve. To put it simply, the buyback program’s objective is for the protocol to accumulate $FXS at prices which it deems $FXS to be undervalued. This delivers a spectrum of benefits including but not limited to 1) POL value accretion, 2) signaling a valuation floor to the market which consequently helps the protocol with more economic use of $FXS as incentives, 3) warehousing $FXS at cheap prices to be used in the future as it grows it value, etc.

Optimize for Acquiring $FXS at Low Prices
Now that we’ve established that the objective of the buybacks are to buy $FXS cheap and signal a psychological price floor to market, I would like to propose parameters which would help optimize for that. I am proposing for a more aggressive TWAMM that increases in magnitude at lower levels but also stop buying $FXS at a higher levels.

What is The Right Size and Price?
Historically the TWAMM buyback have been the most effective at establishing a price floor between the $4-5 level. A level that we should also agree is only more of a value floor as time passes given the growth of the protocol Frax v1 to Frax v2 AMO, Fraxlend, FraxFerry, FrxETH, etc. As such I recommend the program to target these price levels given the historical context.
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However, it is evident that these price levels are not visited for long. Since the introduction of the TWAMM buyback program last year, the price range of $4-5 has only been visited for 74 days. A mere ~20% of the days in the year. We will not be able to efficiently capture the value that presents itself if the TWAMM is spread across a period such as 6 months. Instead, I propose a $1mn TWAMM that spans over 1-month (30 days), buying only when price is below $5 and an additional $1mn 1-month TWAMM on top of it that starts buying only when price is below $4. The price limits circumvents the protocol chasing FXS higher and stops once the original objective of establishing a price floor has been achieved.

This more aggressive buyback would 1) create a stronger signaling to the market and 2) allow the protocol to more promptly capture these rare value windows.

Digesting Existing Sell Flow
It is worth highlighting too that the Uniswap and FraxSwap pools have seen an increase in ~74K $FXS since 5 days ago when price dipped below $5. Assuming $5 FXS, this is ~$370K of FXS sold in 5 days (~$2.2mn in 30 days) which the above proposed $2mn TWAMM should be able digest.

I welcome any suggestions and hope as a community we can work towards designing a better buyback program.

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Another point worth noting. Amongst the Top 100 wallets that hold $FXS. Only 4 have sold in the past 7 days. For context, wallet #100 holds ~$200K of $FXS. Those 4 wallets combined have less than $4mn of $FXS. If those holders are willing to sell half their holdings at below $5 and the other half at below $4 - 2 batches of these proposed TWAMMs should digest all big sellers.

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Also the last twamm order was 1 month in duration, so why lessen this one’s impact by 5x this much further into a bear market?

Completely agree with this proposal. If you’re going to show strength to the market don’t undermine that with such poor parameters.

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The right price is below intrinsic value. Buying back above intrinsic value transfers value from long term holders of FXS to sellers. Buying below intrinsic value will transfer value from sellers to long term holders of FXS. Without a framework for at least being directionally correct on intrinsic value, buybacks risk value destruction for FXS holders.

What is intrinsic value?
A conservative approach is to say intrinsic value is residual value + current assets

The components of residual value are the cost of capital and 1 year earnings to the treasury. As I’m new here the below numbers maybe incorrect and pointing out correct sources for the data would be appreciated.

going off Frax Finance : the one year accumulated profit is ~+18M. I’ll assume of cost of capital of 8%. Therefore residual value = 18M/0.08 = $225M

According to DefiLama Treasury value excluding native tokens is: $530K

So intrinsic value is $225.5M.

Current market cap is $356M.

If we assume an average purchase price of $4.50, that is 10% lower, so a marketcap of $320M at purchase time.

The return to FXS holders is: (cost of capital)/(1-percentage undervalued)

Even at $4, at 20% discount to current price, that gives a marketcap of $284M which is still a premium to intrinsic (assuming the inputs are correct). So the return would be negative.

However let’s use the scenario that FXS drops to $3, a marketcap of $142M or a 58% undervaluation to intrinsic value. The expected return on buy back in such a case would be (0.08/1-0.58) = 19%

Using $2m as the buyback amount at $3, that would return an additional $380K to long term holders of FXS.

Of course intrinsic value is subject to change by increasing profits, adding new projects to intrinsic value and factoring growth into residual value. However factoring in these things makes the calculation more aggressive and risks overpaying and thus destroying value for long term holders of FXS.

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My view on this is if we become too academic on these things, we will end up not being able to execute on any buybacks which would then defeat the purpose on such a mechanism. Price is often not a function of academic models. If a DCF model can properly price a stock then we wouldn’t have bad investors. Historical price levels reflects the psychological “fair price” the market ascribes to an asset. Right or wrong, that’s what everyone in the room thinks is the consensus standard of “cheap”.

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The issue is your saying price is not always equal to value and then say we should use price as a proxy for value.

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the “problem” with the analysis is that the 8% is completely subjective. could just as easily say 5% which would correspond with a 20 PE and we are at fair value. the public markets are currently at a 25 PE, so I don’t know why an early stage growth company would be 12.5 (perhaps some discount because it’s in a risky industry…) but the valuation isn’t going to be agreed on by everyone. The only thing to do is put it to a vote and see what the DAO thinks. If they think $4-5 is overvalued, then they should vote no, and perhaps put up a new vote for $3-4. If they think $4-5 is good value, then they should vote yes.

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8% is my mental estimation based on a long run minimum expected annual return required for giving capital to such a project given the risk vectors. I agree a valid alternative is to put up for a vote what the hurdle rate should be. If you want a more precise way to approximate the cost of capital here it is:

The long term risk free rate 10-year is 3.77%.
The bottom up 2024 earnings estimate for the S&P 500 is 246.68
S&P index: 4409
S&P forward yield = 5.6%
Equity risk premium = 1.83
FXS beta against SPY = 1.2
FXS cost of equity = 3.77 + 1.2*1.83 = 5.95%

Using 5.95% for cost of equity would give a higher valuation. My point is not that it’s not over or undervalued, it is that a framework should be used for determining buybacks otherwise there is a risk of value destruction for FXS long term holders.

Using this cost of capital residual value is $305M. It doesn’t scream undervalued. Perhaps there are investments in product development that would increase residual value and would provide a much better return on that $2m?

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all that is fair, but essentially that’s what this vote is, and it’s up to the voters to decide what they think. i suspect most won’t actually be that thorough in their evaluations, but I would expect the above vote to pass as is. You are certainly welcome to suggest an alternative vote in a place you are more comfortable, but I personally think this is reasonably close to fair value. I’m personally buying more in the 4.50-5.00 range. /shrug

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What do you expect earnings to the treasury will be over the next year?

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Mostly it doesn’t matter to me. I’m much more concerned about the long term opportunities. I think the most likely outcome is 0, but the potential opportunity for stablecoins is measured in trillions. so the difference in a 250 mil or 350 mil valuation isn’t that meaningful. It will either be worth 0 or much much more in 10 years. That said the frxeth/sfrxeth business might add the potential for a non zero floor price potentially. Overall the odds are that 10 years from now the valuation won’t be anywhere close to current. it will either be near 0 or much bigger.

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Then why vote to return capital to token sellers instead of investing it in projects to increase the probability of those future outcomes?

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I don’t think I said anything about how I’d vote, just noting the other side of the conversation, and that valuation is subjective. If there is some development that is currently unfunded we should definitely do that, but I’m not sure that’s the case (i guess we could always hire more devs…). Marketing is … tricky … in the current environment. I think I’d probably just put the money towards the CR personally, but don’t have a problem with the buyback. I’d expect the token to be higher in the future, and we aren’t burning them, we can use them for investing in the project at a future date. It’s essentially a question of holding this piece of the treasury as usdc or fxs. As long as the runway is funded, i think it’s mostly fine.

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First of all, I want to say great discussion and really great commentary. I’m wondering if we should wait at least another 2-3 days to see if anyone else has any modifications/feedback?

As for my own overall views:
1.) I think we should try to keep it simple and clear so that when this gets translated for a formal vote on Snapshot and if it should pass, then it is actionable and clear exactly what parameters there are. I agree with the general idea that the TWAMMs should be sped up as the price ever goes down to $4, $3, $2. And in general I also agree with the other direction that we should slow down/stop the TWAMMs in amount+duration as the price rises toward $7, $8, $9, $10+.

2.) There should still be some discretion in terms of overall duration for how long to use the remaining $20m allotment. For example, it’s unknown how long the market will remain bearish overall and prices depressed. It would be unwise to spend all the allotment extremely quickly and then sit idly by as FXS continues to trade at depressed prices (assuming a long bear market which isn’t a certainty). Simply put, the protocol’s buyback allotment is finite and we don’t have infinite “dry powder.” The duration of macro headwinds is finite as well but the length of time it will remain is not known.

Overall, I think this is a pretty good proposal with the intent to maximize value long term for FXS holders at an improved rate than the previous FIP-77 loose parameters.

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The funds usage should be compared against alternatives. What else could the $20M be put towards that would increase long term value?

The one concern I have in this discussion so far is a lot of talk about price but little talk about underlying value.

A buyback would likely boost price in the short term over alternatives, why is this important?

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Well I don’t agree on some of the objectives. This has a I want a pump vibe to it. Before posting this some one said “6months has no price impact” and OP replied with “hold my beer” before posting this.(edit: this is just a fun jab and can be ignored)

But I do think that Frax buying back is NOT to guard some price point or to “signal valuation to the market”. It’s merely to pull some fxs back into treasury to be used later when it thinks it could be cost efficient in the long term. It’s not like there’s infinite powder to protect or it’s part of the protocol’s mandate. I only see it as to reserve some potential fxs to use again later.

I’m ok with some price points where acceleration can be made. The suggested two tiers is fine. No need to over complicate things.(and define a price ceiling is fine too)

I however don’t think it needs to be rushed to 1 month. Slow accumulation can fit the goal of the buybacks just as well, if not better. If frax ends up spending the whole allocation then that’s fine, if price goes up and the twamms stop then that’s fine too.

Edit: I guess one thing that’s not clear to me is if this is a recurring change or one time. Is this for 1-2m every month until exhaustion? Or 1-2m and then reevaluate?

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Well put. I think in order for this gov proposal to be translated to a formal vote, 2 things need to happen:

1.) Clearly explain how much of the remaining 20M from FIP77 are these parameters referring to.

2.) Explain what said parameters are in stepwise instructions. Ex: At $4 FXS, place a $2M TWAMM over 1 month etc.

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A few points here that I’d like to address.

  1. Signalling a Valuation Floor - I personally think that this is in fact a strategic objective for the protocol and NOT a mere exercise of price speculation. The protocol emits 6,250 $FXS per day at the moment (~$11.4mn based on $5 $FXS). A strong psychological valuation floor signal, will help emissions achieve better effectiveness. Not just emissions but also bribes and CR; moving parts that have $FXS price as an input. Further, this is a measured proposal that aims that buy $FXS at prior lows despite the protocol having grown significantly since those levels. In other words, we are not simply “pumping price” but initiating these buybacks with a premise

  2. 30 Days - The reason 30 days had been proposed was due to it covering the lengths of time that price has previously dipped the $5 level. See dates below. It is also very likely that the TWAMM does not complete when its initiated due to the effectiveness of the buyback allowing price to quickly recovering back to $5.

Prior Dates since FIP-77 when $FXS is below $5:

  • 7-9 Jun '22 (2 days)
  • 13-20 Jun '22 (7 days)
  • 28 Jun - 5 Jul '22 (7 days)
  • 12-14 Jul '22 (2 days)
  • 20 Sep - 8 Oct '22 (18 days)
  • 12 Nov - 5 Dec '22 (23 days)
  • 22 Dec '22 - 6 Jan '23 (15 days)
  1. Recurring or One-Time: I recommend we test the proposal out first and later re-evaluating when as we go. Tweaking the parameters (size, time and price) as we deem fit later.
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Correct me if I’m wrong but wasn’t the market cap back then nearly 1/4th the size it is now? Did underlying value increase 4X to justify buying at those same prices?

What’s the criteria by which this would be successful or not?

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Hey guys, this is Jake from Bastion Trading. Now that FXS price has been rallying, I think its a good time to sell put options with low strikes and earn extra yield on FRAX Treasury. Because FXS put options buyer needs to hedge the exposure, option buyer (Bastion) needs to keep buying FXS when FXS prices goes down. Also, if price ends up below the strike levels, Bastion needs to buy all contract amount of FXS in the market, which will contribute to FXS price rallying (this is due to Bastion delivering FXS to Frax Treasury. Let me know what you guys think. We can be flexible in terms of strike, size and maturity so that Frax Treasury can benefit from this proposal.