Hedging Liabilities with Aera
December 22nd, 2022

Throughout the development of DeFi lending protocols, the best way to manage protocol funds for sustainable growth and risk coverage has been a major open question. As a customizable optimization platform, Aera offers a compelling solution for the treasury management needs of DAOs. Primarily, lending protocols need to provide coverage for insolvencies (loan losses) that may be realized in market shocks. 

Though protocols can reduce losses with active risk management, there is always some risk that markets move too abruptly for loans to remain sufficiently collateralized. In these scenarios, protocols rely on their treasury to provide an additional backstop. To achieve this objective, treasury managers want to select an appropriate portfolio of assets to provide reliable coverage under any conditions.

Diversification vs Hedging**

In the search for a reliable treasury strategy, the concept of diversification is often referenced. While diversification can provide some benefits, the more accurate way to represent the objective of a lending protocol treasury is liability hedging. The level of losses the treasury may have to cover is highly uncertain, and so is the market value of treasury assets at any given time. In a liability hedging framework, the role of treasury management is to align these two uncertain quantities such that the assets always exceed the liabilities.

In this sense, the protocol’s goal can be expressed with a single key metric: the expected solvency buffer under stressed market scenarios. Liability hedging may overlap with the idea of diversification, but the optimized portfolios are generally materially different. While there are many ways to achieve fixed diversification, the more nuanced problem of liability hedging is perfectly suited for Aera.

Aera Solution

The goal of Aera is to help protocols solve this hedging problem with automated rebalancing vaults that target customizable objectives. Since an Aera vault can be set up to optimize almost any quantifiable metric, treasury management with Aera can efficiently adapt to changing market conditions and user needs. Beyond simply diversifying, third-party Guardians within Aera can use live data and analytics to inform real-time rebalancing decisions.

With this more flexible approach, a protocol’s allocation across assets can be tailored to match its specific risk profile. Since this hedge more closely matches the liabilities, it does not have to be as large as a reserve fund allocating to less well-matched assets. As an alternative to fixed or ad hoc treasury allocation, a customized and data-driven Aera vault can provide valuable benefits to protocol safety and efficiency.

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