Whitepaper.pdf - Julian Kuan

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Safeforge: Towards an Optimal Store of Wealth Julian Kuan November 13, 2022 Abstract Economic and financial theory, following Markowitz and Sharpe, posits the existence of an optimal risk-adjusted portfolio, the best possible risky-asset portfolio. In practice, it has been very difficult to predict this optimal portfo- lio, resulting in the market holding many different mixes of assets. Safeforge is a protocol that is designed to communally find this ideal portfolio formula, and hence, create the best possible token for a long term passive investor to store their wealth. The Safeforge protocol creates SAFF, a token backed by an index of as- sets. There are two main members of the Safeforge token community, storers and forgers. Storers simply buy the Safeforge token and enjoy the optimised portfolio. Forgers create branches on the current main portfolio, putting up collateral of their own against its performance. The branches created by forg- ers are tested for a period of 6 months with real money, and the overperforming branches are merged into the main formula, with the responsible forgers being rewarded, while the underperformers are discarded, with the loss borne by the collateral. Collateralised improvements reduce the chance of noisy strategies being chosen, as successful strategies have already been filtered by forgers. 1 Introduction For as long as human civilisation has existed, there has been the possibility of accu- mulating wealth. Whether it was by farming, craftsmanship, or trade, as civilisation spread, people began accumulating more wealth than they could spend in the short run. Thus there began to be an interest in long term stores of wealth. Gold has fulfilled that role for much of human history, alongside other valuable and scarce resources (at various times salt, beads, and silver were all used as long term stores of value). More recently we’ve seen people store wealth in Bitcoin, as well as index funds. When investigating these stores of wealth, there are three main features that all of them contain. The three requirements are (1) It must be anti-inflationary, prefer- ably growing, (2) It must have relatively low volatility, (3) It must be somewhat 1 liquid. There is a fourth requirement – that there must be almost no chance of catastrophic loss. All the stores of value discussed above fulfil each of these three requirements, to varying degrees of success. Assets that violate 1. (e.g cash), 2. (e.g derivatives), or 3. (exotic art) can function sometimes as stores of wealth, but they never become mainstream. Regardless, all of these stores of wealth have their benefits and disad- vantages, but there is one thing that is constant about all of them – none of them were designed to be stores of wealth. Safeforge is the result of asking the question of what a store of wealth would be if it was ideally designed. When looking at the foundations of modern finance, Markovitz’s (1952) Modern Portfolio Theory, we find a very interesting conclusion. Following the logic of William Sharpe (1964), under certain assumptions (the key practical one is access to leverage at the risk free rate), there should be a optimal risky portfolio of assets. This is the portfolio with the best risk adjusted return – the portfolio with the highest Sharpe Ratio. The conclusion is that everyone should own an amount of this optimal portfolio, borrowing or lending according to their risk preference. In practice it has been impossible to find the optimal Sharpe Ratio, forward looking portfolio using traditional techniques. Even if a method was found, it would quickly be out of date as market conditions change. Safeforge is designed as a community driven approach to the problem of the store of value. Given that no individual has been able to find the optimal portfolio, it makes sense that we work together as a community to find it. There is a base formula that is improved continually by the community through a competitive process, with ad- justments to the formula being tested in real time, with real money. The Safeforge formula therefore becomes a constantly improving formula that will approach the Sharpe ideal as a store of value. Initially, Safeforge will be launched on the blockchain, limiting the assets that the protocol has access too. We believe that the future of finance lies on the blockchain, and that all assets will eventually be tradable on it. Safeforge therefore is a protocol that looks to grow from it’s initial point as the optimal store of wealth in the Crypto space, to the optimal store of wealth in the world. 2 Theory Refresher Here is a brief description of Markowitz’s Modern Portfolio Theory to illustrate the theoretical basis of Safeforge’s goal. It is short – more detail for the interested can 2 be found in many places. We start with a universe of assets I, each with an expected return µi and an return variance σi2 . The assumption is that individual’s utility is increasing in return and decreasing in variance (as people dislike risk). Individuals can take the assets in the universe and combine them into portfolios. Each portfolio will have their own expected return µp and expected variance σp2 . We will not prove this (this can be looked up in many textbooks), but the expected return of a portfolio is given as the simple weighted sum of expected returns of the constituent assets: X µp = wi µ i (1) i Where wi is the proportion of the portfolio that is put in asset i. Variance (Risk), acts in a very different way – risk sums non-linearly, so it is very possible to build a portfolio that has lower risk than any of it’s constituent assets: X XX σp2 = wi2 σi2 + wi wj σij (2) i i j6=i Where wi is the proportion of the portfolio that is put in asset i, and σij is the covariance between asset i and asset j. Constructing all possible portfolios, and keeping in mind that people prefer higher returns and lower risk, we can find, for every given risk level, an optimal portfolio. This constructs the efficient portfolio frontier. In a world without lending, any of the portfolios along the efficient frontier can be optimal – which one is best for an individual depends on that person’s risk aversion. Sharpe(1964) extended the model to include borrowing and lending at a risk free rate. Adding this to the model expands the options available – now individuals can construct a portfolio of the risky asset and the risk free asset. Combinations of the risk-free asset and any portfolio create a straight line with the slope being the risk adjusted return – the Sharpe ratio: µp − E[Rf ] Sp = (3) σp Where E[Rf ] is the expected return on the risk free rate, and σp is the standard deviation of the portfolio. 3 With the addition of lending and borrowing at a risk-free rate, the optimal risky portfolio becomes the portfolio with the highest Sharpe ratio – any other portfolio’s risk-return profile can be beaten by a combination of that portfolio and the risk-free asset. 3 The Safeforge Token and the Ecosystem The Safeforge token (SAFF) is the central product of the Safeforge protocol. SAFF is a token that is backed by a basket of assets – everytime a new SAFF is minted, the underlying assets are purchased automatically using the Safeforge smart contract. The ecosystem consists of three main actors – storers, who are the main users of our protocol, forgers, who work on improving the underlying formula for the good of the entire community, and protectors, who provide a hedge against large movements in return for a constant return. SAFF is a token whose value is derived from an index of other assets. Initially those assets will be purely cryptocurrency based, but as the number of available assets increase on the blockchain, it is foreseen that eventually the Safeforge Token will eventually be backed by real world assets as well. 3.1 Storers Storers are the central users of the Safeforge protocol. A typical storer will be an in- dividual that wants to store some of their wealth, but doesn’t have the time/knowledge/interest to build their own portfolio. SAFF allows these individuals to gain access to an op- timised portfolio, by simply purchasing the SAFF token. A storer does not need to do anything more to store their wealth. The funds used to purchase SAFF are converted to the assets based on the current formula. A storer is always guaranteed at least the risk adjusted return of the cur- rent base formula, as any new branches created by forgers are backed by collateral provided by the forgers, which is forfeited to the storers in the event of underper- formance. 3.2 Forgers The Safeforge protocol can be thought of as a tree (or a Github Repo), with the trunk containing the main portfolio. Forgers create branches, which are adjustments to the main portfolio. The most promising branches are merged back into the main 4 portfolio, thus creating a cycle of continuous improvement. Forgers are the explorers of the Safeforge community – they’re the people who take the protocol and improve it over time. There are two main reasons why forgers must exist in the Safeforge ecosystem – one, they allow us to communally approach the optimal portfolio in way that an individual cannot, and it allows us to update the optimal basket of assets over time – as things change in the world, the optimal weighting formula will change as well. 3.2.1 Evaluation of Branches Forgers create branches, which are adjustments to the main formula. Branches (in- cluding the main branch) are evaluated by the 6-month observed Sharpe Ratio: E[Rp − Rf ] Sp = (4) σp Where Sp is the Sharpe Ratio, E[Rp − Rf ] is the average return over the risk free rate, and σp is the standard deviation of the portfolio. Branches are evaluated over a 6-month period. At the end of the 6 months, a branch that has overperformed the main portfolio will be merged back into the main port- folio, while a branch that has underperformed will be discarded. 3.2.2 Creating a Branch In order to test their new algorithms, Forgers need to stake a certain amount of SAFF. This stake enables them access to Safeforge funds to test their formula changes, but their own wealth is held as collateral against their performance. If the branch underperforms the main branch over a 6-month period, then a por- tion of the collateral is forfeited to the protocol. The amount forfeited is equal to the amount required to make the risk adjusted return equal to the main branch – ensuring that storers always get at least the risk adjusted return of the main branch. In return for taking this risk, forgers are rewarded when their formula update does outperform the main branch. They receive both a long run and a short run gain: a proportion of the overperformance (initially set at 50 %, but subject to change by a vote of the Governance Token holders), as well as a certain amount of governance tokens. 5 Other people can also stake behind specific forgers, enabling good branches to be tested. An individual who stakes SAFF as collateral behind someone elses branch receives a share of the rewards given. 3.3 Protectors Protectors are the third group of the Safeforge protocol, to be launched after the main protocol with storers and forgers is launched. A protector commits their wealth to a central pool. In this central pool different benchmarks are purchased, each of them representing another store of wealth: Bitcoin, a Bitcoin/Eth mix, a balanced portfolio of stablecoins, etc. A storer can rent a protection pool by paying a fixed amount to the protectors. In return, after every three month period, the storer will be able to swap their SAFF for the protection pool asset at a rate fixed at the beginning of the three month period. In essence the protectors are selling a put option, denoted in SAFF, for the protection pool asset. The price of the protection pool will be market driven, with the yield for protectors being determined by the demand for protection. 3.4 Growth of SAFF Over Time SAFF is not a supply limited token. There are two ways that new SAFF can be created. The first is the most straightforward: Anyone can come to the Safeforge protocol and mint a new SAFF by providing cryptocurrency. The Safeforge token will have a small amount of inflation built into into the SAFF token. Every 6 months (epoch), the protocol will automatically mint up to 1 % of the existing SAFF supply. This SAFF will be used for upkeep of the protocol, im- provements on the protocol, and will ultimately be controlled by governance token holders. 4 Safeforge Formula Requirements The Safeforge Formula is designed as a linear weighting of assets within an Asset universe A. Factors are constructed using publicly available data. Forgers can introduce new assets and new data sources (factors) to the ecosystem by staking. A significant benchmark of wealth (determined by the community) needs 6 to be staked behind each new asset and data source to ensure that they’re reliable. In this way Safeforge will continue to grow as the number of assets on the blockchain increase. Also, as the underlying financial regime changes, Safeforge will be able to adapt as well. 5 Governance Token Safeforge is envisaged as a fully decentralised, community run and maintained store of value. The entire process of going from a centralised team to a fully decentralised protocol is expected to take 5 years, until 2028. With this goal in mind Safeforge will launch governance tokens (SAFG). Unlike SAFF, SAFG will be limited in supply. To honour the power of exponential growth that underpins long term investing, SAFG will be limited to 271828182 to- 7 ken, which is e10 rounded to the nearest whole number. These tokens will be distributed as follows: • 15 % to Investors • 10 % to Founders • 18 % to Team • 5 % to Key Community Contributors and Advisors • 47 % to the Community • 10 % in Treasury 5.1 Community Distribution The 47 % of tokens that is allocated to the community will be distributed between storers, forgers, and protectors. The initial tokens will be distributed over a 5 year period, split up into 20 epochs of 6 months each. The amount of tokens that will be given out every epoch is given by the formula: a(−x2 + 20x) (5) Where x is the number of the epoch, and a is a constant that is chosen so that all of the allocated tokens are given out by the end of the 20 epochs. 7 This means that tokens will be given out to the community in a first increasing, then decreasing fashion. The goal is to initially grow the number of tokens with the community, rewarding all the community members that have contributed to Safe- forges growth, and then, once Safeforge has grown to a large size, begin limiting the emissions of governance tokens. 6 Conclusion This paper lays out a methodology for the creation of a token that will become an optimised store of long term wealth. Safeforge’s token is designed to have optimal risk-adjusted return, based on an optimised index formula. Safeforge’s protocol, relying on communal updates (from forgers), allows the formula to remain optimal, despite changing market conditions. Storer are protected by the fact that forgers must put collateral upon creating and testing their branches. Protectors complete the ecosystem, allowing any storer to further limit their downside risk. Safeforge will initially launch on the blockchain, but the ultimate vision is to go beyond just cryptocurrencies. The Safeforge team strongly believes that blockchain technology is the future of finance, and that eventually all the different assets, from real estate to equities to small business shares, will be tradable on it. Safeforge will grow alongside this general blockchain adpotion, becomming the store of wealth for the 21at century. 8