Price Exposure and Voting Power

The simplest method of controlling voting power in a decentralized protocol is to own the underlying governance token outright. Owners receive power in proportion to their stake, with capital invested serving as a form of bond against negative behavior.

Owners are exposed to governance token price changes in 1:1 parity to their voting power. Their percentage ownership stake in the underlying network is insensitive to price changes, and is solely dependent on their buying and selling decisions.

Uniswap and similar decentralized exchange platforms offer a unique form of asset exposure.

Owners provide liquidity of a governance token along with another asset (such as a USD stablecoin or Ether), and the exchange protocol makes the liquidity available for traders to swap against according to a preset formula (X * Y = K). Liquidity providers earn accumulated fees from traders, but experience losses from changing reserve proportions when the relative price of the supplied assets shift.

For a given sum of capital invested into a Uniswap pool, half of the value would be held in the governance token with half in another reserve asset. Typically tokens deposited in external defi protocols can’t participate in governance, but protocols that use snapshotting mechanisms (also known as checkpoints) can accommodate voting from within AMM pools. Existing examples of this include Yam Finance and Sushiswap, which have opted to include tokens in AMM pools in their Snapshot voting systems.

In cases where AMM voting is not supported natively, a wrapper contract could be employed to deposit underlying tokens into the governance contract or delegate voting power, while still allowing the tokens to be traded or used in an external defi protocol. This means protocols have limited scope to discourage this sort of ownership structure, other than restricting contract interactions with the underlying governance system (similar to Curve Finance’s smart contract whitelisting).

AMM liquidity providers have lower exposure to price changes in the underlying governance token on a dollar for dollar basis. But with only ½ of pool value invested in the governance token itself, the price exposure per unit of voting power is very similar to direct token ownership.

Users generally borrow assets on defi platforms in order to sell them short, in the hopes of buying them back at a cheaper price and profiting from the difference. This requires the user to put up a deposit of collateral, which can be liquidated under certain conditions to ensure loan repayment. Short sellers have opposite price exposure to token holders, but the act of selling the tokens removes their voting power so this misalignment is not so problematic from a governance perspective.

Alternatively, a user could borrow tokens from a lending platform and then use them to participate in governance instead of selling on the market. This would result in a neutral price position, as any change in token price will be counterbalanced by an equivalent change in the value of the user’s debt. This is substantially more risky for protocol governance, as the user would be insensitive to token price drops caused by malicious proposals or other negative voting behavior.

This mode of governance engagement is limited by lending platform support, capital requirements, and borrowing costs. Cryptocurrency lenders require users to post collateral that exceeds the value of their borrowed tokens, so acquiring a given value of voting power through borrowing could require twice as much (or more) initial capital as simply purchasing the governance tokens. Lenders also adjust interest rates based on market supply and demand, so borrowing a large amount of a particular token could lead to increasing rates and high recurring costs for holding the position.

As the cryptocurrency markets have matured, a wide range of derivative products have emerged to meet user demand for hedging or leveraging their positions.

The dominant instruments, futures and perpetuals contracts, track the value of an underlying asset (such as a governance token) and allow for users to post collateral to take leveraged long or short positions. In cases where the market price of a contract diverges from the underlying token price, borrowing costs incentivize traders to buy or sell contracts to bring the price back in line.

Futures tracking governance tokens don’t confer any voting rights in the underlying protocol. But, they do allow token holders to efficiently hedge their price exposure. A user could hypothetically purchase governance tokens and use them to participate in voting, while at the same time selling equivalent value of futures contracts. Any increase or decrease in price of owned governance tokens would be offset by the derivatives position.

With retained voting power and zero token price exposure, this type of position is very similar to the borrowed tokens position described above. But there are a few key differences which may make derivatives strategies more attractive to users.

Derivatives platforms tend to allow much greater leverage than lenders, which means a user can hedge their price exposure to governance tokens with a lower collateral deposit and better capital efficiency. For example, a user seeking to hedge voting power on a borrowing platform that permits up to 3x leverage would need to deposit collateral worth at least 50% more than the value of their voting power. If the user instead chose to hedge their position on a futures platform permitting 10x leverage, their excess capital requirements would drop to only 10% of the value of voting power.

And while borrowing rates on lending platforms cannot go below zero, derivatives platforms have two sided funding rates that allow contract sellers to earn positive yield on their position when market conditions are bullish. This means that a derivatives position may face lower carrying costs over time than a similar borrowed token position.

A final mode of ownership we review is using governance tokens as collateral for a loan (commonly known as a collateralized debt position or “CDP”). Users can access short term funds or meet needs for liquidity by posting their existing assets as collateral. While users must pay interest on the borrowed amount, they can retain full exposure to the underlying collateral asset and don’t need to abandon potential future upside.

To protect against defaults, lending platforms institute minimum collateral requirements and liquidation fees. If the ratio of collateral value to loan value falls below the required levels, the lending platform can involuntarily sell users’ assets to repay their debt, and withhold the specified fee as a penalty.

The chart below shows the profit or loss of the CDP based on underlying token price. This analysis assumes the borrowed funds are held in a price neutral position (eg. using funds to earn yield in an external protocol such as Curve Finance). The price exposure is generally equivalent to outright ownership, until the position’s collateralization level falls below the liquidation ratio. When this happens, the user’s collateral is sold to repay the debt and penalty fee, and they are left with zero price exposure.

Let’s consider a case where a user does not invest loan proceeds into yield generation, but instead uses them as collateral for a derivatives position. By selling futures contracts equivalent to their governance token collateral assets, the user can hedge their profit and loss across most of the price curve. Borrowing the funds needed to serve as derivatives collateral also improves capital efficiency, allowing the user to maintain the hedged position without additional investment beyond the cost of governance tokens.

Troublingly, this strategy experiences improved profitability at the bottom end of the price spectrum. When users post their assets as loan collateral, in a way the lender is implicitly agreeing to purchase the collateral at the liquidation price (similar to a put option) — paired with a short derivatives position, this creates a problematic PnL profile. A user holding this position could have strong economic incentives to inflict harm on the underlying protocol.

Among all of the modes of ownership considered, outright ownership and AMM liquidity provision seem to be the most incentive aligned. Each unit of voting power owned results in positive exposure to the success of the underlying protocol, which helps protect against rational attacks and malfeasance. Governance systems not already supporting voting from within AMM liquidity pools may want to consider how to safely include these users in governance, which could help improve participation and engagement.

Token borrowing and derivatives hedging present a greater challenge, as users can obtain voting rights without direct exposure to the underlying. While there are funding costs involved in keeping their exposure hedged, these may be insignificant compared to potential gains from self dealing or governance attacks. Governance systems can address these risks via a few methods.

To the extent that derivatives and lending platforms are altruistic or concerned with their reputation, they may be persuaded to limit access to short exposure (borrowing or derivatives) on governance tokens. This seems fairly unlikely in the long run, as each platform can argue someone else would provide the service if they do not. The Aave community has already expressed their reservations about limiting token borrowing for these reasons.

Alternatively, protocols can encourage token holders to starve lending and derivatives platforms of liquidity. For example, a protocol could offer incentives for depositing tokens in the governance contract, which would make supplying tokens to lenders or opening long futures positions relatively less attractive. This lowers available liquidity and increases the cost of hedging governance token exposure, making these strategies less viable.

Most lending platforms don’t currently support governance participation from within borrowing positions. In these cases, users have no voting power regardless of tokens owned within their collateral position. But, certain lenders including Aave and Compound are beginning to experiment with utilizing voting power, and other platforms such as MakerDAO could be adapted to give users control of their collaterals’ embedded governance rights.

Protocols have tended to consider pledged collateral and CDPs as low risk, with Yearn even specifically granting voting power to tokens held within MakerDAO vaults (in Yearn’s case this only covers snapshot votes, without any direct execution risks). However, collateralized debt positions implicitly offer users an embedded put option on their collateral, and borrowed funds can also be used for hedging purposes. This makes collateralized lending positions potentially the most capital efficient way to stage a governance attack or other negative use of voting power.

Protocols should carefully consider the risks before supporting voting from within collateralized debt positions, particularly for voting mechanisms that control funds or admin privileges. The decision to support collateral voting power may be made by the lending platform without consulting underlying protocols; this presents a challenge as any platforms that refuse to offer voting to clients may be at a competitive disadvantage, similar to the argument against restricting governance token borrowing.

Protocols’ most coherent and feasible response may be to limit voting and participation from smart contracts — reducing risk from CDPs, as well as from other potentially malicious contracts. This approach was pioneered by Curve’s whitelisting mechanism, which requires governance approval before a contract address can interact with governance.

In summary:

• Voting from within automated market maker (AMM) pools poses low risk of misaligned incentives

• Lending and derivatives platforms create considerable risk by enabling voters to hedge price exposure

• Governance systems can’t limit lending or derivatives directly, but they may be able to deter this behavior by incentivizing staking

• Collateralized debt positions pose an under-appreciated risk to governance, but protocols can mitigate this by restricting smart contract interactions with governance

The simplest method of controlling voting power in a decentralized protocol is to own the underlying governance token outright. Owners receive power in proportion to their stake, with capital invested serving as a form of bond against negative behavior.

Owners are exposed to governance token price changes in 1:1 parity to their voting power. Their percentage ownership stake in the underlying network is insensitive to price changes, and is solely dependent on their buying and selling decisions.

Uniswap and similar decentralized exchange platforms offer a unique form of asset exposure.

Owners provide liquidity of a governance token along with another asset (such as a USD stablecoin or Ether), and the exchange protocol makes the liquidity available for traders to swap against according to a preset formula (X * Y = K). Liquidity providers earn accumulated fees from traders, but experience losses from changing reserve proportions when the relative price of the supplied assets shift.

For a given sum of capital invested into a Uniswap pool, half of the value would be held in the governance token with half in another reserve asset. Typically tokens deposited in external defi protocols can’t participate in governance, but protocols that use snapshotting mechanisms (also known as checkpoints) can accommodate voting from within AMM pools. Existing examples of this include Yam Finance and Sushiswap, which have opted to include tokens in AMM pools in their Snapshot voting systems.

In cases where AMM voting is not supported natively, a wrapper contract could be employed to deposit underlying tokens into the governance contract or delegate voting power, while still allowing the tokens to be traded or used in an external defi protocol. This means protocols have limited scope to discourage this sort of ownership structure, other than restricting contract interactions with the underlying governance system (similar to Curve Finance’s smart contract whitelisting).

AMM liquidity providers have lower exposure to price changes in the underlying governance token on a dollar for dollar basis. But with only ½ of pool value invested in the governance token itself, the price exposure per unit of voting power is very similar to direct token ownership.

Users generally borrow assets on defi platforms in order to sell them short, in the hopes of buying them back at a cheaper price and profiting from the difference. This requires the user to put up a deposit of collateral, which can be liquidated under certain conditions to ensure loan repayment. Short sellers have opposite price exposure to token holders, but the act of selling the tokens removes their voting power so this misalignment is not so problematic from a governance perspective.

Alternatively, a user could borrow tokens from a lending platform and then use them to participate in governance instead of selling on the market. This would result in a neutral price position, as any change in token price will be counterbalanced by an equivalent change in the value of the user’s debt. This is substantially more risky for protocol governance, as the user would be insensitive to token price drops caused by malicious proposals or other negative voting behavior.

This mode of governance engagement is limited by lending platform support, capital requirements, and borrowing costs. Cryptocurrency lenders require users to post collateral that exceeds the value of their borrowed tokens, so acquiring a given value of voting power through borrowing could require twice as much (or more) initial capital as simply purchasing the governance tokens. Lenders also adjust interest rates based on market supply and demand, so borrowing a large amount of a particular token could lead to increasing rates and high recurring costs for holding the position.

As the cryptocurrency markets have matured, a wide range of derivative products have emerged to meet user demand for hedging or leveraging their positions.

The dominant instruments, futures and perpetuals contracts, track the value of an underlying asset (such as a governance token) and allow for users to post collateral to take leveraged long or short positions. In cases where the market price of a contract diverges from the underlying token price, borrowing costs incentivize traders to buy or sell contracts to bring the price back in line.

Futures tracking governance tokens don’t confer any voting rights in the underlying protocol. But, they do allow token holders to efficiently hedge their price exposure. A user could hypothetically purchase governance tokens and use them to participate in voting, while at the same time selling equivalent value of futures contracts. Any increase or decrease in price of owned governance tokens would be offset by the derivatives position.

With retained voting power and zero token price exposure, this type of position is very similar to the borrowed tokens position described above. But there are a few key differences which may make derivatives strategies more attractive to users.

Derivatives platforms tend to allow much greater leverage than lenders, which means a user can hedge their price exposure to governance tokens with a lower collateral deposit and better capital efficiency. For example, a user seeking to hedge voting power on a borrowing platform that permits up to 3x leverage would need to deposit collateral worth at least 50% more than the value of their voting power. If the user instead chose to hedge their position on a futures platform permitting 10x leverage, their excess capital requirements would drop to only 10% of the value of voting power.

And while borrowing rates on lending platforms cannot go below zero, derivatives platforms have two sided funding rates that allow contract sellers to earn positive yield on their position when market conditions are bullish. This means that a derivatives position may face lower carrying costs over time than a similar borrowed token position.

A final mode of ownership we review is using governance tokens as collateral for a loan (commonly known as a collateralized debt position or “CDP”). Users can access short term funds or meet needs for liquidity by posting their existing assets as collateral. While users must pay interest on the borrowed amount, they can retain full exposure to the underlying collateral asset and don’t need to abandon potential future upside.

To protect against defaults, lending platforms institute minimum collateral requirements and liquidation fees. If the ratio of collateral value to loan value falls below the required levels, the lending platform can involuntarily sell users’ assets to repay their debt, and withhold the specified fee as a penalty.

The chart below shows the profit or loss of the CDP based on underlying token price. This analysis assumes the borrowed funds are held in a price neutral position (eg. using funds to earn yield in an external protocol such as Curve Finance). The price exposure is generally equivalent to outright ownership, until the position’s collateralization level falls below the liquidation ratio. When this happens, the user’s collateral is sold to repay the debt and penalty fee, and they are left with zero price exposure.

Let’s consider a case where a user does not invest loan proceeds into yield generation, but instead uses them as collateral for a derivatives position. By selling futures contracts equivalent to their governance token collateral assets, the user can hedge their profit and loss across most of the price curve. Borrowing the funds needed to serve as derivatives collateral also improves capital efficiency, allowing the user to maintain the hedged position without additional investment beyond the cost of governance tokens.

Troublingly, this strategy experiences improved profitability at the bottom end of the price spectrum. When users post their assets as loan collateral, in a way the lender is implicitly agreeing to purchase the collateral at the liquidation price (similar to a put option) — paired with a short derivatives position, this creates a problematic PnL profile. A user holding this position could have strong economic incentives to inflict harm on the underlying protocol.

Among all of the modes of ownership considered, outright ownership and AMM liquidity provision seem to be the most incentive aligned. Each unit of voting power owned results in positive exposure to the success of the underlying protocol, which helps protect against rational attacks and malfeasance. Governance systems not already supporting voting from within AMM liquidity pools may want to consider how to safely include these users in governance, which could help improve participation and engagement.

Token borrowing and derivatives hedging present a greater challenge, as users can obtain voting rights without direct exposure to the underlying. While there are funding costs involved in keeping their exposure hedged, these may be insignificant compared to potential gains from self dealing or governance attacks. Governance systems can address these risks via a few methods.

To the extent that derivatives and lending platforms are altruistic or concerned with their reputation, they may be persuaded to limit access to short exposure (borrowing or derivatives) on governance tokens. This seems fairly unlikely in the long run, as each platform can argue someone else would provide the service if they do not. The Aave community has already expressed their reservations about limiting token borrowing for these reasons.

Alternatively, protocols can encourage token holders to starve lending and derivatives platforms of liquidity. For example, a protocol could offer incentives for depositing tokens in the governance contract, which would make supplying tokens to lenders or opening long futures positions relatively less attractive. This lowers available liquidity and increases the cost of hedging governance token exposure, making these strategies less viable.

Most lending platforms don’t currently support governance participation from within borrowing positions. In these cases, users have no voting power regardless of tokens owned within their collateral position. But, certain lenders including Aave and Compound are beginning to experiment with utilizing voting power, and other platforms such as MakerDAO could be adapted to give users control of their collaterals’ embedded governance rights.

Protocols have tended to consider pledged collateral and CDPs as low risk, with Yearn even specifically granting voting power to tokens held within MakerDAO vaults (in Yearn’s case this only covers snapshot votes, without any direct execution risks). However, collateralized debt positions implicitly offer users an embedded put option on their collateral, and borrowed funds can also be used for hedging purposes. This makes collateralized lending positions potentially the most capital efficient way to stage a governance attack or other negative use of voting power.

Protocols should carefully consider the risks before supporting voting from within collateralized debt positions, particularly for voting mechanisms that control funds or admin privileges. The decision to support collateral voting power may be made by the lending platform without consulting underlying protocols; this presents a challenge as any platforms that refuse to offer voting to clients may be at a competitive disadvantage, similar to the argument against restricting governance token borrowing.

Protocols’ most coherent and feasible response may be to limit voting and participation from smart contracts — reducing risk from CDPs, as well as from other potentially malicious contracts. This approach was pioneered by Curve’s whitelisting mechanism, which requires governance approval before a contract address can interact with governance.

In summary:

• Voting from within automated market maker (AMM) pools poses low risk of misaligned incentives

• Lending and derivatives platforms create considerable risk by enabling voters to hedge price exposure

• Governance systems can’t limit lending or derivatives directly, but they may be able to deter this behavior by incentivizing staking

• Collateralized debt positions pose an under-appreciated risk to governance, but protocols can mitigate this by restricting smart contract interactions with governance

<100 subscribers

<100 subscribers