🗳 Deep Dive into Meta-governance
By: Nate Parton
Tags: Decentralized Finance, Governance, Ethereum, Defi, Asset Management

As projects steadily devolve power to their communities, the importance of protocol governance is becoming more and more apparent. Governance decisions can impact critical system parameters, token reward distributions, and various integration and whitelist permissions.

With so much at stake, it’s striking that governance participation is extremely low across the board. Prominent protocols such as Uniswap and MakerDAO have seen initiatives fail due to low voter turnout, with even highly visible proposals relying on a small subset of active token holders for support.

High participation costs are a key driver of voter apathy. Beyond the transaction fees required to submit votes in many protocols, users need to dedicate time and effort to evaluating proposals and voting within irregular timeframes. Several protocols are now seeking to address these scalability issues through vote aggregation and meta-governance.

Vote Aggregation

Vote aggregators use their intermediary positions to influence governance decisions of underlying protocols. There are a couple approaches being pursued within the ecosystem, with all seeking to rectify the cost and time scalability issues inherent in direct governance participation.

Vote aggregators protocols fall into two main categories: lenders and asset managers. Lending protocols naturally accumulate governance tokens as deposits and collateral, while asset managers allocate client funds towards governance tokens as part of their strategy.

In this post, we’ll take a look at the current leaders in meta-governance, considering how their implementations will impact voting and participation in underlying protocols.

Index Coop

Index Coop is the asset manager of the Defi Pulse Index (DPI), a collection of 9 sector specific tokens controlled via Set Protocol’s framework. Token weights are rebalanced once per month based on market capitalization, so the governance token constituents of the index can be easily used for voting in the interim period.

While DPI holders gain economic exposure to the underlying tokens, governance rights are controlled by INDEX token holders. This allows DPI to remain a fully passive investment, relying on the asset manager community to protect their interests through voting.

Index Coop’s current implementation supports voting in governance systems based on token snapshotting, including Aave, Compound, and Uniswap. Whenever a vote in an underlying protocol is scheduled, a corresponding Snapshot poll will be posted for INDEX owners. If voters come to a majority with at least 5% quorum, DPI assets will be used to vote in the underlying protocol as a block. Index recently had its first meta-governance participation in Aave’s AIP-2 and AIP-3.

PieDAO

PieDAO’s defi indexes have heavy allocations to governance tokens. But their current implementation relies on Balancer smart pools to rebalance assets, which prevents the assets from being used for voting.

To overcome this limitation, PieDAO is developing a new framework for managing and rebalancing assets within its indices. The “ExperiPie” framework will allow PieDAO’s DOUGH holders to exercise governance rights and vote in underlying protocols. The indices will also be able to participate in yield farming using the system’s flexible support for contract interactions.

While this offers more flexibility than Index Coop’s snapshotting mechanisms, the ability to interact with various contracts also brings increased risk of bugs or mismanagement. PieDAO will likely need to create additional safeguards before pushing this framework into production.

Powerpool

Powerpool is another defi index manager, but with a specific focus on governance tokens and vote participation. Their core product is the power index, a collection of governance tokens that are rebalanced, traded, and lent out via Powerpool’s bespoke infrastructure. By integrating trading liquidity and lending into the core product, Powerpool offers depositors opportunity for additional returns over simply holding the tokens individually.

Users also receive liquidity incentives in the forum of Powerpool’s native CVP governance token, which controls protocol development as well as all voting rights in underlying governance systems.

Powerpool is unique in trying to take a more active approach to participation and network effects; they recently reached out to several prominent governance systems to solicit partnerships from community members. Powerpool has also raised eyebrows by including its native CVP token in each of its indices and taking an equal weight approach to asset allocation. While the proposed community partnership incentives may pose risk of conflicts of interest, Powerpool indices arguably have higher price exposure to underlying governance tokens due to divergence loss risk caused by equal weighting assets.

xToken

xToken is an asset manager that specializes in active strategies for individual governance and utility tokens. With many protocols now providing rewards based on participation, xToken makes it simple for token holders to maximize their earnings potential and impact protocol development.

xToken currently offers strategies for KNC, SNX, and AAVE tokens. While the SNX token strategy is fundamentally focused on yield farming and hedging, KNC and AAVE take active roles in protocol governance. They offer two separate strategies for depositors for both KNC and AAVE tokens, with each adopting a slightly different governance mandate.

KyberDAO’s governance process focuses on fairly well defined revenue allocation parameters, which makes KNC voting strategies relatively simple; one strategy votes to maximize governance incentives, while the other votes for market maker rebates. The two strategies for AAVE are more abstract, as each Aave governance proposal is unique and doesn’t follow a preset format. While xToken has stated voting will be based on centre-right vs centre-left politics, it’s not clear how they will apply this in practice.

Yearn Finance

Yearn’s vaults have traditionally focused on non-voting assets. But considering that so many vault strategies rely on CRV for their underlying returns, Yearn has a huge interest in CurveDAO governance. Yearn’s recently launched yveCRV vault represents a natural first step in vote aggregation.

Users who deposit CRV to the vault receive supplementary vault revenue sharing on top of the regular veCRV admin fees, but in exchange they give Yearn perpetual control over voting rights. This allows Yearn a greater say in Curve’s development and increased influence over reward distributions.

Yearn’s implementation is unique among vote aggregators, as tokens will be locked in perpetuity and users are not able to redeem their holdings. This could be risky for Curve governance, as Yearn may gain an ever increasing share of total voting power. Users also have no way of rescinding their votes if they disagree with Yearn’s voting behavior, limiting the scope for incentive alignment that exists in other protocols.

Compound

Compound’s two newest markets, UNI and COMP, offer interesting opportunities for vote aggregation. For each of these tokens, votes are based on delegation snapshots with no locking required, so it’s technically feasible for Compound’s money markets to exercise their governance power.

In the case of the cUNI market, Compound has already passed a governance proposal to activate and delegate voting power. A linked Snapshot polling space will allow cUNI depositors to signal on proposals, and final poll results will be executed on chain by Compound’s community multisig.

Aave

Aave’s money markets support key governance tokens including MKR and KNC. In their original implementation, these markets function the same as Aave’s other markets: assets are available to supply, borrow, or flash lend, but tokens that remain in the pool are inactive for voting purposes.

Aave recently proposed a revised market implementation for governance tokens to increase the security of adjacent protocols. Borrowing of governance tokens would be disabled, which prevents common voting manipulation attacks. At the same time, Aave would encourage relevant governance systems to grant voting rights to aToken deposits, allowing users to continue participating while they use their assets as loan collateral.

While Aave’s individualized approach gives up on the scalability advantages of Compound’s implementation, it also avoids potential risks of block voting and concentration of power. Voting with aTokens requires action from each related protocol, so it remains to be seen if this idea will gain the necessary traction across the ecosystem.

Governance Impacts

The vote aggregation mechanisms outlined above have clear potential to influence protocol governance. With most development occurring in the past few months, it’s too soon to evaluate historical track records, but the incentive structures built into these systems can help point towards their potential future impact.

Asset managers generally earn revenue based on a combination of management and performance fees. So while holders of INDEX, DOUGH, or CVP may not have price exposure to the protocols they vote in, they have an indirect incentive for prudent governance that will help increase asset value and AUM. The same goes for xToken and Yearn, which earn performance fees on staking rewards. Index managers may have greater risk of incentive misalignment, as they could potentially increase total AUM by favoring one of their holdings over another.

Typically, meta-governance frameworks require managed assets to vote as a single block. This gives vote aggregators considerable power as a Schelling point in distributed governance systems, similar to how special interest groups can have outsize impact in traditional governments. As aggregators increase in scale and relative voting power, it may become more cost effective to obtain governance rights through these entities rather than through direct exposure to underlying governance tokens. This is somewhat troubling when one considers aggregators may also have incentives for self dealing (for example, using voting rights in lending protocols to onboard their tokenized products as collateral).

Beyond alignment between token holders, certain vote aggregators also raise questions from a security standpoint. For example, Compound and Index use a multisig to enact token holders’ off chain snapshot votes within governance systems. This raises the possibility of faithless electors/signors executing their own vote preferences instead of the majority opinion.

Most of the vote aggregators feature redemption or withdrawal capabilities, which serve as a critical backstop for maintaining incentive alignment. If voting rights are misused, or otherwise lead to suboptimal governance outcomes, token owners are free to reclaim direct ownership of their assets. The notable exception to this is Yearn’s yveCRV vault, which cannot support withdrawals due to Curve’s vote locking requirements. While Yearn generally has aligned business interests and is itself a large CRV holder, token owners have no recourse if they become unhappy with its voting strategy.