DeFi’s ‘honest’ market manipulation

This article is part of Crypto Insights, a segment by major crypto exchange Bybit that dives into the latest and most pertinent issues in the crypto space.

Decentralized finance (DeFi) voting systems are anonymous and “trustless,” which means that each vote is immutably recorded and open for verification. In a strange twist of fate, this system has created a boisterous market for DAO votes.

Photo credit: Shubham Dhage

Decentralized autonomous organizations (DAOs) run some of the most powerful protocols in crypto. They use smart contracts to democratically vote on proposals that affect the business or nature of the protocol.

Usually, the voting process is open to holders of the DAO’s governance token — a crypto asset that can be traded on the open market. DAO members deposit their tokens in a smart contract and receive voting rights in return.

However, it turns out that many holders of these governance tokens bought them as an investment or a speculative trade, not to be bothered with the business of governance. So several protocols sprung up and offered to sell these unused voting rights on the open market and split the profits with the original holders.

For example, look at Curve Finance, a cornerstone of the DeFi world. It generates billions in daily trading volume with very low slippage. Currently, Curve has nearly US$6 billion in “total value locked” — a measurement that shows the amount of money held in its smart contracts, according to DefiLlama.

Curve allows holders of its veCRV governance token to vote on which trading pairs will command the rewards for liquidity providers. Essentially, veCRV holders play kingmaker for any new stablecoin that is released because they can direct liquidity — the lifeblood of the coin — to its trading pair or choke it off.

Enter Convex Finance. The team behind this protocol realized the value of controlling Curve votes and set about accumulating as many as they could. Today, Convex is the largest voting block for Curve.

Several market actors have tried similar moves to accumulate a controlling stake in the Curve voting process. Convex remains the largest, directing about 50% of Curve votes, according to Dune Analytics.

Bribery in DeFi

One of the hardest things for a new DeFi project is bootstrapping the liquidity to create robust trading pools for their token. By “bribing” — Curve’s words, not mine — members of Convex (which is to say, any holder of the Convex governance token), new projects can drive liquidity to their trading pair and give themselves a higher chance of attracting the capital they need to thrive.

So, whoever controls Curve controls the stablecoin market, and whoever controls Convex controls 50% of the votes on Curve. Stablecoin issuer Frax Finance realized this and accumulated voting power in Convex.

Frax Finance now has the largest Convex position, controlling over 6% of supply. This allows it to direct incentives to its FRAX+3CRV pool on Curve in perpetuity.

Redacted Cartel is another DAO that offers Curve and Convex votes for sale. It controls over 2% of the supply for CVX (Convex’s token) and allows stakers of its Btrfly token to decide which Curve pools will receive votes.