Why Governance Tokens as Collateral Undermine Entire Ecosystems

Maker's stability relied on its own governance token, MKR, as a backstop. A ~60% drop in ETH price triggered mass liquidations, cratering MKR value and threatening the solvency of the entire $10B+ DAI system. This exposed the circular dependency: the collateral of last resort was the system's own equity.

• Reflexive Risk: MKR price drop impairs the very capital meant to absorb losses.
• Systemic Contagion: A failure to recapitalize would have vaporized DAI's peg, destabilizing protocols across Ethereum.

Aave v2's Safety Module staked its native AAVE token to insure protocol shortfalls. This concentrated $1B+ in risk into a single volatile asset. A major market downturn would liquidate staked AAVE, dumping the token and creating a death spiral that could bankrupt the insurance fund and the lending pool simultaneously.

• Correlated Failure: The insurer and the insured asset are the same.
• Ineffective Backstop: The module provides a false sense of security; its value evaporates when most needed.

The Curve Finance ecosystem binds liquidity, governance, and collateral through its veCRV model. Protocols like Convex Finance borrowed heavily against locked CRV to amplify yields. A severe depeg in Curve's pools could trigger a cascade: CRV price falls → Convex's CRV collateral is liquidated → CRV sells off further → Curve's gauge incentives collapse.

• Hyper-Correlation: Governance, liquidity, and collateral are the same token.
• Protocol Capture: The entire "Curve Wars" edifice is built on a single, manipulable asset.

Robust DeFi systems must separate governance from risk-bearing capital. The solution is collateral that is exogenous (outside the protocol's control) and non-correlated with its core business cycle. Think LSTs like stETH, real-world assets, or diversified basket tokens.

• Breaks Reflexivity: Protocol failure does not directly impair its collateral base.
• True Risk Isolation: Creates a genuine capital buffer, not a circular promise.

Governance token value is a function of protocol utility. Using it as collateral creates a positive feedback loop: price drop → forced liquidations → sell pressure → further price drop. This correlates financial and governance security, a critical design flaw seen in the 2022 contagion.

• TVL becomes a phantom asset during stress.
• Liquidations trigger cascading governance attacks.
• Undermines the risk separation principle of DeFi legos.

Maker's early reliance on MKR as backing for the PSM was a canonical case study in reflexive risk. The protocol had to aggressively pivot to real-world assets (RWAs) and diversify collateral to survive. This established the blueprint for stablecoin issuers.

• RWA exposure now exceeds ~$5B in Maker.
• MKR collateralization was a single point of failure.
• Proved that governance tokens are liabilities, not assets on a balance sheet.

Aave's Safety Module uses staked AAVE as a backstop for shortfalls, creating a misalignment of incentives. Stakers bear ultimate risk but lack direct control over the credit policies that create that risk. This concentrates systemic risk onto the protocol's most loyal users.

• Staked AAVE can be slashed up to 30% for a single incident.
• Creates a pool of last-resort liquidity that is highly correlated to Aave's own health.
• Contrast with non-correlated asset backstops used by newer protocols.

Robust systems separate money from power. Collateral must be exogenous to the protocol's success and exhibit low correlation to crypto-native volatility. This means ETH, LSTs, stablecoins, and RWAs.

• ETH/LSTs provide crypto-native but broad-based security.
• USDC/USDT offer stability but introduce centralization risk.
• RWAs offer yield but require legal scaffolding.
• The goal is de-risking the governance flywheel.