In Credora’s Morpho Market Methodology, governance tokens are assigned no probability of default. In comparison to various types of derivative tokens or stablecoins, there are no underlying credit exposures for governance tokens in isolation.
For example, holders of WBTC absorb smart contract and custody risks (via BitGo). Holders of governance tokens also absorb smart contract risk, although historically there have been minimal incidents of successful exploits at the token contract level. That said, the governance tokens are directly tied to specific applications, and application smart contracts may indirectly expose users to a broader set of smart contract risk, where there are varying degrees of complexity.
Current Approach
Although Credora assigns no default risk, governance tokens generally display relatively high volatility. Additionally, Credora inserts historical market tail events, or extreme market moves which result in a more conservative asset pair return profile. Where a specific asset has a limited history, Credora assigns a proxy asset.
As an example, the Eigen token has the following 30-day volatility against the select base assets.
| Loan Asset | Collateral Asset | 30-day Volatility |
|---|---|---|
| USDC | EIGEN | 5.75% |
| USDC | WETH | 4.70% |
Additionally, MKR is used as the proxy asset considering Eigen’s limited history. As the time period for consideration is the prior 3 years, this results in the insertion of multiple large single day price moves.
The combined return profile is utilized in Monte Carlo simulations, where the following table displays the adverse price moves associated with a specific percentile, where USDC is the loan asset and EIGEN is the collateral asset.
| Percentile | Daily Price Move |
|---|---|
| 90th | 10.47% |
| 95th | 12.27% |
| 99th | 16.14% |
Potential Enhancement
The remainder of this post explores whether or not the above approach is sufficient. There is an indirect relationship amongst governance tokens, and the associated applications. Where there are major smart contract breaches or incidents in the latter, they typically have a direct impact on the governance token price.
Consider the following historic example:
Mango Markets
- In October 2022, a ~$117 million exploit occurred.
- On the exploit, the price of the token dropped from ~$0.40 to ~0.17, or a ~57% loss.
Credora is considering enhancing the methodology by considering the risk of the set of smart contracts that are tangent to a specific token, where currently there is no default risk assigned.
Let’s explore an example of the enhancement:
Credora currently assigns a probability of default to various smart contracts. This is calculated using the smart contract custody methodology. For example, EigenLayer smart contracts are assigned a 0.27% PD. Note, this is the isolated risk assigned to the smart contracts, and does not consider the additional risk of restaking activity (Credora methodologies assess this separately).
According to Credora methodologies, the corresponding Loss Given Default (LGD) range for a 0.27% PD or BBB- implied rating is 4 - 13%. The LGD range targets the loss of assets from a protocol (i.e. the exploit amount relative to TVL), rather than the decline in the governance token. In the context of a wrapped token, a 5% exploit of TVL is expected to result in a roughly 5% decline in the price. Governance tokens are typically more volatile, and their value is arguably valuing protocol growth, where an exploit event may materially impair future expectations. As a result, and for simplicity in the initial version, we propose using 2x the LGD range, or 8 - 26%.
As an adjustment to the Morpho Market Methodology, Credora is proposing considering the PD of associated smart contracts when analyzing markets which utilize their governance tokens. In the case of USDC as the loan asset vs. EIGEN as the collateral asset, this results in the following changes to the probability of specific adverse price moves:
| Percentile | Daily Price Move (Current) | Daily Price Move (PD) |
|---|---|---|
| 90th | 10.47% | 10.78% |
| 95th | 12.27% | 12.89% |
| 99th | 16.14% | 19.01% |
Overall, this is a more conservative approach as it applies to governance tokens. It recognizes that although holding governance tokens does not directly expose users to a material amount of default risk, an exploit of associated smart contracts creates risk for excessive price volatility.