Understand why Compound, the leading DeFi lending company, can attract $4.5 billion in liquidity
Editor's Note: This article comes fromBabbitt Information (ID: bitcoin8btc), by kyle, published with permission.
Editor's Note: This article comes from
Babbitt Information (ID: bitcoin8btc)
Babbitt Information (ID: bitcoin8btc)
, by kyle, published with permission.
This article will introduce Compound, one of the leading projects in the DeFi lending track. Compound, released in 2018, now has a locked value of $4.5 billion. In June 2020, Compound released the governance token COMP, joining the DeFi summer boom. It will not be easy for Compound to maintain its status as the top lending protocol, especially since it has yet to implement a consistent revenue stream model. With the release of the Compound Chain plan, how can the project perform in 2021?
Compound - protocol overview
Compound is a protocol on the Ethereum blockchain that allows users to borrow and lend cryptographic tokens. Its interest rate is set algorithmically based on the supply and demand of each asset. Lenders and borrowers interact directly with the protocol, earning (and paying) floating rates without negotiating terms such as terms, rates, or collateral with peers or counterparties.
Launched in 2018, the protocol raised $8.2 million in a seed round and another $25 million in a Series A round in November 2019. The list of early investors reads like a who's who of blockchain VCs, including industry giants Andresen Horowitz, Polychain Capital, Coinbase Ventures and Bain Capital Ventures.
At the time of writing, Compound is one of the top three DeFi protocols by total value locked (TVL). The exponential growth in value locked in 2020 (from $15 million at the start of the year to over $1.9 billion by the end of 2020) reflects confidence and trust in the protocol. This strong growth has been supported by liquidity mining incentives, which, in our view, have little to do with Compound’s achievements.
History — Becoming a Main Pillar of DeFi
MakerDAO can be seen as the first DeFi project to allow users to take out loans, while Compound is the first to offer a permissionless lending pool where users can earn interest rates on their deposits. The Compound v2 whitepaper was published in February 2019 by Founder/CEO Robert Leshner and Co-Founder/CTO Geoffrey Hayes. Compound quickly became one of the mainstays of DeFi. Initially, the protocol supports six tokens (ETH, 0x, Augur, BAT, Dai, and USDC).
Since then, some additional tokens have been added to the market (some have been deprecated). Both the project team and the Compound community are constantly innovating. While the protocol was already popular with many active ethereum users, the protocol really gained traction when they announced that they would be rewarding their users with the protocol’s own governance token, COMP.
What started as a measure to increase decentralization became a pivotal moment for the entire Ethereum ecosystem, triggering what is now known as DeFi Summer 2020. In the next three months, countless projects adopted a similar method, rewarding their users with different tokens, chasing the highest yield among various projects, which is "yield farming".
Borrowing and lending - the use of cToken
Lending an asset to the Compound protocol results in two transactions. The first is to deposit the original token (such as Dai) into the protocol. The second is to automatically credit cTokens (cDai) to the wallet providing the asset. The newly issued version-c tokens serve as IOUs (IOUs) and act as a redemption token allowing holders to redeem the original tokens. The value of cTokens is determined by Compound through an exchange rate designed to increase in value over time.
By holding a cToken, the owner can earn interest through the appreciation of the cToken compared to its original counterpart. Therefore, when cashing out cTokens (i.e. cashing out), the user will receive more actual base tokens than was initially deposited. Borrowers, on the other hand, ensure that more tokens are paid to lenders by consistently paying a higher interest rate when borrowing assets. The actual rate is determined by supply and demand (utilization).
Borrowing - Overcollateralized Loans
Borrowing tokens on Compound is similar to minting Dai on Maker. However, compared to Maker, Compound requires users to store cToken as collateral. As with a loan, there are no terms to negotiate, maturity dates, or the length of time the loaned asset is financed. To mitigate default risk, Compound utilizes overcollateralization to limit the amount that can be borrowed.
The amount a user can borrow is determined by a collateral factor ranging from 0 to 1. A Collateralization Factor (CF) of 0.7 equals 70% of the value of the underlying asset that users can borrow. Below is an example of how much a user can borrow with a CF value of 0.5.
The interest rate for each token will again be algorithmically determined based on supply and demand (utilization).
If the amount borrowed exceeds the user's ability to borrow, a portion of the outstanding loan can be repaid in exchange for the user's cToken collateral. This liquidation can occur when the value of the collateral drops below the required minimum, or when the value of the borrowed tokens exceeds the maximum that a user can borrow.
Risks and Incentives
Aside from smart contract risk (i.e. hackers exploiting vulnerable smart contracts), another risk associated with money markets like Compound is that in the event of a bank run, the platform could run out of liquidity and be unable to meet all withdrawal requests. To mitigate this, Compound's interest rate is based on a "utilization ratio" which defines the extent to which a lender's assets flow to a borrower (see black line in the graph below). For example, if 80% of all available assets are borrowed, the utilization rate is 75%. As a result, only 20% of lenders have immediate access to their assets.
Through the interest rate model, Compound can disincentivize lenders from withdrawing, since interest rates rise when utilization rises (to incentivize borrowing), while disincentivizing borrowers to increase their borrowing (as it becomes more expensive to borrow money). The graph above shows an increase in the borrow rate (purple) and lend rate (green) as utilization increases.
Whether Compound can survive a black swan event like a bank run remains to be proven. Gauntlet underwent a simulated stress test in early 2020. Furthermore, Compound did survive Black Thursday in March 2020 (when Bitcoin and most other assets fell by more than 40% in one day), compared to other protocols much better. However, it was not in full DAO mode at the time.
The closest thing to a black swan event occurred in November 2020, when the price of the stablecoin Dai temporarily spiked to $1.3 on Coinbase. Compound uses the Coinbases price feed to determine its market price. Due to the sudden 30% increase in DAI price, some positions were undercollateralized, resulting in over 80 million collateral being liquidated.
Regardless, ensuring high liquidity is critical for Compound. High interest rates are one way to incentivize liquidity, but Compound has gone a step further and started incentivizing by rewarding users with COMP tokens.
Governance - handing over the protocol to the community
With the launch of the governance token in June 2020, the team behind the project took the first step towards decentralizing protocol ownership and governance. Compound started using the protocol to distribute its governance tokens to all individuals and applications — with an even 50/50 split between lenders and borrowers. Initially, token distribution is done automatically based on the usage of each token. This results in different rewards depending on which tokens the user provided or borrowed. However, with the implementation of Proposition 35, it has been changed so that the amount is partially fixed (10% per market) and the rest is variable based on usage.
At the time of writing, the daily COMP token allocation is 2,312. This distribution mechanism will continue until the reserves are depleted. It will take approximately four years for all of the 4,229,949 COMP tokens allocated to the reserve to be distributed. The remaining 10 million capped supply is allocated to the team and founders (22%, released over 4 years), shareholders of Compound Labs (24%), and future team members and community funds (4% and 8% ).
This innovative approach to transferring ownership of a start-up to its community has several important implications. This is most evident in the TVL graph shown at the very beginning. Although officially looking like voting rights, the token quickly attracted many new users, leading to explosive growth in the lending pool. Likewise, the price of the COMP token is another factor that indicates interest in owning a piece of the protocol.
COMP token
As mentioned above, the idea behind COMP is to increase the decentralization of the protocol, and this token is a tool to control the protocol. Governance can determine many things, such as:
Add support for new assets
Change the collateral factor of an asset
Changing the market's interest rate model
Change other parameters or variables of the protocol
Even compensate users (user assets are liquidated due to abnormal price feeds)
Essentially, protocol governance can be likened to governing a company through community voting, rather than a handful of managers behind closed doors. However, to be eligible to create a governance proposal first, the initiator must either hold 1% of all COMP tokens delegated to the wallet, or have at least 100 COMP to create an Autonomous Governance Proposal (CAP). A self-sovereign proposal allows anyone with less than 1% of total COMP to deploy a proposal (as a smart contract), which can be transformed into a formal governance proposal if it receives sufficient support and reaches the threshold of 100,000 delegated votes. All proposals must be submitted as executable code.
That said, COMP tokens currently have no other function. However, when considering price and market cap, it can be assumed that a value capture mechanism that favors token holders is expected. For example, similar projects such as Aave have implemented a fee that is collected by the protocol and paid in part to stakeholders.
Business Model - Target Audience
While lending has clearly found a product-market fit (with over 250,000 individual wallets lending their assets to Compound), there are still some questions about the value of the lending feature. Why would anyone provide collateral to borrow crypto assets when you can get a "real credit loan" without providing ETH or BTC.
The number of borrowers also highlights that borrowing is not for everyone. Only about 6900 wallets borrow assets from Compound. Also, isn't the main advantage of a loan, that at a certain point in time someone can spend more money than he/she actually has? We know from traditional finance that overcollateralization negates the most common form of credit.
Here are some use cases:
Leveraged long/short cryptocurrency
If a user is bullish on a volatile asset such as ETH, he/she can deposit ETH to borrow USDC and buy more ETH for more upside. On the other hand, if a user is bearish, he/she can deposit a stable asset (e.g. Dai), borrow a volatile asset (ETH) and sell it. Assuming that the price of one ETH is $1000 at the time of sale, if the price drops to $300, repaying the borrowed ETH will only cost $300, bringing the user a profit of $700 (minus the interest rate).
Get More Yield Farming and Arbitrage Opportunities
Another common use case revolves around borrowing liquidity to use it for arbitrage opportunities, where traders profit from price or interest rate differences.
In addition to arbitrage, yield farming also attracts borrowers. For example, a user could deposit Ethereum to borrow another asset with higher yields elsewhere in the DeFi ecosystem. By lending that asset to another platform, users can keep the difference between the rates. However, this is also the primary use case for Maker DAO, since the borrowed APY is more or less stable.
liquidity needs
In many other situations, users need liquidity. Compound makes it easy to deposit your cryptocurrencies (which you can earn interest on) for even more liquidity. An example is a miner who wants to buy more mining equipment without having to sell his ETH. He can do so using a loan from Compound. The miner can then use his mining rewards to pay back the loan without losing his investment in ETH.
All in all, while the “regular person” wouldn’t borrow to hedge their collateral, many in the DeFi space are using it. Compound’s staggering total borrowing of over $2.9 billion shows as much. Approximately 50% of the value provided is currently borrowed. The majority of borrowed assets are stablecoins, ie Dai and USDC make up over 80% of loans.
Business Model - Revenue Stream
While many DeFi protocols implement a fee-based revenue model, Compound has yet to implement a fee model for generating revenue. However, Compound uses a "reserve factor", a parameter that controls how much of a given asset's lending interest is routed to that asset's reserve pool. Reserve pools are only used to protect lenders from borrower defaults and liquidation failures, compared to fees flowing into the Treasury.
For example, a 20% reserve factor means that 20% of the interest paid by borrowers is routed to the reserve pool instead of lenders.
The reserve factor can be changed by the community through proposals. In theory, the use of funds in the reserve pool can also be changed. It remains to be seen if and when Compound will implement a fee structure or other means of generating revenue.
Conclusion and Outlook
