COMP Reaches Unicorn Status

VeradiVerdict - Issue #90

  • Compound is a DeFi protocol that enables users to borrow and lend cryptocurrency with algorithmically determined interest rates and integrate these capabilities with Dapps and other services. Compound uses a native token called a cToken, which is provided in exchange for other assets, that enables efficient, secure, and optimal lending and borrowing.

  • Compound is now the largest DeFi protocol in the world in terms of total value locked, with 915 million USD in collateral, dethroning the long-standing leader MakerDAO (at 470 million USD in collateral). Roughly 38% of the total value locked into DeFi as a whole belongs to Compound. 

  • Much of Compound’s rise to success can be attributed to its unique decentralized governance. Compound distributes its own token, called COMP, to the Compound community. COMP holders have the ability to vote or delegate voting rights on various proposals about how Compound should operate (modifying interest rates, collateral ratios, etc.). The idea is to have the governance of the protocol entirely managed by the community, as opposed to a centralized organization like the Compound team. Compound has a supply of 10 million COMP tokens, of which 4.2 million remain to be distributed. So far, most tokens have been distributed to shareholders and team members.

  • In mid-June, Compound approved a proposal to distribute COMP tokens to regular borrowers and lenders on the platform. Because so many users want COMP for its high financial value and voting powers, users loaded more and more assets into the COMP protocol, increasing the total value locked by nearly 5-fold –– this is what led it to surpass MakerDAO. COMP has also gained prominence as a tradable asset, with a price of $280 and a market cap of 2.8 billion USD, in comparison to MKR’s (MakerDAO’s token) market cap of 0.5 billion USD. 

  • Ultimately, Compound’s recent growth both demonstrates its strength as a lending platform, but also as a case study for fully decentralized governance. Demand surrounding the COMP token is largely responsible for the immense recent growth of the protocol. By asserting itself as the new King of DeFi, Compound shows that people deeply care about decentralized governance; it has the potential to become the industry standard.

The New King of DeFi

This past weekend, the algorithmic crypto lending platform Compound overtook MakerDAO as the largest decentralized finance (DeFi) protocol in terms of most value locked, with 579 million USD locked compared to Maker’s 470 million USD locked. In reality, the size gap between the two may be even larger; total value locked isn’t necessarily a fair comparison, because much more of Compound’s collateral is borrowed by others. Compound has 915 million USD in collateral (of which 330 million USD has been borrowed) while Maker has 470 million USD in collateral (of which 127 million USD has been borrowed).

Since the beginning of the DeFi craze, Maker has been the industry’s dominant platform. The popular site DeFi Pulse (which reports various statistics on DeFi markets) even highlighted Maker’s overwhelming presence in DeFi by reporting what share of total locked value was held in Maker –– a stat referred to as “Maker Dominance.” Today, the site reports “Compound Dominance” instead, which stands at roughly 38% of the total value locked in DeFi. In a little under 3 years, Compound has asserted itself as the new king of DeFi.

What even is Compound?

Compound is an algorithmic DeFi protocol that allows users to lend and borrow money using cryptocurrency. Users can lock in popular crypto assets, like ETH or USDC, into the protocol in exchange for Compound’s native token –– cToken. These cTokens are then used in borrowing and lending markets with algorithmically calculated interest rates, implemented entirely over smart contracts. It gained popularity as many crypto users found themselves hodling (crypto slang for “holding”) onto crypto assets without doing anything with them; by locking them into Compound, they could lend to other users and earn an interest rate, producing a profit in exchange for liquidity. 

cTokens are also so versatile and easily movable that they’ve become an integral part of many decentralized apps (Dapps). One popular Dapp built on Compound (using the USDC cToken) is TokenSet which intelligently and automatically trades crypto. Since cTokens can be easily minted using an Ethereum wallet like MetaMask, several dapps use cTokens are critical components of their service, integrating with Compound.

The use cases for Compound largely mimic those of traditional financial lending, except with much greater efficiency, transparency, and security thanks to the decentralized nature of the protocol. Borrowers can borrow to finance personal expenses, or even to short assets. Lenders can lend to earn money from simply hodling, issuing stablecoins, and or finding arbitrage opportunities between different tokens. But since the entire protocol runs on the blockchain, users don’t have to put unwarranted trust into a centralized service that manages everyone’s funds. It also enables more native integrations with other financial technologies (including Dapps), because applications can directly move funds with the Compound protocol, removing the need for a middleman like Plaid that helps connect tech to bank accounts. 

Compound’s Special Sauce – Governance

Beyond being one of the first and largest crypto lending platforms, Compound also distinguishes itself with its unique, decentralized governance. Many DeFi lending platforms are implemented on P2P networks or over smart contracts but are still internally managed by a singular party that designs the interest rate algorithms and other characteristics of the platform. At its launch, Compound was the same –– the Compound team had complete control over the operation of the protocol. This year however, Compound made a step to decentralize its governance via a governance token called COMP, which gives users voting and proposal rights for referendums on how Compound should operate. Proposed changes must be executable code, meaning the Compound team doesn’t even maintain control over the implementation of the changes. Everything is up to the broader community. 

How has governance gone so far?

Incredibly well. Some of the biggest proposals that have been approved since the launch of decentralized governance include:

  • Adding support for USDT to the protocol (~90% in favor)

  • Reducing the collateral factors for single-collateral Dai, or Sai (100% in favor of the most recent reduction to a factor of 35%)

  • Increasing the reserve factor for USDT (~99% in favor)

  • Distributing COMP to users (100% in favor)

In fact, the last referendum is one key reason Compound has skyrocketed in size recently. COMP tokens are valuable to everyday users because of (1) governance privileges and (2) they’re transferable, so they can be traded like any other cryptocurrency asset. I’ll discuss the widespread bullishness on COMP below, but the end-all-be-all is that this token is in high demand. As a result, users were pleased by the fact that Compound as a platform would distribute COMP to users for engagement. To maximize their COMP rewards, they locked more and more assets in the platform to lend, increasing the total value locked into the platform by around 5-fold. 

Compound’s total value locked grew nearly 5-fold around mid-June, which is when the referendum to distribute COMP to users was approved. (Source: DeFi Pulse)

A full history of governance can be found here.

At time of writing, there are nearly 373 unique addresses that hold voting privileges thanks to COMP, with a total of nearly 1.7 million unique votes delegated. 

Users are prompted to vote and can either vote directly or delegate their vote to another party that they trust will be providing thoughtful governance.  In order to delegate, you would just go to the voting page and choose from a leaderboard of folks.

In addition, there is even a discussion forum where folks can discuss each of the proposals before decisions are made. 

Distribution of the COMP Token

Compound will supply a total of 10 million COMP tokens over its lifetime, of which approximately 4.2 million tokens remain. At its start, Compound exclusively distributed COMP to its shareholders, but with the approved referendum, it will start distributing COMP to regular borrowers and lenders on the platform for engaging with it.

Specifically, Compound will distribute 0.5 COMP for every Ethereum block, across the ETH, DAI, USDC, USDT, BAT, REP, WBTC, ZRX markets, based on the interest rates being earned in each of those markets. In each market, half the COMP goes to borrowers and the other half goes to sellers. That means approximately 2880 COMP tokens will be distributed daily for the next 4 years, until the protocol extinguishes its supply of the token. At its end, approximately 42% of COMP will have been initially distributed to regular users of the platform, while 24% of the supply will have been initially distributed to shareholders and 25% will be distributed to individuals on the Compound team. Most importantly, Compound as an organization will retain 0 COMP tokens, meaning the organization has no voting power in governance (but the individual team members will).  

COMP is also transferable between addresses, meaning that users can trade COMP just like any other token. Governance is incredibly important to users, particularly in such a dominant and ubiquitous protocol like COMP, so there’s lots of demand for COMP ownership. As of this week, COMP is priced at roughly $280 (a market cap of ~2.8B USD, compared to MKR’s market cap of 0.5B USD). 

Why exactly is the token valued so highly?

The limited supply naturally suggests that the token must have some nontrivial value. The recent listing of COMP on Coinbase also doesn’t hurt.  Most critically, however, the recent referendum that distributes tokens to users has definitely sparked interest; since 6/16 (around the referendum date), the token has increased in value by more than three-fold.

It’s become a cornerstone of yield farming, which is when users leverage various DeFi projects to maximize rates of return, including cashback and incentives (like COMP). Especially since the COMP returns vary on the exact market (based on interest rate) in which you lend or borrow, this presents an interesting arbitrage opportunity for users. At a high level, users can borrow a token like USDT or BAT, exchange it 1:1 for Dai and provide the Dai as collateral to Compound. In exchange, Compound pays them COMP tokens. Given current numbers, this payback is enough to cover the cost of borrowing and then some, meaning users can literally earn money for borrowing. It’s so powerful that InstaDapp even released a tool for users called “Maximize $COMP mining” that does exactly that. This strategy can be risky because the price of the tokens can fluctuate heavily, which can lead to heavy losses. But most yield farmers on Compound exclusively use stablecoins, which neutralizes the risk of losing money from price fluctuations; InstaDapp’s tool even gives you a risk assessment of the position you’re taking. This video here walks you through exactly how to use the tool to earn money from borrowing and maximize COMP returns.

Overall, this demonstrates the power of decentralized governance. COMP tokens (which function as a proxy for voting privileges) have gained material value as more and more users gain access to it –– it’s an excellent example of decentralization bringing tangible value back to the user. 

Final Thoughts

Compound has always been one of the most important players in the DeFi space but has now definitively established itself as the King of DeFi. Leading in both token market cap and total value locked into the protocol, Compound is now the most popular and versatile platform for users that want to lend and borrow with cryptocurrency, and even integrate those capabilities into higher-level Dapps. The recent success of Compound is undoubtedly linked to Compound’s decision to distribute COMP tokens to users (something that may never have happened without decentralized governance). The bullishness we’ve seen with the price of COMP shows that users deeply care about decentralized governance and that voting rights themselves are valuable assets and even tradable. The platform presents one of the most promising examples for how crypto lending and borrowing can flourish with total decentralization, crafting a future where we have to rely less and less on third-party operators.

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ADDITIONAL INFO

Hi, I’m Paul Veradittakit, a Partner at Pantera Capital, one of the oldest and largest institutional investors focused on investing in blockchain companies and cryptocurrencies. The firm invests in equity, pre-auction ICOs, and cryptocurrencies on the secondary markets. I focus on early-stage investments and share my thoughts on what’s going on in the industry in this weekly newsletter.

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