Compound is undoubtedly the star in the Defi project, and Defi is currently the hottest area in the cryptocurrency industry. Recently, Compound started its decentralization process by introducing a governance system and governance token COMP. As the final step in the process, Compound recently released a distribution plan for COMP tokens.
Although the utility of COMP is designed for governance, it is definitely an incentive design. With COMP tokens, even Compound borrowers can make money! Such strong incentives will undoubtedly drive huge growth. Unfortunately, such incentive design will inevitably lead to unreal growth like FCoin’s “transaction is mining”. And it is likely to lead to centralized governance, which violates Compound’s original decentralized protocol vision or philosophy.
In addition, the DeFi ecosystem is intertwined, and Compound is becoming the basis of many other DeFi products. This huge change will open Pandora’s magic box and greatly change the pattern of the entire DeFi market. It is difficult to predict how this complex economic game will unfold in the market. However, it will be interesting to observe the issuance of COMP tokens.
Borrowers can also make money, really?
Compound’s business is cryptocurrency lending, and the correct measure of traction is the total interest generated by the platform. Therefore, as shown in the figure above, it is not surprising that COMP tokens are distributed in proportion to interest. The design also correctly provides incentives for loan suppliers and borrowers.
In order to make any token-based incentives effective, tokens need to establish a market value. In terms of how to evaluate governance tokens like COMP, there is currently no reasonable way. However, Compound created implicit value for its COMP tokens by distributing the tokens to its equity investors. It is reported that the company raised a total of 33.2 million US dollars through two rounds of financing (Second round of financing of 8.2 million US dollars and A round of financing of 25 million US dollars), and distributed 2,396,307 COMP tokens to investors, and its total tokens were set to 10,000,000 COMP.
If calculated according to the cost of acquiring money by investment institutions, then the market value of COMP = $33.2M/2,396,307*10,000,000 = $13933 million. For ease of analysis, we use 150 million US dollars as the market value, then the price of each COMP token is about 15 US dollars.
Please note that although Compound officials clearly stated that “COMP will not be open to the public until the decentralization process is completed,” it cannot prevent private OTC markets or even public exchanges from trading IOUs. In view of the high popularity of Compound, the above calculated COMP token value is a good reference value. When COMP tokens start to be distributed, the market may rely on this reference value.
According to the COMP’s distribution plan, loan providers and borrowers will receive 0.5 COMP (or 2880 COMP per day) for every Ethereum block. Calculated at the price of $15 per COMP token, the value assigned to Compound users is 15*2880 = $43200 (per day).
$43,200 per day does not seem to be a large amount. However, according to data from COMP Dashboard, the total interest paid by Compound in all markets per day is only $1727.5 (the screenshot time above is May 31, 2020). This is equivalent to 25 times the normal interest incentive ($43,200/$1727.5 = 25)! What does this mean?
For borrowers, this means that they pay $1727.5 in interest per day, but can earn $21,600 (50% of $43,200) per day. For the supply side, this means that their loan interest rate will increase by 12.5 times. For example, for USDT, the loan interest rate may be as high as 25%, while the current interest rate is about 2% (2%*12.5x=25%). Are there any other lending platforms that can match this rate of return? In other words, through the issuance of COMP tokens, Compound will effectively enhance its crypto lending platform.
Unreal growth
With such a crazy and powerful incentive design, the use of Compound protocol will undoubtedly experience growth, and will experience rapid growth, at least in the initial stage. This is because strong incentives will change the behavior of users using the Compound protocol, which will attract new users including speculators and arbitrageurs.
For many borrowers, with the COMP token incentive mechanism, Compound is transforming into an investment platform that initially provides 12.5 times higher returns. Participants will borrow assets that they do not actually need, and only need to pay interest to earn COMP tokens. As long as the return is positive, borrowers will continue to flock.
In the current macro environment where the Federal Reserve interest rate is close to 0, and the interest rate of USDT will be as high as 25%, arbitrageurs will convert fiat currency to USDT and then earn returns through Compound, which does not require brainstorming. Those large Compound asset holders now have a strong incentive to supply their unused assets and use them as mortgages so that they can act as loan providers and borrowers to earn COMP tokens.
Incentive design will initially have a positive amplification effect. Strong incentives will attract more borrowers and suppliers to use the Compound agreement, which will generate more interest, thereby promoting the value of COMP, and then create more incentives.
Does the concert stop? When will it stop? It is difficult to predict when, but one thing is certain, that is, the growth of COMP market value will be much higher than its intrinsic value, and at some point, the market value of COMP will start to fall. Then, it will trigger negative amplification. A lower COMP value will reduce incentives, which will cause the borrower and the supply side to leave, which will generate less interest and thus further reduce the value of the COMP token.
Is it a bit familiar? This sounds a lot like FCoin’s “transaction is mining” design . Will the above scenario be staged in the market? What will happen?
No one can really predict accurately. But let us wait and see, this will be another good case study.
Pandora’s box
The potential impact of the COMP token distribution plan will not be limited to the Compound agreement itself. With the visualization of the “Money Lego” narrative, the DEFI market has become intertwined, and Compound is becoming the cornerstone of many DeFi products. The issuance of COMP tokens will open Pandora’s magic box, and its impact on the entire DeFi ecosystem will be a very complex economic game game, which is worthy of our detailed study.
Compound’s goal is to make its protocol completely decentralized, but in fact Compound is unlikely to achieve this goal, because the issuance of COMP tokens is beneficial to users with large amounts of assets . Some big players with a lot of resources will earn most COMP tokens. Will this lead to centralization? For BAT, REP, ZRX and ETH projects, the relevant holders will transfer their reserve tokens to Compound to earn most of the tokens and vote to veto any new markets so that they can continue to earn more tokens currency? Will USDT and USDC mint new coins and deposit a large amount of new coins in Compound to earn more COMP, and vote to veto any new markets so that they can continue to earn more coins?
Please note that like many other governance token designs, the Compound team and investors control most of the tokens, so they have voting rights at an early stage, which may change the market dynamics.
Many DeFi products are built on Compound, and more importantly, their business model relies on interest earned from Compound. For example, Dharma v2 products provide consumers with a fixed interest rate, deposit stablecoin capital in Compound to earn interest, and capture the difference between interest rates.
COMP rewards are very good for Dharma, because it does not need to transfer COMP tokens to its users, but can get all the value of COMP tokens, and only transfer a part of the value to its users by raising the fixed interest rate . But for Dharma, it also means a huge risk, because large players can overwhelm the supply side, which will reduce Dharma’s interest rate and COMP income. In this case, Dharma’s fixed interest rate for its customers becomes higher, but Interest rates and COMP gains from Compound have become lower, so will Dharma collapse?
Does this design help Compound kill competitors? For example, will users continue to deposit ETH in MakerDAO to cast DAI and pay for borrowing costs, or will they instead deposit ETH in Compound to borrow USDC and actually make money? In order to compete with Compound, will other project parties issue their own tokens to provide similar rewards? Since DAI is the foundation of the DeFi market, will reducing the supply of DAI crash the entire DeFi market?
in conclusion
The issuance of COMP tokens is an effective incentive design, which can promote the rapid growth of the Compound protocol. In fact, through COMP tokens, Compound promotes its crypto lending platform with super high incentives, which will inevitably lead to unreal growth.
Compound’s plan will open Pandora’s box and affect the entire DeFi ecosystem. It is difficult to predict how economic games play a role in the market, but it is worth observing.
Author’s Note: The figures and calculations mentioned in the article are not accurate. However, they are sufficient to illustrate these points. The key assumption in this analysis is that COMP must have determined the market value.
Acknowledgements: The analysis started on the encouragement of Compound co-founder Robert Leshner, who also commented on this article. Thanks also to Jesse Walden, Haseeb Qureshi and Nic Carter for their comments and discussions.