The “Other” Compound

An open source protocol for efficient, algorithmic Money Markets on Ethereum

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a graphic estimating where traditional financial products fall on the risk/reward scale

One concept I’ve long thought about is what the equivalent of a bank might look like in a decentralized, self-sovereign future. While most hodlers today dream of disrupting the traditional financial system and enabling the world’s population to “be their own bank”, if we’re going to achieve this end goal we’ll need products that enable users to earn passive income to offset the risks they’re taking on. As products emerge to solve issues surrounding private key storage and security (like our portfolio company Casa amongst others), the next logical step is for offerings to emerge that enable users to earn interest and yield on the cryptocurrencies they hold. As the Compound team writes in their white paper,

Blockchain assets have negative yield, resulting from significant storage costs and risks (both on-exchange and off-exchange), without natural interest rates to offset those costs. This contributes to volatility, as holding is disincentivized.

Joseph Nocera details in his book, A Piece of the Action: How the Middle Class Became the Money Class how a series of economic circumstances, socioeconomic developments and, technological progress led to many of the financial products we’re accustomed to in today’s banking system. Prior to the development of these products, a savings account was the only option for money-conscious individuals. However, when inflation ran rampant in the 70’s, there was increased government pressure on rates banks could pay their customers and the minimum deposit sizes for market interest rates skyrocketed, followed by the same for treasury bills. The response was the creation of products like money market accounts that offered better interest rates, all of which are ubiquitous today.

Technological progress was another key driving factor to the development of many of these products. As Nocera writes,

True, some clever soul could have created a money market fund without computers, but it could never have been made to look and feel like a bank account, which was the key to its success. And plainly, bankers could make loans without computers, as they had done for centuries. But they couldn’t make unsecured personal loans triggered whenever a borrower handed a piece of encoded plastic to a merchant.

The parallels write themselves. A revolution started by Satoshi Nakamoto in response to the financial crisis in 2008 and driven by technological progress over the preceding years has led to the proliferation of cryptocurrencies and decentralized blockchain protocols which are slowly but surely upending the current financial system.

However, there are a few issues today that are still largely unsolved. For one, prices remain volatile given the nascency of these technologies and the risk that comes along with that. There is a dearth of sophisticated valuation models which has led to most users speculating and/or looking at investing in tokens as if they’re equity in the protocol that they empower.

As early adopters and enthusiasts remind us all during times of depressed prices, the predominant strategy to achieve superior returns is to HODL. As my friend Dillon Chen wrote in his blog post, Cryptobanking: Brain Dump,

Since crypto assets are extremely liquid and can be instantaneously changed into some other digital asset, it’s tempting to do so. Unless you’re a day trader in the top 1%, you’ll probably lose money. With all the complexity in dealing with crypto assets, a person’s best bet is usually to hold, or rather HODL. In this case, individuals are hoping that the base crypto asset that they purchase appreciates in the future. HODLing is basically stashing your coins under your mattress, which many of my friends have expressed as their dominant investment strategy.

However, if we compare this to a traditional asset like cash, that can earn interest by sitting in a bank, stashing your cryptos under a mattress doesn’t seem too enticing. No one’s really figured out a way to earn interest by HODLing for this, of course, we’re not the only ones to have this thought.

As we’ve seen in public markets throughout the course of history, “hodling” is much easier said than done. In good times, everyone claims to be a long-term holder but the cold truth is that most people panic when they see their holdings rapidly decline in value. They sell quickly to recoup whatever they have left before their assets lose even more of their value causing the assets to depreciate further and so on and so forth. This vicious cycle isn’t unique to cryptocurrencies as it is human nature after all, however because of the issues discussed above it’s certainly far more erratic.

Additionally, another factor inhibiting cryptocurrencies from becoming investible assets for the vast majority of the world or as stores of value (especially in more developed nations) is that in many of these protocols, inflation is a feature, not a bug. Inflation is used to incentivize miners, stakers, or other “keepers” to secure these networks. While crypto is still nascent and prices continuously climb higher, not much is made of this fact. As the market matures though, this inflation could hurt the value of an individual’s dormant portfolio.

Like in the 1970’s, these factors have led to the development of alternatives — stablecoins being the most prominent (and also controversial).The risks that come along with stablecoins are well-documented so I won’t rehash them here. For those that are less familiar, the Multicoin Capital team did a great job comparing and contrasting the various protocols and proposals which you can read here and Preston Byrne has done an excellent job highlighting the issues with current proposals which can be found here.

What we need are additional products that give users options to offset the aforementioned risks. Without these developments, cryptocurrency and token investing will continue to be too risky and volatile for many middle class individuals to partake in with any sort of meaningful allocations.

In traditional financial services, there are a multitude of ways to earn interest on your money. You can buy stocks, bonds, savings accounts, money market accounts, mutual funds, amongst others. We need products and services which can enable people to earn passive income to offset risk and other hidden costs. Not just a single alternative either, but akin to the products offered by banks today, choice is paramount. By cutting out the middlemen, interest earned from taking risks and loaning out your money will go directly to you and not lining the pockets of those without skin in the game at all.

These protocols that enable these products to be built through lending, staking pools, or money markets will offer users the power of choice. This is why I’m so excited to unveil our investment in Compound (not to be confused with Compound the VC firm where I’m a Partner). The Compound team is building a decentralized system for the frictionless borrowing of Ethereum tokens, enabling the development of proper, functioning money markets, and creating a safe positive-yield approach to storing assets.

Summing up, it is my belief that a “cryptobank” of the future will empower users to manage their own private keys in a user-friendly manner and provide them with the interface to decide if and how they’d like to earn additional yield on their holdings. Users could decide what their tolerance is for risk and allocate their funds accordingly — putting some of their holdings in Compound’s money markets, lending to a single higher-risk user using another protocol out there, and using the rest to join various staking pools.

At the “other” Compound, we’re thrilled to be backing Robert and the rest of the Compound team as they enable true financial sovereignty without middlemen earning gluttonous yearly bonuses for taking risks with our money. You can learn more about the protocol from today’s press and follow their progress on their website.

Written by

Halcyon Health Co-founder. Former Partner @ Compound.

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