One sign of the maturity of an asset is how reliably you can lend or borrow it. Today’s lending solutions for cryptoassets are not good enough: they are either centralized and have substantial counterparty risk, or require robust order books for each type of cryptoasset, which generally do not exist.
Today we are announcing our investment in Compound, an open source, blockchain based protocol for decentralized money markets, with algorithmically set interest rates. Lenders of cryptoassets can generate a yield by supplying their cryptoassets to the Compound blockchain, and borrowers can borrow a cryptoasset from Compound at market rates.
How it Works
If you are seeking to earn a yield you supply your cryptoasset to the Compound blockchain. These cryptoassets also serve as collateral for your future borrowing. Compound receives these assets and you begin accruing interest hourly, based on the interest rate.
On the other side, to borrow a cryptoasset, you submit a borrowing request to Compound. Compound checks for adequate collateral and fulfills your request. The Compound protocol continues to measure your collateralization ratio against interest rates and price fluctuations to ensure that the loan is adequately collateralized. Why would you want to borrow a cryptoasset? Let’s say you want to short it — you need to be able to borrow it.
Compound adjusts your borrowing limit based on your collateral ratio. If liquidation ratios are crossed, the Compound protocol makes an automatic margin call, liquidating the collateral and selling it at a liquidation discount to speculators.
The owners of the protocol, which one day can be decentralized through a token, collect a protocol-defined commission on each outstanding loan.
It Was Time
Cryptoassets have developed into a rich market of investors, speculators, and traders, trading close to a trillion dollars of value per month. The value and quantity of assets will continue to grow exponentially, and trade volumes will increase. These figures are all the more impressive because the majority of cryptoassets aren’t traded at all, and instead sit idle on users’ wallets, cold storage, or for the less security-conscious, on exchanges.
Contrast that to our existing financial system — almost every single US dollar that is not sitting in a physical wallet in paper form, is used in the financial system. While it may appear to an end-user that a dollar sits idle in a checking or savings account, in reality that dollar is being used (borrowed) by another participant in the financial system, whether it’s a business or government or consumer. That use takes the form of interest; paid to the bank, middle-man, or entity providing the capital.
In fact, the process of lending assets is so automatic, so frictionless, and so fungible, that the “value” of the use of money can be summarized as the spot interest rate: that’s the value of the use of money, devoid of credit and duration risk. Today, in the US, that rate is 1.75%.
The Dangers of Not Having Interest Rates
Properly functioning interest rates markets are fundamental financial infrastructure, and today cryptoassets do not have it. Without the ability to easily borrow assets, markets break down in two profound ways:
- Borrowing is a pre-requisite to to be able to short-sell an asset; without it investors only have a choice to buy, or not-buy an asset; they do not have the ability to short an asset, reducing its value if they believe it to be overvalued. Many tokens with billion dollar valuations and no working products are examples of assets that are grossly overvalued because of the absence of borrowing markets and thus the inability of markets to force the price of those assets to their fair value.
- Without interest rates, cryptoassets have a nominal and a real negative yield; the costs of storage and security (both on and off exchange) and the inflation of the token supply. This is a disincentive to hold cryptoassets.
Two peer-to-peer lending approaches exist for cryptoassets today:
- “Off-chain” centralized exchanges allow customers to trade cryptoassets on margin, with “borrowing markets” built into the exchange. Nice, but these are trust-based systems with counterparty risk (i.e., you have to trust that the exchange won’t get hacked, trust that you will get your lent cryptoassets back, etc.); they are off-chain (i.e., assets can’t be withdrawn from the exchange, or used off-exchange); and they are closed (i.e., they cannot be integrated into other products or distributed systems).
- “On-chain” protocols which attempt to create order-books of lending and borrowing offers for each and every cryptoasset. Unfortunately, these systems suffer from issues of synchronicity and complexity: users have to negotiate interest rates, duration, collateral, and credit risk with other users for each cryptoasset. It’s hard enough to agree to a simple “price”, let alone five other variables at once. Hence it is unlikely that these systems can gather critical mass.
You might call Compound’s approach contrarian — rather than matching a debt obligation between users (with an associated negotiation of maturity, interest rate, collateral, or credit) Compound simplifies the entire supply and demand for an asset into a fungible pool of assets. Interest rates are algorithmically adjusted and float in real-time as market conditions adjust. This should make these “money markets” liquid, transparent, and predictable — prerequisites for developer and institutional adoption.
Compound is fully decentralized, transparent, and trustless. Its money market architecture eliminates the need for counterparties on every loan, making liquidity easier to bootstrap. The “programmable” loans are natively compatible with cryptoassets. The Compound blockchain and protocol is the best approach to creating a horizontal lending platform and can thus become core infrastructure for cryptoassets.