The Inspiration of COMP: on Incentive and FCOIN

Recently, Compound started to distribute COMP on June 15 through governance proposal 007, and initiated the token distribution mechanism of “loan mining”. Subsequently, COMP was listed on Uniswap with its price rising all the way. As I write this article, the price is 0.407 ETH. Its total market value exceeds that of MakerDAO, becoming the project with the highest market value of DEFI. This leads to the comparison and discussion between Compound loan mining and FCOIN liquidity mining in the industry. Based on this background, this paper will make an essential analysis of incentive and FCOIN.

The first question, what are the incentives?

If the incentive itself is not to solve the mismatch between supply and demand, but to stimulate the whole closed-loop of transaction, an issue will arise. The transaction is for the purpose of incentives itself, not for the purpose of trading demand. That is to say, the person who wants to obtain the incentive needs to complete the closed-loop by himself/herself. So once he/she joins the incentive plan, he/she won’t care about the real demand of the exchange. At this time, trading volume is created by the participants seeking incentives. We call them speculators. Real demand for exchange exists, too. We call them traders.

Because speculators also provide a certain amount of liquidity theoretically, and because the interests of the whole system are equally distributed to the participants (excluding the part of operation costs), as long as the whole system can maintain a positive value, the traders will get better benefits than with no incentives. But this benefit is only the spillover effect of incentives. More speculators chase a “revenue illusion”, that is, early participants get a higher distribution of the asset because of the increase of later participants.

But because this kind of distribution contributes no external increment (or relatively small amount), its cost (the commission of the transaction) will exceed the incentives at a specific time for the speculators. So they will leave, leaving only a small number of real traders. At this time, because a large number of incentive tokens already exist, for traders, the extra rewards will be ignored. So it is time for the competition of trading service.

In this regard, the advantages of competitive exchanges are obvious, and FCOIN will lose its attraction because it does not provide a truly unique value. It encourages a subsidy similar to some Internet companies, which only happens to be distributed equally to everyone. The source and redistribution of this subsidy really embody a distributed spirit. However, the misplacement of its own incentive objectives will inevitably lead to an invalid result: value cannot be captured.

However, on the whole, because of this mechanism, FCOIN will obtain faster user growth and more user retention than other exchanges starting in the same period. If we look at it in this way, we can’t find out the essential problem of FCOIN. But the following question is a fatal one.

Here is the second problem. Because most of the incentive tokens are generated by speculators, and their value is also contributed by speculators. Due to its design of completely positive feedback (such as no limit on quantity and time), a positive growth cycle forms in a very short time, and no negative feedback can limit this explosive growth. However, the real trading demand (traders who don’t care or care little about incentives) growth is significantly lower than the positive feedback of speculators, which can be almost negligible. This gives speculators an income illusion.

This illusion was pushed to the extreme in a short time, resulting in the rapid rise of FT price, and then reversed in a short time. We know that this reversal will come sooner or later if the exchange does not capture real supply demand. However, due to the design of FT, this process came in a very short time, leaving no time for the exchange to develop real user value. Once there is a reversal, with a lack of the support of negative feedback (or because of the explosive growth of volume, it is impossible to carry out any effective negative feedback management), the price decline and the exit of speculators accelerates, causing collapse.

Although this structure is different from the traditional pyramid sale structure, their common ground is the lack of negative feedback. In question 1, we pointed out that the mechanism first captures the speculators rather than the real trading demand. Therefore, in such a short period of time, the speculators withdraw quickly, which does not play a decisive role in the normal development of the exchange. On the contrary, the sudden rise and fall of the exchange token have resulted in mass incidents. In the negative cycle time, the FCOIN team tries to make a manual intervention on the negative feedback, such as purchasing some assets in the secondary market, and finally it can’t withstand the flood of negative feedback.

Third, if an enterprise, project, product or system does not create unique value, no matter what incentive mechanism is adopted, it will not bring real prosperity and stability. Everything will be temporary, and someone will always subsidize others.

Fundamentally speaking, apart from things like a lottery that target at the redistribution of people with the same risk preference. Most of the so-called economic models hope to build a mechanism or system that can exist forever and does not need unique value. This is just as futile as the construction of a perpetual motive.

In the incentive mechanism, it is very difficult to minimize unnecessary incentives and ensure the compatibility of each incentive. The pursuit of explosive incentive is doomed to be wishful thinking. It will sooner or later collapse.

Let’s discuss the core of incentive. There is some uncertainty in the process of value creation. The current deterministic cost is used to exchange for a better future in which the uncertainty is gradually eliminated, such as the gap between supply and demand. When the supply is not stable enough, the demand cannot enter the market. So supply incentive is carried out. Or when the demand is not strong enough and the supply cannot be invested (in large-scale), the supply demand incentive is needed. In such situations, it is meaningful to set the incentives. The incentive providers should get compensation through the market value of stable supply and demand. This is reasonable.

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