Compound is undoubtedly a star project in Defi, which is the hottest area in crypto space at the moment. Recently, it started its decentralization process by introducing its governance system and a token COMP — Compound governance token. As the last step of the process, it released the COMP distribution plan.
COMP distribution is absolutely an incentive design even though the utility of COMP is designed for governance. With COMP tokens, Compound can offer “negative borrowing rate with positive high lending rate”! The incentive is so strong that it will no doubt drive huge growth. Unfortunately such an incentive design will inevitably lead to phantom growth like what happened with FCoin’s “Trans-fee Mining”. And it might very likely lead to centralized governance instead of Compound’s original mission to fully decentralize the protocol.
The DeFi ecosystem is intertwined and Compound is becoming the foundation for many other DeFi products. Compound’s big change will open Pandora’s box that will dramatically change the landscape of the whole DeFi market. It will be very hard to predict how the complex economics game will play out in the market. But it will be fascinating to watch if/when the COMP distribution carries out.
Negative Borrowing Rate with Positive High Lending Rate, Really?
The business of Compound is crypto lending. The right metric to measure the traction is the total interest generated in the platform. Hence it should not be a surprise that COMP is allocated proportional to interest as shown in the diagram above. The design also correctly provides incentives to both suppliers and borrowers.
For any token-based incentive to become effective, the token needs to establish a market value. Currently there is no agreement in how to value a governance token like COMP. However, Compound created an implied value to its COMP token by distributing tokens to its equity investors. Compound has raised a total of $33.2M through 2 rounds ($8.2 in Seed, $25 in Series A) and distributed 2,396,307 tokens to investors with 10,000,000 tokens in total supply. A simple calculation will give us a rough market cap of COMP: $33.2M/2,396,307*10,000,000 = $138.33M. For the convenience of this analysis, let’s use $150M as the market cap and that gives us a per COMP token price of $15.
Please note that even though Compound clearly stated that “Until the decentralization process is complete, COMP will not be available to the public.”, it won’t be able to prevent private OTC markets or even IOU being traded on public exchanges like many other tokens. Given its high profile, the value of COMP calculated above is a good proxy that the market may rely on when the COMP distribution starts.
According to the COMP distribution plan, 0.5 COMP per Ethereum block and about 2880 COMP per day will be rewarded to suppliers and borrowers. With $15 per COMP, the value distributed to Compound users is $15*2880 = $43,200 per day.
$43,200 per day does not seem like a big number. However, the total interest paid per day for all markets in Compound is only $1727.5 per day according to the data from COMP Dashboard (The screen shot above is captured on May 31, 2020). Wow, 25x ($43,200/$1727.5 = 25)! What does it mean?
For borrowers, it means that they pay $1727.5 per day in interest but earn $21,600 (50% of $43,200) per day. Borrowers can even earn money, possibly 12.5x return?! For suppliers, it means that their lending rate will jump 12.5x. For example, for USDT, the lending rate could be as high as 25% based on the current rate about 2% (2%*12.5x = 25%). Any other platforms can match such a high return rate for suppliers? With COMP distribution, Compound effectively boosts its crypto lending platform with:
“Negative Borrowing Rate with Positive High Lending Rate”
With such an insanely strong incentive design, the usage of Compound protocol will definitely grow and grow fast at least for an initial period. This is because the strong incentive will change users’ normal reasons to use the Compound protocol and attract new types of users including speculators, arbitrageurs.
With COMP token incentives, to many borrowers, Compound is transforming into an investment platform that delivers high returns like 12.5x initially. They will borrow assets that they don’t actually need, and just pay interests to earn COMP tokens. As long as the return is positive, borrowers will keep coming.
In the current macro environment where the US Fed rate is near 0, with interest rate on USDT as high as 25%, it is no brainer for arbitrageurs to convert fiat into USDT and then supply them to Compound to earn return. Big holders of assets that are live in Compound now have strong incentives to supply their unused holdings and use them as collaterals to borrow so they can earn COMP tokens as both suppliers and borrowers.
The incentive design also creates a positive amplifying force initially. Strong incentives will attract more borrowers and suppliers to use the Compound protocol, which will generate more interest, which will drive up the value of COMP, which will create more incentives.
Will the music stop and when will it stop? It is hard to predict when, but one thing for sure is that the COMP market value will grow way higher than its intrinsic value and at some point, the COMP market value will start to go down. Then it will trigger a negative amplifying force. Lower COMP value will reduce incentives, which will cause borrowers and suppliers to leave, which will generate less interests, which will further drive down COMP value.
Deja Vu, this sounds a lot similar to the FCoin’s “Trans-fee Mining” design. Will the above scenario play out in the market and how will it play out? Nobody can really accurately predict. But let’s watch and it will be another good case study.
The potential impact of COMP distribution will not be limited to the Compound protocol itself. As the “money lego” narrative visualizes it, the Defi market is very intertwined and Compound is becoming the foundation building block for many DeFi products. COMP distribution will open Pandora’s Box and the impact on the whole DeFi ecosystem is a very complex economic game that warrants its own detailed research.
Compound’s goal is to fully decentralize its protocol. It is unlikely for Compound to achieve its goal since the COMP distribution favors users who have lots of assets to lend and money to pay interest as borrowers. Will a few big players that have tons of resources jump in and outgun all other small players to earn majority COMP tokens, which will lead to centralization? Will projects BAT, REP, ZRX, ETH move their reserve tokens into Compound to earn most tokens and vote down any new market so they can continue to earn more tokens? Will USDT and USDC mint and deposit lots of new tokens into Compound to earn more COMP and also vote down any new market so they can continue to earn more tokens? Please note, like many other governance token designs, the team and investors control the majority of the tokens and hence voting rights during early phases, which could change the market dynamic.
Many DeFi products are built on top of Compound and more importantly rely on interests earned from Compound as their business model. For example, Dharma v2 product offers fixed interest rates to consumers, deposits capital in stablecoin into Compound to earn interest, and captures the difference between the interest rates. COMP incentives could be great to Dharma since instead of transferring COMP tokens to its users, it can capture all the value of COMP tokens and only transfer a portion of the value to its users by increasing the fixed interest rate. There is also a huge risk to Dharma as well since big players can flood the supplier side which can drive down the interest rate and COMP earning for Dharma. Now with higher fixed rate to consumers but lower rate and COMP earning from Compound, will Dharma crash?
Will “negative borrowing rate with positive high lending rate” help Compound kill its competitors? For example, will users continue to deposit ETH into MakerDAO to mint DAI and pay a borrowing fee or switch to deposit ETH into Compound to borrow USDC and earn money actually? To compete with Compound, will other projects issue their own tokens to offer similar incentives? Since DAI is the foundation of the DeFi market, will reduced DAI supply crash the whole DeFi market?
COMP distribution is an effective incentive design to drive fast growth of Compound’s protocol. Effectively, with COMP tokens, Compound boosts its crypto lending platform with “negative borrowing rate with positive high lending rate”, which will inevitably lead to phantom growth. Compound’s initiative will open Pandora’s box and impact the whole DeFi ecosystem. How the economic game plays out in the market is so complex to predict, but it will be fascinating to watch.
Author’s note: The numbers and calculations used in this analysis aren’t meant to be accurate. However, they are good enough to illustrate the points. The key assumption in this analysis is that COMP must have established a market value.
Acknowledgement: This analysis is started based on the encouragement from Robert Leshner, Co-Founder at Compound, who also has reviewed the analysis. Thanks Jesse Walden, Haseeb Qureshi, Nic Carter for their reviews and discussions.