Understand the DeFi lending leader Compound: Why does it attract $4.5 billion in liquidity?


It is not easy for Compound to maintain its status as a top lending agreement, especially since it has not yet implemented a stable revenue stream model.

Original title: “The Way of DeFi丨Understanding DeFi Lending Leader Compound, Why Can Attract USD 4.5 Billion Liquidity
Written by: Lavi
Compilation: Kyle

This article will introduce Compound, one of the leading projects in the DeFi lending track. Compound, released in 2018, now has a locked-in value of $4.5 billion. In June 2020, Compound released the governance token COMP, joining the DeFi summer boom. It is not easy for Compound to maintain its status as a top lending agreement, especially since it has not yet implemented a stable revenue stream model. With the release of the Compound Chain plan, how can the project perform in 2021?

Compound-protocol overview

Compound is a protocol on the Ethereum blockchain that allows users to borrow and lend crypto tokens. The interest rate is set by algorithm based on the supply and demand of each asset. The lender and the borrower interact directly with the agreement to earn (and pay) floating interest rates without having to negotiate terms, interest rates or collateral terms with peers or counterparties.

The agreement was released in 2018 and raised US$8.2 million in the seed round and another US$25 million in the November 2019 A round of financing. The list of early investors looks like a Who’s Who of Blockchain VCs, including industry giants Andressen Horowitz, Polychain Capital, Coinbase Ventures and Bain Capital Ventures.

At the time of writing, Compound is one of the top three DeFi protocols in Total Value Lock (TVL). The exponential growth of its locked value in 2020 (from 15 million USD at the beginning of the year to more than 1.9 billion USD at the end of 2020) reflects the confidence and trust in the agreement. This strong growth is supported by liquidity mining incentives, which we believe has little to do with Compound’s achievements.

Understand the DeFi lending leader Compound: Why does it attract $4.5 billion in liquidity?

History-become the main pillar of DeFi

MakerDAO can be regarded as the first DeFi project that allows users to lend, and Compound is the first DeFi project to provide a license-free lending pool, from which users can obtain deposit interest rates. The Compound v2 white paper was published in February 2019 by founder/CEO Robert Leshner and co-founder/CTO Geoffrey Hayes. Compound quickly became one of the main pillars of DeFi. Initially, the protocol supports six tokens (ETH, 0x, Augur, BAT, Dai and USDC).

Understand the DeFi lending leader Compound: Why does it attract $4.5 billion in liquidity?

Since then, some additional tokens have been added to the market (some are deprecated). The project team and the Compound community are constantly innovating. Although the protocol has been welcomed by many active Ethereum users, it really caught people’s attention when they announced that they would use the protocol’s own governance token COMP to reward their users.

What started as a measure to increase decentralization became a critical moment for the entire Ethereum ecosystem, triggering the DeFi now known as the summer of 2020. In the next three months, countless projects adopted similar methods, rewarding their users with different tokens, and chasing the highest revenue among various projects. This is “revenue farming”.

Lending-the use of cToken

Lending assets to the Compound agreement will result in two transactions. The first is to deposit original tokens (such as Dai) into the protocol. The second is to automatically credit cTokens (cDai) to the wallet that provides assets. The newly issued version c tokens are used as IOUs (IOU) and act as a redemption token, allowing the holder to redeem the original token. The value of cToken is determined by Compound through an exchange rate, which is designed to increase value over time.

Understand the DeFi lending leader Compound: Why does it attract $4.5 billion in liquidity?

By holding cToken, the owner can earn interest through the appreciation of cToken compared to its original counterpart. Therefore, when the cToken is redeemed (ie redeem), the user will receive more actual base tokens than originally deposited. On the other hand, the borrower ensures that there are more tokens to be paid to the lender by always paying a higher interest rate when borrowing assets. The actual ratio is determined by supply and demand (utilization).

Borrowing-over-collateralized loans

The method of borrowing tokens on Compound is similar to the method of minting Dai on Maker. However, compared with Maker, Compound requires users to store cToken as collateral. As with lending, there are no conditions to negotiate, maturity date or financing period for the borrowed asset. In order to reduce the risk of default, Compound uses over-collateralization to limit the amount that can be borrowed.

The amount that users can borrow is determined by a mortgage factor ranging from 0 to 1. A collateral factor (CF) of 0.7 is equal to 70% of the value of the underlying asset that users can borrow. The following is an example of how much money a user can borrow when the CF value is 0.5.

Understand the DeFi lending leader Compound: Why does it attract $4.5 billion in liquidity?

The interest rate of each token will again be determined algorithmically based on supply and demand (utilization).

If the borrowed amount exceeds the user’s ability to borrow, part of the outstanding loan can be repaid in exchange for the user’s cToken collateral. This liquidation may occur when the value of the collateral falls below the required minimum value, or when the value of the borrowed token exceeds the maximum value that the user can borrow.

Risks and incentives

In addition to the smart contract risk (that is, hackers using fragile smart contracts), another risk associated with currency markets such as Compound is that in the case of a bank run, the platform may run out of liquidity and fail to meet all withdrawal requirements. To alleviate this situation, Compound’s interest rate is based on “utilization rate”, which defines the extent to which the lender’s assets flow to the borrower (see the black line in the figure below). For example, if 80% of all available assets are borrowed, the utilization rate is 75%. As a result, only 20% of lenders can withdraw their assets immediately.

Understand the DeFi lending leader Compound: Why does it attract $4.5 billion in liquidity?

Through the interest rate model, Compound can inhibit lenders’ withdrawals, because interest rates will rise when utilization increases (to encourage borrowing), and at the same time inhibit borrowers’ motivation to increase borrowing (because borrowing money becomes more expensive). The figure above shows the increase in borrowing rate (purple) and lending rate (green) as utilization increases.

Whether Compound can tolerate black swan incidents like bank runs remains to be proven. Gauntlet conducted a simulated stress test in early 2020. In addition, Compound did survive Black Thursday in March 2020 (when Bitcoin and most other assets fell by more than 40% in one day), it was much better than other protocols. However, it was not yet in full DAO mode at the time.

The closest event to the Black Swan event occurred in November 2020, when the price of the stablecoin Dai temporarily soared to $1.3 on Coinbase. Compound uses Coinbases’ feed price to determine its market price. Due to the sudden increase in the price of DAI by 30%, some positions were under-collateralized, resulting in the liquidation of more than 80 million collateral.

In any case, it is essential for Compound to ensure high liquidity. High interest rates are a way to incentivize liquidity, but Compound has taken a step forward and started incentives by rewarding users with COMP tokens.

Governance-hand over the agreement to the community

With the release of the governance token in June 2020, the team behind the project has taken the first step towards ownership and management of the decentralized protocol. Compound began to use the protocol to distribute its governance tokens to all individuals and applications-to evenly distribute 50/50 shares between lenders and borrowers. Initially, the distribution of tokens was done automatically based on the usage of each token. This leads to different rewards, depending on the tokens provided or borrowed by the user. However, with the implementation of Proposal No. 35, it has been changed so that the amount is partially fixed (10% per market) and the remaining amount is variable based on usage.

At the time of writing, the daily distribution of COMP tokens is 2,312. This allocation mechanism will continue until the reserves are used up. It will take approximately four years to distribute all the 4,229,949 COMP tokens allocated to the reserve pool. The remaining 10 million capped supply is allocated to the team and founders (22%, released within 4 years), shareholders of Compound Labs (24%), and future team members and community funds (4% and 8%) ).

Understand the DeFi lending leader Compound: Why does it attract $4.5 billion in liquidity?

This innovative method of transferring ownership of start-ups to their communities has several important implications. The most obvious content can be seen in the TVL chart displayed at the beginning. Although officially looked like voting rights, tokens quickly attracted many new users, leading to explosive growth in the lending pool. Similarly, the price of COMP tokens is another factor that indicates interest in having a part of the agreement.

COMP token

As mentioned above, the idea behind COMP is to increase the decentralization of the protocol, and this token is a tool to control the protocol. Governance can determine many things, such as:

  • Increase support for new assets

  • Change the mortgage factor of an asset

  • Changing the market’s interest rate model

  • Change other parameters or variables of the protocol

  • Even compensate users (user assets are liquidated due to abnormal price feeds)

In essence, protocol governance can be compared to managing a company through community voting, rather than having a few managers behind closed doors. However, you must first be eligible to create a governance proposal. The initiator must either hold 1% of all COMP tokens and delegate to the wallet, or have at least 100 COMP to create an autonomous governance proposal (CAP). An autonomous proposal allows anyone with less than 1% of the total amount of COMP to deploy a proposal (as a smart contract), and if it receives sufficient support and reaches the threshold of 100,000 delegated votes, it can be transformed into a formal governance proposal. All proposals must be submitted as executable code.

In other words, COMP token currently has no other functions. However, when considering price and market value, it can be assumed that there will be a value acquisition mechanism that is beneficial to token holders. For example, similar projects such as Aave have implemented a fee that is collected by the agreement and partially paid to stakeholders.

Business model-target audience

Although lending has clearly found products suitable for the product market (more than 250,000 personal wallets lend their assets to Compound), there are still some doubts about the value of the lending function. When you can get a “real credit loan” without providing ETH or BTC, why should anyone provide collateral to borrow crypto assets?

The number of borrowers also highlights that borrowing is not for everyone. Only about 6900 wallets borrowed assets from Compound. Besides, the main advantage of a loan is not that someone can spend more money than he/she actually has at a certain point in time? We know from traditional finance that over-collateralization negates the most common form of credit.

Here are some use cases:

Leveraged long/short cryptocurrency

If the user is bullish on volatile assets (such as ETH), he/she can deposit ETH to borrow USDC and buy more ETH to gain more room for upside. On the other hand, if the user is bearish, he/she can deposit stable assets (such as Dai), borrow volatile assets (ETH) and sell them. Assuming that the price of an ETH at the time of sale is $1,000, if the price drops to $300, it only costs $300 to repay the borrowed ETH, which will bring users a profit of $700 (minus interest rates).

Gain more income farming and arbitrage opportunities

Another common use case is around borrowing liquidity to use it for arbitrage opportunities, where traders profit from price or interest rate differentials.

In addition to arbitrage, income farming also attracts borrowers. For example, users can deposit in Ethereum to borrow another asset with higher returns elsewhere in the DeFi ecosystem. By lending the asset to another platform, users can maintain the difference between interest rates. However, this is also the main use case of Maker DAO, because the borrowed APY is more or less stable.

Liquidity needs

In many other situations, users need liquidity. Compound allows you to easily deposit your cryptocurrency (you can earn interest from it) to get more liquidity. An example is a miner who wants to buy more mining equipment without having to sell his own ETH. He can use the loan from Compound to do so. Then, the miner can use his mining reward to repay the loan without losing his investment in ETH.

All in all, although “ordinary people” do not borrow to hedge mortgages, many people in the DeFi field are using it. Compound’s shocking total borrowing of more than $2.9 billion also shows this. Currently approximately 50% of the value provided is borrowed. Most of the borrowed assets are stable coins, that is, Dai and USDC account for more than 80% of the loan.

Business model-revenue stream

Although many DeFi protocols implement fee-based revenue models, Compound has not yet implemented a fee model to generate revenue. However, Compound uses a “reserve factor”, which controls how much of the loan interest of a given asset is routed to that asset’s reserve pool. Compared with the expenses flowing into the Ministry of Finance, the reserve pool is only used to protect lenders from defaults by borrowers and liquidation failures.

For example, a reserve factor of 20% means that the 20% interest paid by the borrower is routed to the reserve pool instead of the lender.

The reserve factor can be changed by the community through a proposal. In theory, the use of funds in the reserve pool can also be changed. It remains to be seen whether and when Compound will implement a fee structure or other methods of generating revenue.

Conclusion and Outlook

DeFi is evolving at an alarming rate and requires protocol innovation without sacrificing reliability. Let’s take a look at what Compound will do to maintain their status as one of the top DeFi projects.

In December 2020, Compound announced their plan to use the cross-chain version of the MakerDAO protocol to build an independent Compound Chain and use a local stablecoin called CASH. The new chain will still be managed by COMP token holders on the Ethereum blockchain. According to the white paper, Compound Chain is a proof-of-authority (PoA) network with verifiers appointed by COMP token holders. It aims to solve the expansion problem of Ethereum and realize the mutual interaction with other blockchains (such as Solana, Polkadot). Operational. This PoA network can potentially enable Central Bank Digital Currency (CBDC)-and exchanges like Coinbase to operate nodes on the Compound Chain.

Although Compound’s future prospects seem very promising, there are still some obstacles to overcome. For example, decentralization is still a hot topic in the Compound community. A critical view often heard is the large number of tokens (almost 60%) allocated to the team and early investors. Especially after seeing other successful agreements conduct more “fair” ICOs—Compared with other communities, Compound provides more tokens to privileged investors (VC)—some people have expressed their voices , And require the issuance of other forms of tokens in addition to income farming (which in turn is beneficial to the already wealthy). There are some suggestions and discussions on the forum, involving rewarding early contributors, airdrops or adding new ways to distribute COMP.

In addition, in order to prevent events such as the DAI liquidation event in November 2020, Compound is also working on its price oracle machine. Last but not least, it remains to be seen whether Compound plans to develop a way to achieve a stable revenue stream.

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