Understanding DeFi Lending Leader Compound: What Attracts $4.5 Billion in Liquidity?

This article is from the DeFi Dao WeChat public account, authored by Lavi.

Launched in 2018, Compound now has $4.5 billion in locked value. In June 2020, Compound released its governance token COMP, joining the DeFi summer craze. Maintaining its position as a top lending protocol is not easy for Compound, especially since it has yet to implement a stable revenue stream model. With the release of the Compound Chain plan, how will the project perform in 2021?

Compound ------ Protocol Overview

Compound is a protocol on the Ethereum blockchain that allows users to borrow and lend cryptocurrency tokens. Its interest rates are algorithmically set based on the supply and demand for each asset. Lenders and borrowers interact directly with the protocol, earning (and paying) floating rates without negotiating terms such as duration, interest rates, or collateral with counterparties.

The protocol was launched in 2018, raising $8.2 million in a seed round and another $25 million in a Series A funding round in November 2019. The list of early investors reads like a who's who of blockchain VCs, including industry giants Andreessen Horowitz, Polychain Capital, Coinbase Ventures, and Bain Capital Ventures.

As of this writing, Compound ranks among the top three DeFi protocols by total value locked (TVL). Its locked value saw exponential growth in 2020 (from $15 million at the beginning of the year to over $1.9 billion by the end of 2020), reflecting confidence and trust in the protocol. This strong growth was supported by liquidity mining incentives, which we believe are not significantly related to Compound's achievements.

History ------ Becoming a Pillar of DeFi

MakerDAO can be seen as the first DeFi project that allowed users to take out loans, while Compound was the first to provide permissionless lending pools from which users could earn deposit interest. The Compound v2 whitepaper was published by founder/CEO Robert Leshner and co-founder/CTO Geoffrey Hayes in February 2019. Compound quickly became one of the main pillars of DeFi. Initially, the protocol supported six tokens (ETH, 0x, Augur, BAT, Dai, and USDC).

Since then, additional tokens have been added to the market (some of which have been deprecated). The project team and the Compound community have been continuously innovating. Although the protocol has already been welcomed by many active Ethereum users, it truly gained attention when they announced that they would reward users with the protocol's own governance token, COMP.

Initially seen as a measure to increase decentralization, this became a key moment for the entire Ethereum ecosystem, triggering what is now referred to as the DeFi summer of 2020. In the following three months, countless projects adopted similar approaches, rewarding their users with different tokens in a race for the highest yields, known as "yield farming."

Lending ------ Uses of cTokens

Lending assets to the Compound protocol results in two transactions. The first is depositing the original token (e.g., Dai) into the protocol. The second is the automatic issuance of cTokens (cDai) credited to the wallet providing the asset. The newly issued cTokens serve as an IOU and act as a redemption token, allowing holders to redeem the original tokens. The value of cTokens is determined by Compound through an exchange rate designed to increase in value over time.

By holding cTokens, owners can earn interest through the appreciation of cTokens compared to their original counterparts. Therefore, when redeeming cTokens (i.e., cashing out), users will receive more of the underlying tokens than they initially deposited. On the other hand, borrowers ensure they have more tokens to pay lenders by always paying higher interest rates when borrowing assets. The actual rate is determined by supply and demand (utilization).

Borrowing ------ Over-Collateralization

The method of borrowing tokens on Compound is similar to minting Dai on Maker. However, unlike Maker, Compound requires users to store cTokens as collateral. As with lending, there are no terms to negotiate, no due dates, or financing periods for the borrowed assets. To mitigate default risk, Compound uses over-collateralization to limit the amount that can be borrowed.

The amount a user can borrow is determined by a collateral factor ranging from 0 to 1. A collateral factor (CF) of 0.7 means that the user can borrow up to 70% of the value of the underlying asset. Here’s an example illustrating how much a user can borrow with a CF value of 0.5.

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

If the borrowed amount exceeds the user's borrowing capacity, part of the outstanding loan can be repaid in exchange for the user's cToken collateral. This liquidation can occur when the value of the collateral falls below the required minimum or when the value of the borrowed tokens exceeds the user's maximum borrowing capacity.

Risks and Incentives

In addition to the risk of smart contracts (i.e., hackers exploiting vulnerable smart contracts), another risk associated with money markets like Compound is that the platform may run out of liquidity and be unable to meet all withdrawal requests in the event of a bank run. To mitigate this, Compound's interest rates are based on "utilization," which defines the extent to which lenders' assets flow to borrowers (see the black line in the chart below). For example, if 80% of all available assets are borrowed, the utilization rate is 75%. As a result, only 20% of lenders can immediately withdraw their assets.

Through its interest rate model, Compound can suppress lenders' withdrawals, as rates will rise when utilization increases (to incentivize borrowing), while also suppressing borrowers' motivation to increase borrowing (as borrowing becomes more expensive). The chart above shows the increase in borrowing rates (purple) and lending rates (green) as utilization rises.

Whether Compound can withstand black swan events like bank runs remains to be seen. Gauntlet conducted simulated stress tests in early 2020. Moreover, Compound did manage to avoid disaster during the Black Thursday event in March 2020 (when Bitcoin and most other assets fell by over 40% in a single day), performing much better than other protocols. However, at that time, it was not yet in full DAO mode.

The closest event to a black swan occurred in November 2020, when the price of the stablecoin Dai temporarily surged to $1.3 on Coinbase. Compound uses Coinbase's price feeds to determine its market price. Due to the sudden 30% increase in the price of DAI, some positions were under-collateralized, leading to the liquidation of over $80 million in collateral.

Regardless, ensuring high liquidity is crucial for Compound. High interest rates are one way to incentivize liquidity, but Compound took a step further by starting to reward users with COMP tokens.

Governance ------ Handing Over the Protocol to the Community

With the release of the governance token in June 2020, the team behind the project took the first step towards decentralized protocol ownership and governance. Compound began distributing its governance tokens to all individuals and applications using the protocol—averaging a 50/50 share between lenders and borrowers. Initially, the distribution of tokens was automatically based on the usage of each token. This led to different rewards depending on the tokens provided or borrowed by users. However, with the implementation of Proposal 35, this was changed to fix a portion of the amount (10% per market), with the remaining amount varying based on usage.

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

This innovative approach of transferring ownership of a startup to its community has several significant implications. The most obvious can be seen in the TVL chart displayed at the beginning. Although it appears to be a voting right officially, the token quickly attracted many new users, leading to explosive growth in the lending pool. Similarly, the price of COMP tokens is another factor indicating interest in owning a part of the protocol.

COMP Token

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

• Increasing support for new assets

• Changing the collateral factor of assets

• Altering the interest rate model of the market

• Modifying other parameters or variables of the protocol

• Even compensating users (for assets liquidated due to anomalous price feeds)

Essentially, protocol governance can be likened to managing a company through community voting, rather than being dictated by a few managers behind closed doors. However, to be eligible to create governance proposals, the proposer must either hold 1% of all COMP tokens delegated to a wallet or have at least 100 COMP to create an autonomous governance proposal (CAP). An autonomous proposal allows anyone holding less than 1% of the total COMP supply to deploy a proposal (as a smart contract), which can transform into a formal governance proposal if it receives enough support and reaches a threshold of 100,000 delegated votes. All proposals must be submitted as executable code.

That said, the COMP token currently has no other functionality. However, considering price and market capitalization, it can be assumed that an advantageous value capture mechanism for token holders is expected. For example, similar projects like Aave have implemented a fee that is charged by the protocol and partially paid to stakeholders.

Business Model ------ Target Audience

Although lending has clearly found a product-market fit (with over 250,000 individual wallets lending their assets to Compound), the value of the lending function still raises some questions. Why would anyone provide collateral to borrow crypto assets when they can obtain "real credit loans" without providing ETH or BTC?

The number of borrowers also highlights that borrowing is not suitable for everyone. Only about 6,900 wallets have borrowed assets from Compound. Moreover, the main advantage of loans is not that someone can spend more money than he/she actually has at a given point in time, right? We know from traditional finance that over-collateralization negates the most common forms of credit.

Here are some use cases:

Leveraged Long/Short Cryptocurrency

If a user is bullish on a volatile asset (like ETH), he/she can deposit ETH to borrow USDC and buy more ETH for greater upside potential. Conversely, if the user is bearish, he/she can deposit stable assets (like Dai), borrow volatile assets (ETH), and sell them. Assuming the price of one ETH is $1,000 at the time of sale, if the price drops to $300, repaying the borrowed ETH would only cost $300, yielding a profit of $700 for the user (minus interest).

Gaining More Yield Farming and Arbitrage Opportunities

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

In addition to arbitrage, yield farming also attracts borrowers. For example, a user can deposit Ethereum to borrow another asset that yields higher returns elsewhere in the DeFi ecosystem. By lending that asset to another platform, the user can capture the difference in interest rates. However, this is also the main use case for Maker DAO, as the APY on borrowed assets is more or less stable.

Liquidity Needs

In many other cases, users need liquidity. Compound allows you to conveniently deposit your cryptocurrency (from which you can earn interest) to gain more liquidity. One example is a miner who wants to purchase more mining equipment without having to sell his ETH. He can use a loan from Compound to do so. Then, the miner can repay the loan with his mining rewards without losing his investment in ETH.

In summary, while "ordinary people" may not hedge collateral through borrowing, many in the DeFi space are using it. The staggering total borrowing amount of over $2.9 billion for Compound also indicates this. Currently, about 50% of the provided value has been borrowed. The majority of borrowed assets are stablecoins, with Dai and USDC accounting for over 80% of loans.

Business Model ------ Revenue Stream

While many DeFi protocols have implemented fee-based revenue models, Compound has yet to implement a fee structure for generating revenue. However, Compound uses a "reserve factor," a parameter that controls how much of the borrowing interest from a given asset is routed to that asset's reserve pool. Unlike fees flowing into the treasury, the reserve pool is only used to protect lenders from borrower defaults and liquidation failures.

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

The reserve factor can be changed by the community through proposals. Theoretically, the use of funds in the reserve pool can also be altered. Whether and when Compound will implement a fee structure or other revenue-generating methods remains to be seen.

Conclusion and Outlook

DeFi is evolving at an astonishing pace, requiring protocol innovation without sacrificing reliability. Let's see what Compound will do to maintain its status as one of the top projects in DeFi.

In December 2020, Compound announced its plans to build an independent Compound Chain using a cross-chain version of the MakerDAO protocol and a native stablecoin called CASH. The new chain will still be governed by COMP token holders on the Ethereum blockchain. According to the whitepaper, Compound Chain is an authorized proof-of-authority (PoA) network with validators appointed by COMP token holders, aimed at addressing Ethereum's scalability issues while achieving interoperability with other blockchains like Solana and Polkadot. This PoA network could potentially enable central bank digital currencies (CBDCs) and allow exchanges like Coinbase to operate nodes on Compound Chain.

While the future prospects for Compound appear very promising, there are still some obstacles to overcome. For example, decentralization remains a hot topic within the Compound community. A frequently heard criticism is the large number of tokens allocated to the team and early investors (almost 60%). Especially after seeing other successful protocols conduct more "fair" ICOs—where Compound allocated more tokens to privileged investors (VCs) compared to other communities—some voices have expressed concerns and called for the issuance of other forms of tokens beyond yield farming (which again benefits the already wealthy). There have been suggestions and discussions on forums regarding rewarding early contributors, conducting airdrops, or adding new methods for distributing COMP.

Additionally, to prevent events like the DAI liquidation incident in November 2020, Compound is also working on its price oracles. Last but not least, it remains to be seen whether Compound plans to establish a way to achieve stable revenue streams.