Reunderstanding Compound's Value: Where is its Moat?

This article was published on the Unitimes Unicorn Era public account, written by: Ben Giove, a Bankless contributor, translated by: Nanfeng

Legendary investor and baby boomer Warren Buffet has a famous saying: "In the short term, the market is a voting machine, but in the long term, it is a weighing machine."

Buffet's words apply to any market, and the crypto market is no exception. The crypto market seems to constantly shift from one exciting thing to another, whether it's Dogecoin, meme coins, or other boring imitators.

Perhaps no project is more susceptible to this mentality than Compound. Although COMP is one of the oldest projects in the DeFi space and one of the most outstanding money markets, it may be the least discussed token among DeFi blue chips. There seems to be no obvious reason for this phenomenon: a deeper dive into the protocol reveals that it is just as interesting as these other tokens.

Let’s take a look at what investors might be missing and whether COMP is worth considering in your portfolio.

What is Compound?

Compound is a money market on Ethereum. Users can deposit assets to earn interest, and these deposits can be used as collateral for borrowing. In the Compound protocol, the interest rates for lenders and borrowers are determined algorithmically and vary based on the supply and demand of assets within the protocol.

This is represented in the form of utilization rate, which measures how much of an asset's underlying liquidity is being borrowed. The protocol itself takes a portion of the interest paid by borrowers as reserves, which serves as a backstop in case the protocol becomes insolvent.

To allow for permissionless use of the protocol globally without assessing the creditworthiness of participants, all borrowing on Compound is over-collateralized. When the value of a user's collateral falls below a certain threshold, a third party is eligible to liquidate (purchase at a discount) the user's collateral.

While relatively simple, Compound provides valuable services to DeFi users, offering a plethora of options that allow them to leverage their existing assets in various ways, such as:

• Leveraged long
• Shorting
• Gaining liquidity without triggering a taxable event
• Yield farming by borrowing assets

Compound's Moat

Like any other business, DeFi protocols seek to establish their own competitive advantages (or moats) so they can thrive in bull markets and survive in bear markets.

Compound has proven capable of doing this for several different reasons:

Brand

One key reason is that Compound has a very strong brand. Under the leadership of a world-class DeFi team, Compound has earned a reputation as one of the safest and most battle-tested protocols in the DeFi space.

The project has never been hacked or exploited, surviving the "Black Thursday" of March 2020, a oracle failure in December 2020, and the recent market crash in May 2021. The project's conservative approach to listing new assets further enhances trust among users.

Currently, Compound only supports 11 assets, far fewer than competitors like Aave (which lists 26 assets) and Cream Finance (which lists 80 assets). While this may invite some criticism from investors that Compound is "moving slowly," we must recognize that this limited asset selection reduces the risk of insolvency, as depositors in the money market bear the risk of all assets.

The number of assets available for collateral is an adjustable variable; while more assets mean more choices for users, it also means more risk. Compound has chosen fewer assets and less risk.

Integration

Another reason for Compound's success is that the protocol is one of the most integrated protocols in DeFi, with projects like Zerion, Instadapp, and DeFi Saver providing advanced users with ways to interact with the protocol. These partnerships bring features that other protocols may lack. Notably, compared to its competitors, Compound has chosen to be a lower-risk money market, making it a more attractive money Lego in DeFi composability.

Difficulty of Creating Money Markets

The reason you rarely hear about Compound being forked (aside from Cream Finance and Venus on Binance Smart Chain) is that managing a money market requires a lot of work.

Between evaluating new assets to be listed, ensuring liquidation operates smoothly, and adjusting collateral and reserve factor risk parameters, a money market requires an active, engaged, and long-term oriented community to function properly.

In addition to management, a money market also needs liquidity; the more capital locked in the market, the more borrowing capacity the market can provide. Unlike DEXs (decentralized exchanges), these money markets are over-collateralized, meaning these protocols are nearly incomparable in capital efficiency to Uniswap, SushiSwap, or Curve.

This is a major reason why Compound and Aave face almost no competition: attracting significant liquidity across many different assets is not easy. Unless they provide…

Yield Farming

When discussing Compound's success, it would be remiss not to mention the key driving force behind the DeFi Cambrian explosion—liquidity mining.

Compound's liquidity mining program is legendary, as in June 2020, the protocol began distributing COMP tokens to users, which sparked the DeFi summer of 2020. While Compound was not the first project to implement a liquidity mining mechanism, it proved to be an incredible catalyst for the growth of both Compound and the entire DeFi space, with the protocol's TVL (Total Value Locked) growing nearly tenfold in five months. All DeFi protocols followed in Compound's footsteps, and this event (liquidity mining) changed the trajectory of the entire DeFi industry.

While it is reasonable to question the long-term sustainability of liquidity mining and what will happen after the program ends, to some extent, whether in a bull or bear market, capital will be sticky, as DeFi participants seek to acquire the protocol's native token, providing them with a permanent incentive to use the protocol… as long as the native token has market value.

Tokenomics

Currently, the only right granted to COMP holders is governance. Unlike its competitor Aave, COMP does not play any role in the underlying protocol's functionality (for example, COMP holders cannot capture the protocol's generated revenue, while Aave's native token AAVE allows holders to protect the protocol through staking and capture AAVE token issuance rewards and protocol fees). Instead, COMP is more akin to a non-dividend-paying equity we see in TradFi (traditional finance).

Despite this, some investors completely overlook the tokenomics.

One important metric to note for Compound is its supply schedule.

Above: COMP's supply schedule, source: Messari

The maximum supply of COMP is 10 million tokens, distributed as follows:

• 42.3% (4,229,949 COMP) allocated to protocol users (released over 4 years)
• 24% (2,396,307 COMP) allocated to shareholders of Compound Labs
• 22.25% (2,226,037 COMP) allocated to founders & team (unlocked over 4 years)
• 3.72% (372,707 COMP) allocated to future team members
• 7.75% (775,000 COMP) allocated to the community for governance advancement through other means

Despite the fixed total supply of 10 million tokens, COMP's circulating inflation rate (i.e., the expected COMP supply after 12 months divided by the current supply) is 30.57%.

This is a high number, especially considering that only 29.6% of the issuance will flow into the protocol's reserve fund (this portion of tokens is effectively removed from circulation), while the remaining 70.4% of COMP is distributed directly to the open market through liquidity mining.

While the distribution of COMP helps the protocol attract and maintain liquidity, it also puts downward pressure on the price of the token itself, as users who yield farm and immediately sell COMP tokens create continuous selling pressure. This may explain why the performance of the COMP token has lagged relative to ETH (COMP has only risen 61% year-to-date, while ETH has risen 152% year-to-date), while other DeFi blue chips (like MKR and UNI) have outperformed ETH.

During bear markets, this situation is likely to exacerbate, as yield farmers may have little incentive to maintain the value of COMP rewards, further driving down the price. While the distribution of COMP will decrease over the next three years, without a fundamental reduction in supply to help buffer this impact, Compound's tokenomics are not particularly "bear market friendly."

Governance

Governance may be the most important yet least discussed aspect of DeFi. In many cases, governance is the only right directly granted to token holders.

This lack of discussion is surprising, as governance is an area that can make or break a project. Without a reasonable governance system and an active community of participants, a protocol may self-cannibalize and fail to adapt to the ever-changing DeFi environment. For investors, this may also serve as a warning sign, as low activity and voting rates on governance forums could indicate a lack of community engagement in governance.

So, how is Compound's governance?

First, the governance of the Compound project is completely decentralized. COMP holders maintain full control over the protocol, as changes to the protocol can only be made through the Compound community governance system.

Compound's governance system is quite simple: COMP token holders can delegate their voting power to themselves or to an address of their choosing. When an address holds or is delegated at least 100,000 COMP (equivalent to 1% of the total supply), it can create a governance proposal. Once a governance proposal is created, it enters a 2-day review period, followed by a voting period of 3 days. If a majority votes in favor of the proposal and at least 400,000 COMP supports it, the proposal will queue in the Compound Timelock contract and can be implemented after 2 days. Overall, any changes to the Compound protocol require at least a week. See the diagram below:

This governance system of Compound has become one of the industry standards, adopted by other large projects like Uniswap, Gitcoin, and PoolTogether.

While governance within Compound itself has been very active, with 49 proposals voted on since the launch of autonomous governance (in contrast, other blue chips like Aave have voted on 18 proposals, and Uniswap has only voted on 5 proposals), the decision-making process has remained concentrated among a small group of COMP holders.

First, 46% of the COMP supply is held by the Compound team and investors (shareholders); however, they often abstain from voting. Additionally, the voter turnout and participation rates for Compound governance proposals are very low, with only 0.55% of COMP holders participating in governance, and this is not an issue unique to Compound.

Several reasons can explain this phenomenon, such as the difficulty in keeping up with proposal progress and the gas fees associated with on-chain voting. However, this does indicate that while Compound is a decentralized protocol, its governance has not reached the same threshold.

It is worth noting that token democracy in DeFi does not translate 1:1 to the traditional democracy we are familiar with. In DeFi protocol governance, a lack of voter participation may indicate consensus among token holders, as if the trajectory of the proposal you support indicates it will be accepted, your motivation to participate in voting is nearly zero.

High voter turnout is more likely to occur in a contentious protocol upgrade, as this affects all stakeholders and incentivizes them to pull out their private keys to vote.

Metrics for Protocol Performance

One of the wonderful aspects of evaluating crypto assets built on public blockchains, compared to stocks, is that we have access to and can analyze an infinite real-time database. Unlike the waiting time for traditional companies' quarterly reports and a carefully selected set of metrics by corporate management, DeFi investors can accurately verify how DeFi protocols are performing.

Let’s take a look at Compound.

Above: Changes in TVL (Total Value Locked) in the Compound protocol. Source: DeFi Llama

At first glance, the protocol seems to have grown rapidly in 2021. The TVL (Total Value Locked) in the protocol increased from $1.9 billion to $5.9 billion, a growth of 210%; the total borrowing amount rose from $1.8 billion to $5.1 billion, a growth of 183%.

These metrics indicate that despite high gas fees on Ethereum L1, user demand for utilizing the borrowing features offered by the protocol remains strong. This demand may stem from the bull market in the first half of 2021, as market participants are more willing to take risks and borrow more funds when prices rise.

While these numbers look great on the surface, a deeper dive into the data reveals that this growth is not as it appears; when priced in ETH, the TVL in the Compound protocol only grew by 15.1% year-on-year, from 2.7 million ETH to 3.1 million ETH. See the diagram below:

Above: Changes in TVL in the Compound protocol when priced in ETH. Source: DeFi Llama

In recent months, Compound's main competitor Aave has also captured its market share. While Compound's outstanding debt accounted for 48.5% of the total outstanding debt among the three major DeFi lending protocols (Compound, Maker, Aave) at the beginning of this year, this proportion has since dropped to 28.4%. Meanwhile, Aave's share of outstanding debt has increased from 18.2% to 39.5%. See the diagram below:

Source: Dune Analytics

The reason for this shift is clear: since Aave launched its own liquidity mining program in April of this year, there has been a sharp migration of capital between these two DeFi protocols, causing Compound to start losing market share. While what will happen after Aave's liquidity mining program ends in July remains to be seen, it indicates that the capital competition between these two protocols is still fierce.

We can also observe the stagnation in Compound's growth from user metrics. Although the protocol experienced rapid growth in the number of unique addresses interacting with it during the DeFi summer and winter of 2020, its user growth has stabilized in 2021. See the diagram below:

Source: Dune Analytics

While this is more of a complaint about the expensive Ethereum L1 gas fees (rather than Compound itself), it is indeed a noteworthy area, especially since the project currently has no plans to deploy on any Ethereum L2 scaling solutions.

Scaling Strategy

At a time when there are options to use application-specific rollups (like Loopring and dYdX), Compound has chosen to create its own separate blockchain—Gateway. This independent blockchain will allow users to borrow any asset from any other chain, while Gateway itself is governed by COMP holders through a proof-of-authority (PoA) consensus. For more about the architecture of Gateway, please see here.

While Gateway is an ambitious vision that could significantly increase the revenue the protocol can generate and the value of governance, it may pose short-term challenges for Compound, as it may cause them to miss growth opportunities brought by universal scaling solutions. For example, Aave's deployment on Polygon (an Ethereum sidechain) has seen its TVL grow by over $2.2 billion in just two months, establishing a virtual monopoly in the lending market on Polygon. This has proven to be a missed opportunity, both from a competitive and marketing perspective, as new users are being introduced to Aave through Polygon rather than Compound.

However, it is worth reiterating that the potential of Gateway is enormous. For instance, there are speculations that this chain will position itself to interoperate with central bank digital currencies (CBDCs).

Protocol Revenue

A notable feature of DeFi protocols and their native tokens is their ability to generate cash flow.

As discussed earlier, Compound generates revenue by taking a portion of the interest paid by borrowers, which is now used to build reserves to support the protocol.

This means that the protocol's revenue is ultimately determined by two factors:

• Interest rates, which depend on the supply and demand of assets
• Reserve factor (the percentage of interest paid by borrowers that the protocol takes), which varies by asset (in the Compound protocol, different assets have different reserve factors)

While this revenue source is currently not utilized by COMP holders or the protocol's reserve fund, this situation is likely to change in the future.

Through this model, Compound has created the third-largest cumulative revenue among all DeFi projects, with total revenue exceeding $216 million over the past year, of which the protocol's depositors (asset providers) earned $191 million (89%), and reserves earned $24 million (11%). See the diagram below:

Above: The green section represents the total daily income of depositors in the Compound protocol, while the blue section represents the total daily income of reserves in the Compound protocol. Source: Token Terminal

A deeper analysis of the composition of total revenue reveals that the vast majority of revenue for the Compound protocol, specifically 80.9%, comes from three major stablecoin markets: DAI, USDC, and USDT, accounting for 37.4%, 37.0%, and 6.5%, respectively. See the diagram below:

Above: Growth in daily revenue generated by various markets on the Compound platform over the past 180 days. Source: Token Terminal

This seems logical: stablecoins almost always have the highest utilization rates (i.e., borrowing demand), which means the interest rates paid on stablecoins are the highest. Remember, borrowing assets from a money market means you are effectively shorting that asset, and so far, many DeFi users have hesitated to take on this risk.

This also emphasizes the fact that revenue is highly dependent on borrowing demand, which has a strong correlation with the performance of the broader crypto market (see the diagram below). Essentially: when prices rise, borrowing demand increases, leading to increased revenue. Conversely, when prices fall, borrowing demand decreases, and revenue also decreases.

*Above: **The blue line represents the daily changes in the fully diluted market capitalization of COMP over the past 180 days, while the *green bars* represent the daily changes in the revenue of the Compound protocol over the past 180 days. It can be seen that the two are strongly correlated. Source: Token Terminal*

We can see this from the daily revenue of the Compound protocol: over the course of a month, the current daily revenue of Compound has decreased by more than 71% from the peak before the market crash in May.

That said, it is important to remember that when it comes to determining the income that goes into Compound's reserves (or potentially into the protocol and COMP token holders in the future), interest rates are not the only factor, as the reserve factor also needs to be considered.

The reserve factor, which is the percentage of interest paid by borrowers that is taken, plays a crucial role in determining how much revenue goes into and constitutes the reserves.

Above: At the time of writing, the deposit rate for the DAI market in the Compound protocol is 2.53%, the borrowing rate is 4.18%, and the reserve factor is 15%. The asset utilization rate in the DAI market is 71.76%.

For example, as mentioned earlier, while the DAI and USDC markets account for almost the same share of revenue in the Compound protocol (37.4% and 37.0%, respectively), the DAI market has a reserve factor of 15%, meaning that the reserves extracted from the DAI market account for 55% of the interest that goes into the protocol's reserves, while the USDC market, with a reserve factor of 7%, accounts for only 26%.

This difference adds an interesting detail to Compound's revenue dynamics, as it indicates that the reserve factor represents a form of pricing power. For instance, in a bear market, Compound can raise the reserve factor to help offset lower protocol revenue levels due to declining interest rates. While it is generally thought that DeFi fees are in a race to the bottom, given the barriers to creating money markets, competition among money markets is limited, meaning that, theoretically, compared to DEXs (decentralized exchanges) facing a series of competitors, Compound has a greater opportunity to "raise prices."

Conclusion

Compound is a contradictory project. While liquidity mining has been very successful in initially driving its growth, it has come at the cost of putting downward pressure on the price of COMP tokens. Perhaps in the long run, this will benefit the distribution of COMP, thereby aiding the decentralization of the protocol, but only time will tell.

Additionally, as the protocol has ceded a significant market share to Aave, this growth has now essentially stabilized. Furthermore, although the protocol itself is decentralized, a small group of participants has exerted too much influence over its governance. Finally, while the project has an ambitious scaling plan (Gateway), avoiding universal scaling solutions has led to missed growth opportunities for the protocol.

However, Compound remains a dominant force within DeFi and will continue to maintain this position, as its brand, liquidity, integration, and the difficulty of running a money market create a wide moat for it. Moreover, the protocol is a cash cow, possessing the coveted trait that all DeFi enterprises covet: pricing power.

Yes, it is not perfect. But COMP is indeed worth discussing.