Compound is at the end of its beginning as a controlled DeFi money market protocol - and has made some tremendous progress in enabling a broader community to steer the direction of its growth. Compound has managed to make some radical changes to the perception of user-centric ownership of the protocol - and has been at the forefront of driving token distribution on the basis of user-owner incentive designs. The Compound team and community has managed to create a large pool of assets locked up in the protocol - while continuing to build better, more liquid and well-utilized markets with high user and continued developer engagement.
As investors, Consensys Labs decided to showcase our position, what metrics we keep an eye on and present our viewpoint from our perspective in the ecosystem - via a brief walkthrough on the events in the last few weeks. We hope that this would encourage more critical discussion, induce feedback and help drive the Compound and DeFi ecosystem towards a place of more transparency, sustained value capture and cement its place as a truly successful community-owned and governed project.
Consensys Labs invested in Compound’s equity fundraise as part of a $20m fundraise which was led by a16z, with participation from Paradigm, Polychain, Bain Capital and other investors. The intention of the founding team was clear in creating a transition from equity-oriented stakeholder governance to a community-oriented voting model - and began token issuance for investors on March 3rd (via the creation of the COMP token contract). The cumulative supply of COMP was 10M tokens, with 50% of the tokens allocated according to the pre-launch cap table (investors, advisors and employees), and the remainder to be distributed to the community over time (approx. amounts):
4.2M to Users of the protocol (over 4-year period)
2.4M Shareholders of Compound Labs, Inc.
2.2M Founders & team (4-year vesting)
0.4M Future team members
0.8M Allocated for the community to advance governance through other means
Compound had decided to move towards a community-owned money market protocol and chose to do so via the release of their platform governance COMP token. The team chose to release 42% of the supply in the form of ‘mining’ incentives to drive users to deposit to and borrow from the protocol. The initial distribution assumed a block time of 15s and originally issued 3297 COMP/day (or 0.5 COMP/block) - furthermore, the rate of COMP distribution was directly proportional to interest paid on Compound markets (a.k.a. the borrow-volume multiplied by the interest rate) incentivizing people to borrow assets on markets tending towards the highest utilization (a.k.a. with the highest amount of interest rates per unit borrowed): of this, 50% of the COMP generated would be distributed to borrowers and the remaining to lenders. With this schedule, the remaining tokens would be distributed in about 4 years from the start date of June 17th (2 days after having passed governance proposal #7).
The COMP distribution was set to drive price appreciation along the following lines:
Boost initial liquidity on Uniswap v2 with a 50-50 COMP/ETH pool set in conjunction with the launch of the mining program, and set towards initiating interest in early buyers
Kickstart COMP mining release on the basis of a combination of borrowed volumes and amounts repaid (on the basis of interest rates)
Launch of COMP on Coinbase to continue driving demand for COMP on the basis of increased TVL’s, leading to a factor increase in price
Uniswap pool depletion leads to more interest in COMP and demand is translated to multiple venues. Furthermore - Compound charges a high txn fee to move the COMP mined in an account to further put a dampener on supply
All of these essentially led to a significant increase (initially) in USDT deposits to the point where Compound had over $1B in TVL as well as a market capitalization that moved from $500M to roughly $3.3B (with a trade of over $400/token at one point) - and had clearly overtaken Maker as the most valuable network within the DeFi ecosystem.
The aforementioned distribution had led to incredibly heady markets with borrowers initially tapping into multiple leverage mechanisms to enhance portfolio yield. As mentioned earlier, COMP distribution was skewed to markets that had the highest utilization - making it common practice for people to go after the markets with high rates and compounding leverage in order to maximize COMP earnings on both the lending and borrowing sides. This occurred to the extent that lenders were seeing APY’s in excess of 160% for a short span on their USDC borrowings - and this created a dynamic feedback loop with higher utilization driving the COMP price higher, which in turn created more attractive mining distribution rewards for suppliers and lenders. The increased rate of return in COMP rewards (at 0.5 COMP/block) was something that got more people to amp up leverage in more volatile and utilized assets and push higher utilization for underlying markets.
This was slowly changed as governance measures came up to address some of the systemic behaviours these incentives were affecting - and managed to curb some of the changes in the different Compound markets, but we still see a significant change in the ownership of certain tokens (BAT had a majority of its circulating supply locked up on COMP in a self-referential fashion - with supply APY’s up to 16% and borrow APY’s up to 27% - and this has now shifted to DAI, with a market liquidity of 85.8M DAI, or 43% of the minted supply).
Source: DeFi Pulse
All of this was responsible for an increase in assets managed under the Compound protocol ($1.7B in the last week with 6700+ new unique users added to the protocol and $780M in loan originations), along with spurring some extremely interesting 2nd-order effects in other protocols and tokens (as discussed in the next section) and an increase in activity in front-ends (such as Instadapp’s DSA and Furucombo) to support users from tapping into positions where they could benefit from the high yields. We’ll continue to cover these in the following sections.
Compound liquidity incentives have been responsible for triggering multiple communities of people acting towards maximizing COMP exposure and earning yields. One very interesting outcome was the increased interest in incorporating such incentives into other DeFi protocols to spur user engagement - this is something that we’ve been seeing since the time of Synthetix, but it has also acted as a marker for the Balancer Labs protocol to accumulative over $110M in cumulative deposits as well as kicking off more liquidity transfers and deposits into Curve and Synthetix. This is something Dan Elitzer (from Ideo) described as the transformation of certain characteristics of liquidity into a form that suits other purposes - framing it as the rehypothecation of assets on the basis of their functionality, and enabling the co-existence of different asset forms across different protocols in the lending and trading space. Outside of these, we’ve been seeing an explosive increase in front-end development (be it through Instadapp’s DSA’s or through Furucombo’s cubes for flash loans) that enable people to tap into different strategies across protocols and gain exposure to COMP, SNX, BAL, CRV and REN tokens as part of the work by some of these teams to set up incentivized pools.
The COMP token price has seen an increase due to the confluence of different factors as a virtuous feedback loop: liquidity mining incentives → additional deposits and increase in utilization → increase in assets under protocol (AUP), utilization and interest rates → appreciation in COMP price → liquidity mining incentives (the cycle repeats), as mentioned in the previous section.
We believe that there could be a downturn in the upcoming weeks (COMP dropped 13.3% July 2nd, along with the presence of COMP synthetics that could allow traders to go short on COMP) and the sell-side dynamics of yield farmers before there is wide distribution to the community - and a second wind in the sails leading to another price appreciation event. This factors in potential distribution of rewards to token holders, broader lock-up of liquidity in the protocol, more uniform asset markets and standardized interest/reserve models along with more derivative products built on top of cTokens. Furthermore - there could be native demand sinks in the form of additional COMP reserves which could be useful towards securing the sustained growth of Compound markets.
All of these would primarily be driven through governance and attracting developers to build on top of the core protocol and its underlying assets - and ensuring that the community has enough interest, skin-in-the-game and participation in framing, driving discussions and adopting new measures. This is something that we reflect upon in the governance section below.
Our pricing outlook and our thinking on protocol governance rest on some on-chain metrics that we keep in mind and track. These are early signals that are emergent in the broader lending landscape that could help drive a more quantitative approach towards understanding the value generated by Compound, as well as its relative impact when compared to other popular projects in the DeFi ecosystem - and these would hopefully evolve over time and become leading indicators.
Some of the metrics we like to keep an eye out for include:
Assets under protocol (AUP) & TVL
P/E (on the basis of reserves and earnings)
Network Value/TVL and Circulating Market Cap/TVL
Source: Token Terminal
We listed some prominent DeFi projects below, all of which are vying for liquidity. Note that Balancer and Synthetix are DeFi protocols which come with slightly different financial product offerings and economics, built up on the core proposition of the utilization of locked up collateral; we might see these arise as part of functionality built on top of Compound.
The Compound community has been active since early May and getting to work on different aspects (onboarding, deprecating, adjusting parameters) for different markets on Compound. This has been marked by a move away from less liquid and low volume assets (such as SAI deposits via increasing reserve factor to 100% and collateral factor to 0%) and enabling the creation of assets with deeper liquidity and demand from the community (such as USDT) - all of which were steps taken to ensure adoption of assets with more stable active circulation, deeper liquidity and utilization + easy for liquidators to function in in volatile market conditions, along with resilience to deflationary spirals. But the initial launch itself was geared differently and aimed at driving higher utilization and interest payments - and we enclose a brief timeline narrative as follows:
This activity had only been increasing since the launch of COMP tokens (via prop. 7) - which saw an 10x increase in USDT assets, leading to the establishment of a higher reserve (20%) to set up insurance for any untoward incidents via proposal 8. There had also been a broader indication of putting tokenized BTC assets to use on lending, which led to an increase in WBTC APY up until the point that the COMP token distribution was focused more on assets with broader interest accrual, leading to a subsequent decline. However, the general price shift seen with this is also indicative of more people expressing a desire to utilize their WBTC assets as collateral on Compound (which has in fact crystallized as CP 16).
This led to a general shift in the markets from USDT to BAT thanks to the smaller circulation and higher utilization ratios for BAT, leading to a significant part of its circulating volume being locked up on Compound for yield farming purposes - posing an increasing systemic risk - especially compounded by the relatively thin liquidity on exchanges for BAT.
This was countered by a proposal to reduce the rate of COMP distribution to 0.44 COMP/block (or an equivalent of 2880 COMP/day) and an increase in the reserve factors for ZRX, BAT and REP from 10% to 50% to counter these systemic efforts and build protocol reserves
Furthermore, there has been an increase in demands from the community over establishing proper mechanisms to discuss protocol upgrades and drive better and more sustainable practices for the Compound ecosystem. This led to a the creation of a more organized system for seeking to modify COMP distribution on the basis of the natural market demand for assets borrowed (making COMP distribution proportional to each market’s borrow demand) and creating a more established set of guidelines for code audits and coverage as well as proposals for creating economic simulations of these changes as and when created
The next steps for Compound would be to normalize interest rate models across different markets to facilitate more natural market demand for different assets on the protocols
We have been active members of the discourse and have voted on 10 proposals - but believe that it would be good to keep making more proactive efforts to drive a large pool of assets and reserves being created and managed under the protocol to ensure the viability of long-term network appreciation.
In general, as part of our participation in governance, we are focused on ensuring that there are no threats in the forms of reactionary proposals, non-uniform treatment of stablecoin assets and broader mindshare for Compound as a composable primitive for cross protocol integration. The key metrics that we are watching for are:
Sustained AUP levels
High utilization metrics for various assets (high interest accruals, turnover and capital efficiency wrt to COMP price appreciation + normalization of reserves and rates across different assets
Sufficient liquidity for these assets outside of COMP and capability for a diversified and healthy set of liquidators
Impact on asset prices and circulating volume along with the impact on stablecoin pegs
You can find a comprehensive list of governance proposals on the governance page for Compound - as well as a list of all the participating token holders and delegates. Our participation in these proposals can be found on this page.
It’s fascinating to see Compound evolve to be the one of the first demonstrations of user-owned and governed financial services - and it is our duty to ensure that this keeps spurring more innovative initiatives from the community to help create money-market and debt infrastructure that is highly accessible, available and efficient.
A consistent theme of discussions in the community has been towards ensuring more transparent and fair systems - be it for equitable COMP distribution, building sufficient reserves and normalization across markets. Towards this, the community has been extremely active in proposals tending to uniform reserve factors and caps across assets, enabling a smoother transition towards parameter setting via governance without increasing the surface area of smart contracts; most importantly however - the aim is to also formalize elements of the governance process to account for results on economic simulations, reviews and test coverage and getting enough time for the community to weigh in, discern different opinions and have the adequate representation across the board. We’re fully onboard with the spirit of these - and would encourage more members to have an active say on the governance forum.
We think that there is great potential to help drive discussions around normalizing reserves and enabling the utilization of COMP in various aspects of the protocol - and ensure that it could be used as a substrate to build up new markets, ensure adequate rewards to holders and appreciate in utilization and value. We would like to work towards seeing more proposals that enable for higher COMP utilization across multiple functions - and act as a core capital tier that would serve in the creation of multiple debt and credit services on top of the protocol across a wide variety of stakeholders.
We also believe there are several elements that need more participation from protocol developers, designers and economists in order to help extend Compound - to assist the creation of fungible debt positions and fluid rehypothecation, the ability to extend liquidity in multiple assets and higher order instruments in different forms to a long-tail of user and protocol interests & sustainable value capture mechanisms for the governance token - all the while keeping in forefront the safety of user deposits, resilience in unfavourable market conditions and a sufficient base of reserves that could help create more automated systems of governance and algorithmic control. We are firm believers that safety of user deposits would be at the forefront to all of these developments - and would like to see more work along economic simulations in stressed markets to back any of the upcoming changes to Compound.
We’re still very early in the road - but we’re in this for the long ride, and believe Compound would continue to drive value to multiple stakeholders and become a basis for creating more transparent, accessible and available infrastructure for money markets!
Principal, Investment Team