What is Compound Finance and $COMP?

What is Compound Finance and $COMP?

. 10 min read
I’m an honest laborer sir. I farm morning till night, and then wake up again. I tend to my crops and watch them grow. It ain’t much, but it's mine.

One of the core aspects of finance is the time value of money. In fact, Finance is Interest Rates, Not Trading. The problem a lot of people had back in 2017 was that there was no way to short any of the multitudes of altcoins hitting multi-billion dollar valuations. If you had seen Dragonchain do a 100x with disbelief, the only thing to do at the top was to pour a little out for the homies about to suffer a 99.9% loss.

Without delving too deeply into conspiracy, it was the launch of Bitcoin futures on the CME that marked the top of the market. To say there was an underwhelming amount of on and off-chain financial products for crypto at the time is an understatement.

Real markets need interest rates. They are the lifeblood for any financial institution and economy. With Ethereum, the institutions are coded into smart contracts that trustlessly exchange and pool assets.

Back in 2017, there was no way to effectively and trustlessly lend or borrow against your crypto assets. For larger investors, their assets essentially had a negative yield, as storage costs and other risks would eat into the realized returns. If you wanted to earn interest on your crypto assets, you had to have trading knowledge high enough to be able to navigate derivatives markets or other centralized platforms.

Here’s an example, your an ICO that raised 50k ETH at $1,000 and now are sitting on 50million that is rapidly declining in value. Every day you wake up, another million or two is gone. Markets are in freefall. Selling is a grim outlook as it would incur significant capital gains taxes. Derebit doesn’t offer ETH puts yet and Bitmex has yet to launch ETH swaps and futures. What do you do?

In 2017, you're screwed. Most ICO projects took the cash out option and bought a few yachts. A few hired treasury managers, but still lost gobs of money as the instruments lacked at the time and the cost premium for available products was similar to signing away your firstborn.

This led to an interesting dilemma. If you raised and cashed out on the plebs in 2017, you now had a war chest to actually try and achieve some of the goals laid out at ICO. After 2018 rolled around, if you hadn't spent all your money on conferences, champagne and ICO hookers marketing companies.

In 2020, you would either buy puts or effectively dollarize your assets by selling futures (Long Spot + Short Futures = cTokens, but we will get into this later.) ETH derivative markets abound and a competent treasury manager would be able to minimize downside losses on your ETH, while collecting that sweet premium.

For plebs though, trying to collect sweet futures premium isn't very intuitive and comes with its own risks. Plus, the only semi(?)-reputable place to execute these trade was Bitfinex or Bitmex, both exchanges that do not allow US citizens to use their platforms.

Enter Robert Leshner and the Compound team to save the plebs who didn't know they needed interest rates and Defi. In the whitepaper Compound was laid out as:

a protocol on the Ethereum blockchain that establishes money markets, which are pools of assets with algorithmically derived interest rates, based on the supply and demand for the asset. Suppliers (and borrowers) of an asset interact directly with the protocol, earning (and paying) a floating interest rate, without having to negotiate terms such as maturity, interest rate, or collateral with a peer or counterparty.

There is a lot to breakdown here so let's do it in parts.

Supply

Compound facilitates lending through a smart contract controlled liquidity pool.

Deposits are pooled together by their respective asset type. The more assets deposited, the larger the pool and the more liquidity available to borrow. Anyone with approved tokens or ETH can deposit their assets into Compound. No KYC, no AML, no restrictions based on country.

What makes Compound so powerful are cTokens, ERC20 tokens that represent deposited collateral in the smart contract. When any asset is deposited, an equivalent amount of cTokens are given in return. Each asset supported by Compound has its own cToken (cETH, cUSDT, cUSDC). cTokens can be redeemed at anytime for an equivalent amount of the base asset.

As cTokens are ERC20 in format, they are freely movable, tradable and can be used in other Ethereum based applications. cTokens are an instrumental part of the Defi ecosystem. They represent an interest bearing claim on an asset, rather than the asset itself. This allows developers to build apps which use cTokens, such as bZx, Tokensets or any of the other financial based apps on Ethereum.

At Tokensets, Sets are a single ERC-20 token that represents a fully collateralized portfolio of other assets. Sets auto-rebalance according to the chose portfolio strategy. The two most popular strategies on Tokensets are "BTC Network Demand Set II" and "ETH Trending Alpha ST Set II." In each of these strategies, the sets rebalance to cUSDC to capture interest. This integration is only possible as cTokens are ERC-20 and compostable in various applications.

Borrow

Borrowing requires cTokens as collateral. The only way to acquire cTokens is to supply assets into the liquidity pool.

Borrowers are limited by the value of assets supplied and by its collateral factor. This is a ratio ranging from 0-90% that determines the borrow limit based on increases in liquidity. In practice, the most liquid assets have a maximum collateral factor of 75% (USDC, ETH, DAI), while less liquid assets trend around 35%.

The amount borrowed cannot exceed the value of the collateral and its collateral factor. For example, depositing $100 of USDC enables borrowing of up to $75 of another asset listed on the Compound protocol.  If the borrowing limit is exceeded, the supplied collateral is liquidated.

Interest Rates

In the 16th-20th century, in times of economic stress, public sentiment towards bank reserves and the ability of borrowers to repay their loans would falter and depositors would flood the bank with requests to withdraw their capital. Banks, by design, rarely had more than 10-25% of capital in their vaults at anyone time. If depositors believed the bank would soon become insolvent, they would rush to reclaim their assets. If enough people joined in the mayhem, it caused a "bank run" or capital flight away from financial institution.

Bank runs are extremely destabilizing. Famines, wars and social destruction are typical consequences of bank runs. Central banks were specifically designed to ensure bank runs would not occur, as they could step in as "lender of last resort" to prevent panic and destabilization.  All modern banks are supported by Central banks and also provide depositor insurance up to a few tens or hundreds of thousands to protect people in case of a bank collapse.

Ethereum was designed to be immutable and without a lender of last resort. Once a transaction was finalized, there is nothing that can be done to reverse it. There is no lender of last resort. If money is lost or loans go bad, no one can step in to help.

Currently, more than $1.5 billion is supplied and $900 million is borrowed at Compound; a 1.5:1 reserve to loan ratio. 

What happens then when depositors get a bit jittery and start to pull assets at a high rate?

The short answer is interest rates go up.

There are only a few tricks that Compound has to adjust supply and demand of the assets held in their smart contracts. As borrowing increases, interest rates automatically rise to match the demand for the assets. As supply increases, interest rates go down to match the lack of demand for the asset. Interest rates are algorithmically determined based on the ratio of supply to demand. This ratio is called the utilization ratio (UR).

UR = Borrows / (Cash + Borrows)

The bonded curve for interest rates is determined through governance and is a function demand.

Let's take a quick example. If $1,000 is supplied to the Compound smart contract with an average collateralization factor of .7, this puts a hard limit of $700 that can be borrowed. If $350 is borrowed, the UR will be .5. If $700 is borrowed, the UR will be 1. Interest rates adjust based on the UF.

As the utilization ratio climbs closer to 1, interest rates rise precipitously. The result should be one of the following. Either the higher rates attract new supply or borrowers repay their loans to bring rates back towards equilibrium.

Unlike a central bank, Compound makes no effort to ensure liquidity. Interest rates provide all necessary incentives to both suppliers and borrowers. In a world awash with money and near zero interest rates, its important to remember that low rates is equivilant with too much supply and not enough demand. Governments can print as much money as they want, but there is no guarantee for any demand. Liquidity is a poor substitute for natural demand curves. It only distorts lending markets.

$COMP

In May 2020, Compound transitioned away from executive governance to a decentralized model. This was after A16z invested $25 million into the platform for its future growth.

The vote to add COMP won by an overwhelming majority and was proposed as:

“Every Ethereum block, 0.50 COMP will be distributed across ETH, DAI, USDC, USDT, BAT, REP, WBTC and ZRX markets, proportional to the interest being accrued in the market; as conditions evolve, the allocation between markets is updated by invoking the refreshCompSpeeds function. Within each market, half of the COMP is allocated to suppliers, and the other half to borrowers.”

COMP is a governance token. It is used to make proposals and vote on decisions concerning how Compound should be run or what rules should be implemented (i.e. interest rates, collateralization factor, etc...).

COMP is distributed to those who use Compound by borrowing and supplying assets. The ERC-20 is distributed equally between suppliers and borrowers each block. Each day, roughly 2,880 COMP is distributed proportionally to the borrowing demand for each asset.

You can find out which asset is gaining the most COMP on this site.

The total supply of COMP will be 10 million, meaning distribution will take 4 years. 42% of COMP will be distributed by means of usage of the platform. Distribution will be broken as follows:

  • 24% (2,396,307 COMP) to shareholders of Compound Labs, Inc.
  • 22.25% (2,226,037 COMP)  to Compound founders & team, subject to 4-year vesting
  • 3.72% (372,707 COMP) to future team members.
  • 42.3% (4,229,949 COMP) reserved for protocol usage
  • 7.75% (775,000 COMP) reserved for future governance participation incentives
  • Most importantly, ZERO COMP will be sold or retained by Compound Labs, Inc

COMP is currently trading on Uniswap, Coinbase and several other large exchanges.

The Rise of the Yield Farmers

When COMP was released there was a rush to acquire the new governance token. Initial prices for the token started with bids at $60, but soon skyrocketed to $381 as manic fervor took over the Defi community.

Pre-COMP, there was not much incentive to supply/borrow in Compound. Rates had falled from the 7-9% range for most assets down to 1-3% as a proper equilibrium was found for Compound's demand.

The launch of COMP changed everything. In just a couple of days, the total value of dollars locked in the Compound smart contract jumped from $90 million to over $750 million. Yield farmers rushed to supply and borrow to gain COMP.

This started what was known as "yield farming," where capital sitting on the sidelines was moved into Defi to capture returns from governance token distribution. COMP's model is a modified version of liquidity mining that many Chinese exchanges used during 2017/8 to generate interest.

FCOIN was one of the largest exchanges that offered liquidity mining and generated billions of dollars in trade volume a day. It shocked the crypto community as huge piles of capital moved into the exchange to start rampant wash trading to gain FCOIN. The exchange eventually found that it had misappropriated tens of millions in user funds and closed to due insolvency.

The trend towards liquidity mining was far from over though. Distributing tokens through active use of the platform is an extremely novel approach. It's a marketing ploy meant to onboard thousands of new users who you hope will turn into long term traders. I have no doubt that liquidity mining works for some exchanges, but I can't say whether those exchanges would have been successful even without these distribution programs.

Unlike with exchange tokens, where the end result is zero-sum, Defi is able to escape this with its lending markets. Actual utility is created for Compound users. The project team members and Robert Leshner get their exit over the next 4 years after their tokens vest. A16z makes their investment back in folds. Everyone wins (maybe).

In the first few days, the rising price of COMP drove APY well over 100%. As of writing this article, COMP prices have declined to $175. This brings the returns back towards moderate territory.

Eventually, COMP returns should equal pre-release levels plus a bit of premium for the governance aspect. Several other commentators have priced COMP at $30-40 long term as it would represent 4-5x book value of the assets held in the smart contracts.

There are several very cool tools to calculate the best market to supply COMP to and how much your annual returns will be.

For example, if you supply $10,000 DAI at 2.94% and borrow $6,000 USDC at 5.55%, you will end up with a -0.34% effective borrowing rate. However, you would earn 8.20 COMP  over the year, which at these prices is $1,442. This brings your net APY up to 8.64%

All in all, the COMP program is a good example of how to build a well functioning protocol and then release a token. It's the best model. While the token can be released first, higher demand will only be found in projects that provide utility on mainnet.



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