A COMP Case Study
Compound Protocol was one of the first protocols to kickstart native token mining programs, like yield farming or liquidity mining. Compound saw a peak at $372.79 during the height of such token incentive programs. Today, COMP hovers around less than half its peak price.
Compound is a lending and borrowing protocol. Users deposit assets into the protocol and others can lend it out. Users can also use the assets on the protocol as collaterals and borrow against it. Interest rates are determined mathematically onchain.
At its peak, Compound protocol was ranked the top in total locked value according to DefiPulse, the DeFi tracker for ERC20-based tokens, with almost $1b locked. That also translates to activities on Compound, with outstanding borrowing seeing a steady growth. Today, the outstanding borrowing on Compound is inching towards $1b.
Smart Contracts to Reduce Costs
Smart contracts are used in Compound to reduce the operational costs involved in giving out loans, thereby increase the available money for spending, lending or borrowing. The protocol uses an interest rate model to achieve interest rate equilibrium based on supply and demand of the individual assets. The variable that is concerned in the model is the utilisation ratio, U, that connects supply and demand.
In simple words, interest rates increase when there is more people demanding money. Interest rates decrease when there is less people demanding money.
With smart contracts, they are able to take the data onchain and use them in the pricing formula to get a dynamic interest rate that best reflects the demand of money (or crypto asset).
Of course, a dynamic interest rate is not enough. In economics, there are external factors that could affect the stability of the internal market. Hence, there is a buffer added to the calculation. This is to make sure that there is an economic profit in the protocol. Borrowers and lenders will be compensated appropriately and be less affected when a situation happens (aka an adverse shock).
Borrowing on Compound
Before understanding if incentive mechanisms work, let’s look at what is the demand of such crypto assets on the protocol.
THEN: 86% of the total borrowing is concentrated in DAI, followed by 7% in USDC and 4% in ETH.
NOW: 39% in DAI, 23% in USDC and 20% in ETH.
Similar to other lending protocols, most of the borrowing is concentrated in pegged tokens like DAI and USDC. That’s because the exposure to the crypto asset affected by volatility risks of the asset itself.
ETH is in demand, because ETH is the oil to allow any of the protocols to be moving. DAI and USDC are P2P money. We use it to pay one another. ETH is not exactly money that we use to pay one another, but ETH is the money machines use to pay and interact with one another.
Think about it, for one protocol to talk to another and share information (e.g. your transaction), it needs ETH and gas to execute that sharing.
Thus, ETH is money for machines. DAI and USDC is money for people.
Token Incentive Programs
Now back to the main topic.
Do these programs work? For how long do they work? And are they sustainable?
Short answer. Yes.
Yes they work. They work for a while, it depends. The programs alone are not sustainable.
Long answer. No, but Still Yes.
When Compound first launched its COMP native governance token, the COMP token was an additional reward to borrowers and lenders.
For instance, I am a lender. I lend 100 DAI. In return, I get back some interest rates for the DAI people borrowed from me AND a few COMP tokens as rewards.
Yes It Works
This is attractive to users. Other than the usual interest rates, I will be receiving an additional token that has value in the secondary market.
Before COMP distribution, the average collateralisation was higher, between 400-600%. Since the distribution, the average ratio dropped to 180%.
This is not to say the incentive programs do not work. Rather, it is likely that the returns are so attractive that people are willing to take more risks and reduce the collaterals and free up more assets for other revenue-generating activities.
The incentive programs help affect users’ behaviours by making them more risk loving.
It Works For A While
Initially, there was a fixed amount of tokens distributed to the users, at 2,880 COMP per day. Each user receives COMP proportional to their trading activities in the community.
Other than selling it, the tokens have an internal value of allowing the user to participate in governance. After distributing a good amount of tokens, there were sufficient people to vote for changes.
And the first change is to reduce the daily distribution of COMP tokens.
Today, a 20% reduction is seen, distributing about 2,312 COMP tokens to users daily. Down from 2,880 COMP.
A risk here is to map out how distributed these tokens are and the addresses that hold them.
Why? Because if we care less about distribution and place the trust in any one with governance power, we are going back to the problem in traditional finance of asset management companies like JMPC, Goldman Sachs and Blackrock owning about 80% of the market via voting rights through (distributed) ETFs.
Majority of COMP holders hold less than 100,000 COMP. 225 addresses hold at least 100 COMP.
What does this mean? For a user to propose a protocol upgrade, a minimum of 100,000 COMP tokens is needed. Thus, this means that not many users are able to propose any upgrades yet. This can be a good thing as the protocol is still maturing and it’s good to prevent too many changes by users without enough skin in the game. At the same time, it could move towards a centralised governance structure, where only a few people can make changes and the changes might only benefit them instead.
To combat this, users with at least 100 COMP could create proposal templates and get 100,000 COMP (via 1 super-user or many smaller users) to back the proposal and submit it as a formal proposal.
This helps with utilising the COMP tokens for a more community-based, decentralised governance mechanism instead of having governance fully via machines or only to super-users.
Not Really Sustainable
Since the fall in COMP distribution, availability of other protocols with lower rates, available of other protocols with more attractive native tokens, the average collateral ratio has dropped significantly. Loanscan also shows that the average collaterals added has dropped each month.
Thus, the incentive programs are a good tool to gather mass adoption and perhaps to kickstart the protocol usage. However, to really get users on the platform, it requires more than just token incentives. The incentives will run dry, people will get bored or something new will pop up. Thus, the important aspect is still going back to fundamentals to figure out what the comparative advantage is in using the protocol, beyond just these incentive programs.
It boils down to the real value-add. In lending and borrowing, the best comparison is rates that banks are offering. At the end of the day, banks exist to aggregate the money available, and lend it out to users who need it.
With blockchain, we can remove banks as the intermediaries and streamline that with machines, math and code. Instead of banks telling me the rates I will receive, I get to dictate how much I want to lend out, directly to users.
USDC on Compound has an average yield of 2.94% annually, if you are a lender. Compare that to the average interest returns to a US savings account, which is 0.05% yield annually, that is a 58x higher return. Thus, this is the main drawing factor of users towards the protocol. It is not the yield farming, not the native governance tokens (nice to have), not the incentive mining. It is the actual returns and value-add that the protocol brings!
Thus, token mining is just a growth strategy. Without proper real value-add in the protocol, everything is just another #ponzinomics scam. With real value-add, the tokens are just another incentive mechanism to increase the value the protocol can bring to all users in the system!