How centralized exchange volumes illustrate DeFi’s boom-and-bust cycle
The Rise of Compound: Hype-Driven Bubble or Indicator of DeFi’s Strength?
Leading decentralized finance protocol Maker was recently swiftly overtaken by another DeFi protocol called Compound. Both based on the Ethereum network, Maker had held the by far leading spot in DeFi since 2018 in terms of total USD value held or “locked” on the protocol, while Compound has surged in popularity since mid-June.
Compound’s recent rise was, at least partially, connected to the launch of its governance token, COMP, the distribution of which began on June 16. Since then, the price of COMP has more than tripled to $223 — with value locked in the protocol reaching almost $640 million as of June 30.
The surging demand for COMP tokens has also benefited the entire DeFi market, with total assets locked in all protocols rising from $1 billion to $1.64 billion since mid-June, according to DeFi tracker DeFi Pulse.
Compound: DeFi’s new and popular leader
Compound is a decentralized money market protocol for crypto asset borrowing and lending. Its market currently supports nine assets:
- Basic Attention Token (BAT)
- USD Coin (USDC)
- Ether (ETH)
- Tether (USDT)
- Maker’s stablecoin Dai (DAI)
- Wrapped Bitcoin (WBTC)
- Augur’s token Reputation (REP)
- 0x’s token ZRX
- Sai (SAI)
Compound’s founder, Robert Leshner, first unveiled the protocol’s governance model with its ERC-20 token COMP on Feb. 26.
The project moved a step closer to decentralization in April, when community governance replaced the administrative team in governing the Compound protocol. After two months of public testing, the project’s community passed governance proposal 007, which defined how the protocol would distribute tokens to users on June 15, 2020. The distribution of COMP is expected to be completed in four years.
Users are able to participate in Compound’s governance process by using COMP tokens to vote on community proposals.
3 reasons COMP demand is surging
Compound replaced Maker as the leading DeFi protocol following the announcement regarding its token distribution. The most evident reasons behind the surging demand for COMP are threefold:
- Community interest in COMP since its launch
- Certain assets in Compound have higher than average yields
- Multiple cryptocurrency exchanges — including OKEx — have listed COMP
Compound’s reward scheme allows users to earn extra COMP for any borrowing and lending activities in the protocol. This is similar to a cashback system, in which users get paid when they borrow or lend.
When users are enthusiastic to vote for Compound community proposals, this serves as an incentive for them to “farm” or earn COMP by borrowing or lending assets in Compound so that they can be more actively involved in its governance process.
Compound users’ lending and borrowing activities are also encouraged by relatively high yields offered for some of the supported assets in the protocol. BAT, for example, has an annual percentage yield for lenders in Compound, currently standing at 14%. That APY is notably higher than BAT lending on other DeFi protocols such as Nuo Network (5.42% APY) and Aave (4.06% APY).
Each money market on Compound adopts a floating interest rate the value of which fluctuates based on the market supply and demand of the underlying asset. The interest rate of the asset, in short, rises when the asset is scarce and highly sought by traders.
Apart from community interest in COMP and attractive asset yields, announcements of COMP being listed on multiple top digital asset exchanges have also led to the recent popularity of the token and protocol.
COMP also gained widespread attention from cryptocurrency traders following its listings on leading exchanges OKEx and Binance in the past week.
Is Compound's rise a bubble?
While Compound has gathered widespread interest from the community, the hype surrounding its token can be overwhelming and look something like a market bubble — particularly in its resemblance to the initial coin offering, or ICO, bubble that peaked in 2017.
Since the distribution of COMP in June, users have started to farm their yields in an attempt to maximize their returns. This has also led to community concerns of a potential bubble — which are worth examining in more detail.
Less actual floats imply higher price volatility
As indicated by Ethereum blockchain explorer Etherscan, the current total, fully diluted, market capitalization of Compound is around $2.1 billion — that’s the total supply of COMP multiplied by the price per token.
With such a high valuation, the crypto community, as noted, has expressed concern about the vulnerability of COMP to price volatility — particularly because of its low liquidity. As per Etherscan data, the total market cap of COMP’s circulating supply of tokens (those available to market participants) only accounts for 25.6% of COMP’s fully diluted market cap. However, the majority of tokens are hoarded by very few users, with the top 10 addresses owning 80.42% of the total supply of tokens.
Additionally, the actual circulating supply can be much less than the stated circulating supply, which allows for short-term price fluctuations.
Compound could be “extremely overvalued”
The market hype surrounding Compound — and decentralized finance, in general — is a potential indicator of a market bubble with DeFi tokens showing overvalued multiples (i.e., ratios that help to assess financial performance).
In a tweet from June 21, Julien Thevenard from blockchain venture capital firm Fabric Ventures attempted to derive the intrinsic value of Compound using relative valuations. He compared crypto exchanges and DeFi protocols using two multiples, the price-to-earnings, or P/E, ratio and P/E total capitalization, to compare each project’s market value to its earnings.
Thevenard’s findings indicate that the earnings multiples of DeFi protocols, such as Compound and Maker, are much higher than those of major crypto exchanges, such as Binance and Bitfinex.
The data also show that Compound has a P/E total market cap ratio of 760x, which is only second to Maker, with 4,360x. Compound also has a P/E ratio of 200x, which is much higher than the historical average ratio for S&P 500 stocks, at 13x–15x.
According to Thevenard, the high valuation of Compound is a bet from investors on the basis that they can vote on future share earnings using COMP tokens and the hope of mass adoption of Compound, which would serve as a long-term driver of COMP’s price.
Thevenard exclusively shared with OKEx Insights that, while COMP has exploded in value because of limited token distribution and liquidity on exchanges, it is too early to call the protocol’s rise a bubble. He stated in comments this week:
“It can be challenging to value a protocol like Compound because it is in its infancy and has significant room for growth. Similar to early-stage equity, much of the analysis is based on an opinion of future value created and, eventually, value extraction for the token holders.
The Compound token has exploded in value thanks to its small token distribution and, thus, thin liquidity on exchanges. However, one must give credit to Compound for its value creation. Just 10 days ago, the protocol was generating $4 million annualized revenue. Today it is over $100 million.”
That said, Thevenard still recommends a cautious approach, telling OKEx Insights:
“One must be careful here, as the reason Compound fees have increased 25X over 10 days is because of the strong market appetite for COMP. This could stop if we run out of buyers.
I think it is too early to tell if this is a bubble — the valuation in relation to the value captured by the network is already becoming more reasonable when compared to earlier this month. At the end of the day, it can be useful to create hype and create new marketplaces. I am eager to watch Compound and other DeFi protocols like Balancer and Curve grow in 2020.”
In a tweet from June 29 responding to Thevenard’s findings, crypto analytics firm Messari’s Ryan Watkins argued that relative valuation may not be the right approach to valuing DeFi tokens at this point, comparing them to “early stage startups.”
The researcher noted that Defi tokens’ relative valuations have limited applicability because of the evolving token economics (or “tokenomics”) of DeFi protocols but that the valuation results present a key message — Compound and other DeFi protocols are “extremely overvalued”:
“When you consider all these issues combined with the fact that so many of these projects generate such little earnings that the multiples are absurd, it makes it hard to draw any takeaways from the multiples other than that all these projects are extremely overvalued.”
Instead of relative valuation, Watkins suggested assessing the value of DeFi protocols by looking at “а combination of qualitative and quantitative measures.” This could include such factors as the team and community behind the token, as well as users and other growth metrics. It's notable that a similarly holistic approach is also what investors back in 2017 were being encouraged to use to evaluate ICO tokens.
Lennix Lai, director of financial markets at OKEx, also believes that the current tokenomics of Compound could be unsustainable:
“COMP, as well as other yield-farming tokens, is another type of token distribution mechanism in contrast to an IEO [initial exchange offering] or ICO. The effect is obvious. As you can see, the assets under management in DeFi are hitting record highs — and this is risky.
The tokenomics are distorting the rate of the lending market. That’s why there is a high chance that the model is not very sustainable. There was a trade-mining mechanism before and it was not pretty.”
Additionally, Lai suggested that yield farmers should be aware of potential, currently unknown problems caused by DeFi protocols’ incentive systems:
“Yield farmers have to beware of the liquidity, volatility and cross-correlation for each staked non-stable token at the time they unwind their positions. The incentive system of DeFi tokens shoots up the interest rates, implying that users might be stepping into an uncharted area of risk.”
Is DeFi sustainable?
Decentralized finance ostensibly came into existence with the vision of unlocking financial services to the “unbanked” population — or those lacking access to traditional finance. The key categories of DeFi include lending, derivatives, exchanges and staking.
Vitalik Buterin, co-founder of Ethereum, tweeted recently that Compound’s sharp rise to popularity has distorted the community’s original vision of the nature of DeFi. In particular, he believes that the high interest rates currently available in DeFi indicate "temporary arbitrage opportunities" or other "unstated risks."
In a separate tweet, Buterin stated that he believes that the development of DeFi should focus on “solidifying and improving a few important core building blocks” such as synthetic tokens based on fiat currencies and stablecoins.
Moving toward a more robust ecosystem
Apart from the surging interest in and prices of DeFi protocols and their tokens, Compound’s popularity may after all indicate that a more robust decentralized finance ecosystem is being built.
Statistics from Dapp.com show that the daily transaction volume in DeFi skyrocketed since the release of COMP and reached a monthly high of $497 million. The market capitalization of DeFi tokens has also witnessed a drastic increase since mid-June, surging to a whopping $6.1 billion from the $2 billion mark in early June.
However, other key metrics in the DeFi ecosystem — such as number of users — have not seen notable growth following Compound’s rise.
Thevenard told OKEx Insights that the excitement of Compound could lead to the launch of more DeFi projects, which could in turn boost users’ confidence in DeFi’s future. He explained:
“The excitement around Compound is yet another example in DeFi that good token designs can incentivize value creation. While the hype is perhaps reinforced by good timing in regards to exchange listings and the impressive performance of COMP, I think there is value being built here that gives confidence for the future of DeFi.
By distributing ownership early in exchange for valuable work, distributed projects like Compound can grow communities and build network effects much faster than an equity company could — which benefits everyone from the team to the liquidity providers to the users. I do expect we will see many more projects in DeFi and also in other areas distribute their tokens to their most valuable users.”
Felix Mago, co-founder of multiple Asia-based Dash (DASH) adoption companies, told OKEx Insights that he also believes DeFi has the potential to unlock new opportunities in the financial sector, stating:
“I personally believe that DeFi is more than just a flashy word and has the potential to create real value for people and provide new opportunities in the financial sector. Generally speaking, I am happy to see that more and more companies are entering the DeFi space and coming up with many great ideas and products.”
However, Mago also recommends taking a cautious approach to DeFi, especially at this early stage in the ecosystem's development, telling OKEx Insights:
“Whether these new ideas and products are sustainable is another question. Everyone should consider that high yields and interest rates usually bear high risks. I can, therefore, only recommend everyone to do their own thorough research."
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