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Path to a Decentralized Business Model
VeradiVerdict - Issue #81
Compound is a DeFi lending platform that allows users to borrow and lend various cryptocurrency assets at algorithmically priced interest rates. As of now, it’s the second largest DeFi lending platform (after Maker) with over $28 million in outstanding debt.
Previously, Compound’s governance was centralized. The algorithm that determines the interest rates for various tokens, the tokens that the platform supports, and other key characteristics were proprietarily determined by the Compound team.
Compound recently launched the COMP token, which it will use for decentralized governance in the future. COMP token owners can delegate voting rights on Compound’s governance to individuals who will then participate in managing and updating Compound’s protocol.
Users with voting rights delegated by 1% of COMP will be allowed to submit proposals (executable code to modify the Compound protocol) to modify the Compound protocol. For 3 days, users with voting rights will then vote on the proposal. After the 3-day voting period, proposals with a majority vote (after satisfying a quorum of 4% of COMP) will enter a 2 day time-lock period after which they will be implemented.
Compound is gradually launching its decentralized protocol, initially only giving a small amount of COMP to shareholders. In its initial launch, Compound’s team will also be able to suspend the decentralized governance protocol to ensure the ongoing stability and security of the protocol. Once the protocol has been tried and tested, the remaining COMP tokens will be distributed to protocol users and the team will no longer be able to suspend the decentralized governance.
The launch of COMP signals an important step in creating truly decentralized finance and bringing more control over assets to individuals, not third parties.
DeFi, or decentralized finance, has been one of the most prominent aspects of cryptocurrency in recent years. The launch of platforms like Maker, Compound, dYdX, etc. have enabled users to borrow and lend crypto, trade, purchase options, even apply for mortgages, etc. DeFi has arguably been the best “real-world” use case of cryptocurrency, demonstrating the real value of decentralization and distributed ownership.
Nonetheless, many of these “decentralized” platforms are centralized to some extent –– their pricing algorithms are built by an in-house team of engineers, or their custody/collateral is executed through a centralized third party. Compound, one of these prominent DeFi platforms, is making an important step towards true decentralization, by removing dependence on their team, and allowing users to begin upgrading the protocol
What even is Compound?
Compound is a decentralized finance platform on Ethereum that enables users to borrow and lend cryptocurrency at an interest rate. Tons of cryptocurrency are bought by users and then held indefinitely –– a phenomenon that the community has dubbed “hodl”-ing (an intentional misspelling of “hold”). Nearly ninety percent of all crypto assets are held in cold storage, wallets, or exchanges. Compound’s thesis is that crypto users and hodlers can profit off of their assets by borrowing and lending them on an online marketplace.
Compound algorithmically sets interest rates for each coin on its platform. Lenders can profit by listing their assets on Compound and earning interest from users that borrow on Compound; the protocol sets aside a small cut as reserves. On the borrowing side, Compound enables borrowers to borrow cryptocurrency by paying back the given interest rate and also supplying some of their own assets as collateral. It also allows users to short-sell tokens that they may be bearish on.
As of now, Compound is the second most widely used DeFi lending platform (following only Maker). It holds over $28 million in outstanding debt via its loans.
What’s changing with Compound?
Previously, Compound was largely a centralized platform. That meant that the protocol’s rules and permissions (for example, the business logic that sets the interest rates) were proprietarily managed by the Compound team. Yet, the ethos of the platform and the entirely cryptocurrency movement is censorship-resistance and self custody –– not centralized institutions like banks, or in this case, Compound’s management. Thus, Compound made it a key priority to decentralize the governance of their platform across the crypto community.
How are they planning to accomplish this decentralization?
The decentralization has been a key vision of Compound since its inception. Back in 2018, CEO Robert Leshner stated “Eventually our goal is to hand-off responsibility [for setting the interest rate] to the community. In the short-term we’re forced to be responsible. Long-term we want the community to elect the [governance].”
To that end, Compound recently launched the COMP token. COMP is an ERC-20 asset that essentially holds “voting rights” on the Compound governance protocol. The entire goal of COMP is to manage the decentralized governance of Compound, and not to exist as an investment or arbitrage opportunity in typical token trading. Ownership of a COMP token allows the owner to delegate voting rights on Compound governance to someone of their choice –– that someone may be themselves, a friend, an adviser, a different wallet address, etc. This is an important distinction: governance privileges aren’t restricted to exclusively COMP owners, but rather who they choose to delegate the token’s voting powers to (which may very well be themselves, applications built on top of Compound, etc).
How does COMP specifically allow for decentralized governance?
Users with at least 1% of COMP delegated to their address (again, not necessarily owned but delegated by the owner) are able to propose novel actions to modify Compound. These might be things like changing the way that the interest rate is dynamically calculated or offering support for a new token or asset. Strictly, proposals must be executable code and not theoretical changes. The idea is that those with delegated voting rights via COMP are able to submit actual, productionable changes to Compound governance and not get bogged down in theoretical or philosophical arguments.
Once a proposal has been submitted, it enters a 72-hour voting period where any address that has been delegated voting power via a COMP token can approve or reject the proposal. A valid vote requires a quorum of COMP voting rights, which they currently define as 4% of COMP. If a majority of votes approve the proposal, it enters a timelock queue and then may be implemented after 48 hours.
How will Compound launch this new decentralized governance?
Such a big shift is a critical move for a platform like Compound which has already amassed a large clientele that enjoys the platform’s security and stability. Compound has elected to slowly roll out their decentralized protocol to ensure they can maintain this security and stability.
The platform begins with a sandbox period where COMP tokens will be given to the company’s shareholders, who can then delegate the associated voting rights as they wish. The vast majority of COMP at this time will be held in escrow and not be used for voting, as the platform tests the protocol at a small scale. Simultaneously, the Compound team still reserves the right to suspend this new governance protocol as a failsafe, in case the launch of the protocol severely affects the day-to-day operations of the platform.
Once this sandbox runs autonomously for a while without issue, the Compound team will have more confidence in the efficacy of its new governance system. The team then plans to rescind their right to suspend the protocol and will then launch the remaining COMP tokens to protocol users and developers who build on the platform.
Compound is an incredibly promising DeFi platform; in a few short years, it’s demonstrated the real value that lending and borrowing cryptocurrency can bring to its users with nearly $30 million in outstanding debt. It reflects critical innovation in the decentralized finance space and creating novel, productive use cases for cryptocurrency tokens.
Decentralizing the governance of the platform is a natural next step. Centralization streamlines early-stage issues like launch and customer onboarding, but the ultimate mission of Compound, and more broadly decentralized finance, is to give users complete control of their assets and not rely on singular third parties –– like a bank or the Federal Reserve –– to mandate how their money is used. COMP is a simple but brilliant protocol that enables that decentralization. The initial sandbox period is critical for proving the protocol’s efficacy; regardless of the outcome though, the launch of COMP signals an important move towards decentralizing finance and bringing power to individuals over institutions.
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Hi, I’m Paul Veradittakit, a Partner at Pantera Capital, one of the oldest and largest institutional investors focused on investing in blockchain companies and cryptocurrencies. The firm invests in equity, pre-sales/IEO rounds, and cryptocurrencies on the secondary markets. I focus on early-stage investments and share my thoughts on what’s going on in the industry in this weekly newsletter.
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