DeFi Rate Votes “Yes” on Compound Proposal #11

Following Dharma’s recent governance piece along with our continued efforts on transparent governance, DeFi Rate will be releasing our rationale behind Compound Governance votes in a series of blog posts. 

Proposal #11: COMP Distribution Patch (Forum discussions here)

Proposer: Geoffrey Hayes

DeFi Rate Vote: Yes

Voting Weight: 10,211 COMP (~0.10% of total supply) 

Background

While the launch of COMP yield farming has been a massive success, propelling the protocol to $1B in total supply and $383M in total borrows, it has also brought to light some issues surrounding the incentive design.

In short, there are two issues with the COMP Distribution:

1. It’s possible to temporarily grief the COMP distribution using flash loans.
2. DeFi users are “yield farming” in whichever money market has the highest interest rate, ultimately driving Compound to soak up over 80% of BAT’s liquid supply ($319M of the $391M in liquid supply). This is a rather risky situation as there’s a substantial lack of available BAT  to recapitalize the system in the instance of a worst-case scenario situation.

"Yield farming" with volatile assets is ??extremely dangerous?? and you will get REKT.

DO NOT put customer funds into a leveraged $BAT yield farming carry trade.

Everyone, pay attention and be careful. https://t.co/LsFsDZzUTz

— ?? Leshner (@rleshner) June 23, 2020

Proposal #11, proposed by Compound Labs CTO Geoffrey Hayes, addresses the first issue by requiring an externally-owned account to refresh the per-market allocation, rather than allowing a smart contract to execute this functionality.

The second issue regarding risky yield farming is addressed by Proposal #11 by removing interest from the allocation of COMP across markets. Instead, the protocol will allocate COMP proportional to borrowing demand.

Most Compound yield farmers will be affected by the second piece of the proposal. The new proposal calculates COMP distributions based on the total borrow amount of the market with COMP continuing to be distributed 50/50 to market participants.

Here’s how this change will affect COMP allocations at current rates:

Rationale

Given the current issues and the looming systematic risks from cascading liquidations with Compound BAT farming, we believe this proposal (along with the increase in reserve factors from proposal #10) will help mitigate the existing issues and return the market back to a more sustainable equilibrium.

In short, this proposal will change the COMP farming incentive away from borrowing from markets with the highest interest rates to borrowing from markets with the lowest interest rates.

Dan Elitzer stated it best:

To be clear, it creates an incentive to supply in markets with high interest rates and borrow from markets with low interest rates, applying as much leverage as desired. This should push towards something of a consistent floor in borrow rates across markets. 

While BAT will still be the largest recipient of COMP in the short-term, the distribution change will drive users out of BAT as they’re no longer rewarded for paying a high-interest while the high reserve factors will eat up yield farmer profits.

More importantly, the change will emphasize the importance of better interest rate curves across all assets – something we believe to be necessary for the long-term sustainability of Compound.

Drawbacks

While we’re voting “yes” on this proposal, we believe it’s important to highlight the drawbacks too. For one, we’re not huge on the fact that we’re enacting monetary policy changes within a week of the protocol’s token distribution going live.

Looking forward, if Compound community governance wants to make further monetary policy changes (like an issuance reduction), it needs to be communicated well in advance as well as in accordance with some sort of social contract. In short, everyone needs to know about it. DeFi loses an important piece of its value prop if we’re relying on humans to consistently tinker with monetary policy.

The second piece is recognizing the impact COMP farming can have on other protocols. Cyrus from MakerDAO highlighted these concerns in a forum post here. To summarize, due to the high APY from COMP farming, there is a chance that there’s a sudden wave of demand for DAI with the upcoming distribution changes. As a result, a significant amount of the circulating DAI could be locked up in Compound and thinning its liquidity elsewhere, ultimately driving the crypto-native stablecoin off its peg.

We’re not entirely sure of the validity of Cyrus’ analysis but it’s important to recognize it nonetheless.

In Closing

DeFi Rate has voted “Yes” on Proposal #11 due to the looming systematic risks with BAT farming. We believe Proposal #11 will create proper incentives to drive Compound to an equilibrium in the borrowing markets. Moreover, we believe the proposer – Geoffrey Hayes – enacted best practices with decentralized governance, allowing the community to discuss the issues in length and implemented the proposal in a sufficiently transparent manner.

If you appreciate our governance process and decisions, feel free to delegate your COMP to DeFiRate.eth. If you have any further questions or comments on how we can improve our governance processes, feel free to let us know by reaching out on Twitter!

Lucas Campbell

Analyst at Bankless – one of the leading resources for open finance. Lucas is an active contributor to the DeFi ecosystem with appearances in other notable DeFi outlets including The Defiant and Our Network. He has years of experience working with dozens blockchain and token startups where he focused on token economics, marketing, and growth.