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Compound Deflated: Liquidations up 295% in Q1 2022

Neither the author, Tim Fries, nor this website, The Tokenist, provide financial advice. Please consult our website policies before making any financial decisions.

Compound (COMP), one of Ethereum’s groundbreaking DeFi protocols, has been in a downward spiral since the beginning of this year. Messari’s recently released Q1 2022 report reveals several negative metrics that show the once-leading protocol is in decline.

Liquidations on Compound increased 295% in the first quarter of 2022

The most notable begins with a massive 295% increase in liquidations for the quarter, translating to $134 million in liquidated funds. Especially due to Wrapped Ethereum (WETH) volatility in late January.

WETH liquidations on Compound increased to $106 million from $14 million in the fourth quarter of 2021 in Q1 2022. Photo credit: Messari

WETH is an ERC-20 token that is pegged 1:1 to ETH, just like stablecoins are pegged to the dollar. It may seem odd that this conversion needs to be done on a protocol hosted on Ethereum, but the native ETH cryptocurrency is not the same as an ERC-20 smart contract token used to interact with other DeFi smarts -Contracts is required.

As for Compound itself, this DeFi protocol was one of the first to replicate a money market on the Ethereum blockchain. Instead of depositing money in a bank and earning interest or applying for a loan after filling out paperwork, Compound offers users the same service in a permission-free manner using blockchain technology.

Compound’s TVL fell from the April 2021 high watermark of $10.97 billion to $6.33 billion in April. Terra’s Anchor outperformed them all. Photo credit: The Block

In other words, one can get a loan against the security of cryptocurrency tokens. On the other hand, one can also lend tokens to provide liquidity pools for borrowers. In the latter case, users earn an interest rate as borrowers tap into their liquidity pools. Smart contracts handle this process automatically and directly, eliminating the need for intermediaries.

For example, if Tom deposited $8,000 in WETH, he could borrow 50% of that amount, plus interest on the amount borrowed. However, not only is such a loan over-collateralised, but the credit limit depends on the type of cryptocurrency used as collateral, for the obvious reason of crypto volatility.

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Massive drop in stablecoin deposits

Although the dollar is rapidly depreciating with an 8.5% inflation rate, it is still considered stable in the blockchain world. Because of this, dollar-pegged stablecoins are in high demand, which is reflected in their typically high interest rates. The International Monetary Fund (IMF) noted this dynamic in the recently released report, noting the use of volatile assets as collateral for stablecoin lending.

Photo credit: IMF Report Chapter 3: The Rapid Growth of Fintech: Vulnerabilities and Challenges for Financial Stability

Compound saw a sharp 79% drop in deposit volume from $63 billion to $13 billion. In the Compound ecosystem, DAI is the stablecoin of choice with a credit share of 42.2%, followed by USDC (37.6%) and USDT (16%). Therefore, the record-breaking 79% drop in deposits was followed by a 90% drop in quarterly DAI deposits to $4 billion from $44 billion in the previous Q4 2021.

Source: Messari

Finally, Compound’s bread-and-butter interest rates declined only slightly sequentially, from 4.5% in Q4 to 4.12% in Q1. Lending rates averaged 3.8% while deposit rates averaged 1.5%.

Source: Messari

Why did Compound deflate?

While a first-mover advantage can keep momentum in any market for a while, a lot can change in two years, let alone since Compound’s launch in September 2018. Since then, dozens of new lending protocols have entered the DeFi arena and have this niche heavily diluted money market.

This has been clearly demonstrated by the Anchor protocol, which is hosted on a competitive Terra blockchain and offers drastically lower transaction fees to boot.

Additionally, Compound suffered reputational damage last September when an upgrade caused a code error to incorrectly reward 280,000 COMP tokens worth up to $80 million.

A few hours ago, Proposal 62 went into effect, updating the Comptroller contract, which distributes COMP to users of the protocol.

There is a bug in the new Comptroller contract that is causing some users to get far too much COMP. https://t.co/Fy6nLgDqKy

— Robert Leshner (@rleshner) September 30, 2021

COMP tokens were launched in June 2020 as community governance, similar to Yuga Labs’ ApeCoin for its future Metaverse ecosystem. As a voting and incentive mechanism, 42% of the COMP token supply has been reserved for distribution to Compound’s liquidity providers over a four-year period.

However, the protocol upgrades saw COMP incentive premiums drop by 52% in Q1 2022. At the end of the line, the adopted proposal, which aims to completely eliminate such incentives, will further reduce COMP token rewards in the following quarters.

Source: Messari

Needless to say, this trend is pulling the stimulus carpet for both borrowers and depositors. The proposal’s author, Tyler Loewen, justified the move as locking in Compound’s long-term growth.

“With most COMP distributed through the current rewards program selling out instantly, existing users and token holders are at a great disadvantage,”

However, it appears the proposal has significantly weakened Compound’s competitive advantage, as noted by Notional Finance’s Teddy Woodward.

1/ The @compoundfinance Proposal 100 vote to cut $COMP incentives to 0 has just gone live.

That’s a bad idea.

This proposal will drive capital towards Compound’s competitors and could significantly weaken the protocol’s competitive position.


— Teddy Woodward (🥩, 🥩) (@teddywoodward) April 18, 2022

However, it is still too early to say whether the approach of farming and dumping COMP tokens would have been better had the practice continued. In any case, this is putting pressure on Compound as the DeFi money market is dominated by yield farmers who are always on the lookout for greener pastures.

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About the author

Tim Fries

Tim Fries is co-founder of The Tokenist. He has a B.Sc. in mechanical engineering from the University of Michigan and an MBA from the University of Chicago Booth School of Business. Tim was a senior associate on the investment team of RW Baird’s US private equity practice and is also a co-founder of Protective Technologies Capital, an investment firm specializing in sensing, protection and control solutions.

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