The Early days of Crypto Finance and Compound Valuation
Please note that this letter is not intended as financial advice.
The Crypto journey is only in the beginning. If you are here now, congrats, you are still very early for this. Take your seat and enjoy the long ride. A study done by Cambridge University estimates that we only have 101 million users of cryptoassets (Sep 2020).
“In terms of adoption, Bitcoin has roughly the same users as the Internet had in 1997.
But Bitcoin's growing faster. Next 4 years on current path will bring Bitcoin users to 1b people, that's the equivalent of 2005 for the Internet.” (Willy Woo, 2021)
I believe the most promising fields in crypto in the short term are finance and games (eg.: NBA Top Shot that I talked in the last article). I am using the term Crypto Finance instead of Decentralized Finance (DeFi) as I think interesting innovations come not only in the form of DeFi. When companies integrate with protocols they can bring crypto to the mainstream users. Visa, Mastercard, Paypal, CashApp are making their steps in the field and we also have crypto companies as Circle, Blockfi and the exchanges that have an important role in crypto finance.
The figure below shows a good view of how crypto finance is structured. For now, I think great opportunities are emerging in the protocol layer (eg.: Compound, Aave, Uniswap) and the settlement layer (eg.: Algorand). Where will we find barriers of entry that can provide value to token holders?
According to this research, If some issues such as scalability and security, can be solved, DeFi may lead to a paradigm shift in the financial industry and potentially contribute toward a more robust, open, and transparent financial infrastructure.
Despite the concerns, a Messari report shows that losses from exploits and hacks were on average just 0.3% of the Total Value Locked (the crypto deposited in these protocols).
If crypto, in general, is in the beginning, DeFi is even more incipient. We just have around 1.5 million users in DeFi and most of it is concentrated in the Uniswap exchange. Borrow & lending is still very small, and the major player, Compound, has only 300.000 users.
Within Crypto Finance, one of the most interesting areas is lending & borrowing and that is why I will analyze the Compound project.
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Compound Valuation
The Compound protocol uses a loan model that allows users to deposit into a pool that borrowers can then withdraw from provided they post sufficient collateral. Suppliers and borrowers of an asset interact directly with the protocol, earning and paying a floating interest rate, without having to negotiate terms such as maturity or interest rate.
The interest rate paid on the debt is determined by market forces. As the ratio of utilization to total pool size increases, the interest rate will increase accordingly to incentivize more lenders to come in as the figure below shows.
When supplying assets to the protocol, users receive cTokens – Compound’s native tokens – which represent claims to a portion of any given asset pool.
For the next four years, Compound is distributing COMP tokens to users, the ones that are helping the network to grow. This process is known as liquidity mining. For example, If you lend USDCoin using Compound you will earn 6% interest on USDCoin plus 4% of COMP tokens (source: https://compound.finance/governance/comp).
With Compound, borrowers have the ability to hold new assets, without selling their cryptoassets. It can be useful to dApp consumers, traders and developers. From a lender's perspective, it is an interesting way to have a source of additional returns on their crypto investment.
Value Drivers
Easier ways for users to interact with the protocol. For example, partnerships with exchanges, crypto wallets, digital wallets (eg.: Venmo). Just three months ago, the crypto wallet Ledger launched the partnership with Compound, enabling its users to lend the crypto they have in their wallets.
Stablecoin: I expect we will see increasing adoption of stablecoin as we move forward in this bull market. The ones who own stablecoins will see the opportunity to earn interest on it by using Compound.
Institutional investors: more institutional investors entering this space. Bitwise launched a DeFi crypto index fund to serve institutional investors with the initial constituents as follows: (https://www.bitwiseinvestments.com/resources/press-releases/bitwise-launches-worlds-first-decentralized-finance-defi-crypto-index-fund)
Increase in value metrics: Users, Total Value Locked, Loan Origination and Interest per Year.
Risks
Regulation: If regulation has an impact on stablecoins as USDCoin, Compound could decrease in value.
Exploits and Hacks in DeFi. As we talked about before, these were very small until now, but it is a risk to be continuously monitored.
Competition: from other lending protocols (eg.: Aave and Maker), exchanges (eg.: Binance), crypto companies (eg.: Blockfi).
Scalability and high fees from the settlement layer: they currently depend on Ethereum to operate and it has high fees. Compound is already building an alternative, their own settlement layer called Gateway. They just released it for testnet last week.
Competitive Advantages
Network effect: more users bring more liquidity to the protocol, better interest rates, more efficient credit markets and security. Lindy's effect will be important here, as the credit market is about trust.
Team and Community
Team with experience in working together and already founded and sold a startup.
Among the Top 5 addresses with COMP token, we can see relevant VCs that invested in the project such as Andreessen Horowitz and Paradigm.
Price
The COMP token is a governance token that controls the Compound protocol. It is used to propose and vote on changes to the protocol. Holders can vote directly or delegate their voting rights to another party.
Anyone with 1% of tokens held or delegated to them is eligible to submit a proposal. Once submitted, there is a 3-day voting period where COMP holders or delegates can cast their votes. If at least 400,000 votes are cast and a majority vote for the proposal it is then enacted after a 2-day timelock.
Token holders have the ability to list a new cToken market, update the interest rate model per market, update the oracle address, withdraw the reserve of a cToken, choose a new admin and govern the new Gateway network.
A total of 10 million COMP tokens were created and distributed as follows: 4,229,949 Users of the protocol (over 4-year period); 2,396,307 Shareholders of Compound Labs, Inc; 2,226,037 Founders & team(4-year vesting); 372,707 Future team members; 775,000 Allocated for the community to advance governance through other means.
Let's see some valuation multiples (March 8th).
The Total Value Locked is growing at a fast pace:
The borrowing volume increased 2,6x in the last 3 months.
The Price/Interest per year is similar to a Price/Sales multiple. It is low when comparing with other Crypto Lending platforms (Aave and Maker) because COMP holders do not earn any portion of the interest for now.
If we consider Compound could charge in the future the same fee charged by Aave of 0.25% on originated loans, we would have Price/Earnings at 200x. Token holders may eventually vote in a mechanism of value capture providing them with some claim on the cash flows of the system.
The addressable market is huge and it grows as the crypto market expands. Today, 86% of the interest rate per year of Compound comes from stablecoins such as USDCoin and DAI.
USDCoin already has US$ 9 billion market cap and it is growing fast. Compound seems to take advantage of this trend of stablecoins adoption. When BTC price goes down, the Total Value Locked in Compound tends to reduce as investors use USDCoin to buy the dip. As the bull market advances and investors hold more USDCoin it is possible to see Total Value Locked increasing exponentially.
Compound has only a small share when we consider crypto users (less than 3% of crypto users), Total Value Locked to crypto market cap (less than 1%), stablecoins market cap (less than 10%). We are still in the middle of the bull market, so the crypto market cap can advance even more. It is plausible that Compound could grow 10x its operations by the end of this year, bringing the valuation multiples to the level of a common company in S&P.
It will be very interesting to follow the developments in this crypto lending market in the following months and years.
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