COMP: Fundamental Analysis and Valuation Considerations
Though the Decentralized Finance (DeFi) sector has collectively experienced rapid increases in adoption in recent months, there is perhaps a no more dramatic example of supposed growth in the sector than that of Compound, including, among other metrics, the explosive market capitalization expansion of COMP, the money market protocol’s new native governance token. From a fundamental cryptoeconomic perspective, this dispatch critically examines the efficacy of COMP as a governance token, as well as the merits and sustainability of its current market valuation.
Compound is a decentralized, peer-to-peer consumer lending platform that allows users to initiate loans in stablecoins such as Dai and USDC, as well as other tokens such as BAT. Compound was developed with the goal of establishing a credit and money market in the decentralized financial system, which it views as an essential component of any financial system. Compound was originally a tokenless and centrally-governed platform, and remained so until the recent launch of the COMP governance token.
Launched in late June, 2020, COMP is an ERC-20 cryptoasset operating on Ethereum and native to the Compound ecosystem. COMP is designed to function purely as a governance token, conferring pro-rata voting rights to holders, supposedly decentralizing Compound’s upgrade procedures and removing unilateral authority from developers. However, there exist valid reasons for one to be skeptical of such claims. COMP’s initial distribution mechanics resulted in the Compound Labs team holding as much as 46% of the total supply at one point, with equity investors in the firm controlling additional tokens and, thus, voting power. Further, the first and only vote on a system upgrade proposal to occur since COMP’s launch saw only 26% of COMP tokens used to vote which, as discussed in greater detail below, suggests that governance rights do not constitute a primary benefit for many holders; such sentiments are an impediment to the project’s purported goal of achieving meaningful decentralization.
Further, though COMP’s stated raison d’etre is the decentralization of the protocol’s governance via the distribution of voting rights to the greater Compound community, it is worth discussing a highly plausible ulterior motive for token’s conception. At this stage in its maturity, Compound and its decentralized money market protocol peers are effectively unable to compete with more centralized platforms in terms of the yield offered. Compound is likewise incapable of attracting institutional investors due to regulatory compliance issues, creating a notable disconnect between supply and demand on the platform. ‘Yield farming,’ the practice of initiating often unnecessary DeFi loans with the primary intention of maximizing yield, is heavily incentivized by COMP’s distribution mechanics and serves to attract new users to the platform, partially alleviating and obfuscating these issues faced by Compound: since COMP’s launch, the platform’s borrow rates have risen 628%, its lending rates have increased 1650%, and an over 600% increase in total value locked alongside its current intake of around 91% of all DeFi interest fees now spuriously distinguishes Compound from its similarly-ailed peers.
Also worthy of scrutiny is the token’s market valuation. In the week following its launch, COMP saw its market price rise to over $370, up significantly from the roughly $16 for which it was sold privately to some investors. At the time of this writing, COMP is trading at $164, computing a fully diluted market cap of over $1.6B. Smith + Crown believes that the token’s functionality and utility do not lend themselves to such a high valuation and, thus, it’s price is likely driven by extrinsic and potentially ephemeral factors. COMP is not a security nor is it a utility token that confers rights or access to goods or services; there currently exist no dividends or buyback-and-burn-mechanisms in COMP’s cryptoeconomic design. It’s only functionality is the provision of voting rights on system upgrade proposals. In traditional equity markets, there are few examples of governance rights carrying any significant premiums, and there are virtually none in excess of 10%. In most cases, shareholders’ governance rights are considered simply a driver of company growth and not an economically-valuable asset in and of themselves. For these reasons, Smith + Crown considers pure governance tokens to have very little economic value. Thus, COMP, in its current form, has an intrinsic value far closer to zero than its current exchange rate suggests.
The theoretical notion that governance rights alone cannot support COMP’s high valuation is practically evidenced by recent user behavior. The aforementioned proposal brought to vote earlier this month, in which only 26% of COMP was used to vote, represented COMP holders’ first opportunity to exercise governance rights, directly implemented changes to COMP’s distribution mechanics and likely occurred during COMP’s period peak relevance and visibility. One-quarter participation under circumstances presumably ideal for attracting maximum participation strongly suggests that governance rights are not the primary driver of value from holders’ perspective. As governance is the only demonstrable utility of COMP, it stands to reason that the token’s market valuation is being driven by extrinsic factors such as speculation. Acknowledging that frequent irrationality of cryptoasset markets, Smith + Crown nonetheless believes such drivers to be ephemeral and expects COMP’s market price to come to reflect its true utility value as a governance token in the near-to-mid-future.