December 6, 2023

Gauntlet, Alameda Research, and Dharma are all among the top 10 holders of circulating COMP. Gauntlet, an economic simulation platform, is considered the gold standard of testing cryptoeconomic system performance, and their participation in governance is a sign of endorsement and alignment with Compound. Dharma, now one of the top smart contract wallets, pivoted from competing with Compound on the protocol level to becoming a provider of Compound-powered financial services — a move that would likely not have happened without alignment in the form of token incentives. Alameda Research is another clear strategic partner that has already contributed to the liquidity of COMP by listing it on its FTX exchange. These strategic partners add clear value to the Compound ecosystem, and without a token, it would have been much more difficult to align them with Compound.

In addition to using tokens to drive alignment with partners and users, they can be used for aquaponic farming with other DeFi systems to compound user incentives across multiple liquidity mining programs. For example, imagine a protocol that rewards its users for staking the protocol’s native token. The protocol can let users deposit tokens in a staking contract, rendering the tokens unusable for anything else — or they can consider anyone who adds token liquidity on an exchange protocol like Balancer to be a staker. This would allow the staked tokens from the lending protocol to also provide liquidity on Balancer, and thus provides increased market depth for the token, as well as allowing stakers to earn fees from the Balancer pool and BAL liquidity mining rewards — boosting their income from staking beyond the core staking rewards.

When baked into the token mining process, this type of cross-protocol integration allows protocols to tightly intertwine their user-bases and allow each other to add additional utility for their users. There are clear synergies realized by users, who earn more rewards, and by the protocol, which can offer more functionality without having to build out a new protocol from scratch. It is the natural path of composable, complementary systems to share rewards across their mutual communities, and it means that there will be significant community overlap and alignment between certain complementary DeFi systems — a dynamic that is incompatible with the tribalistic and competitive nature of base layer cryptocurrencies and fork-chains. This is a superpower for DeFi protocols.

To really drive this home, there is no clearer example of mining synergies than what is possible with Nexus Mutual, the leading provider of insurance for the DeFi ecosystem. Other protocols can allocate part of their token issuance to users who stake on their address in Nexus Mutual — an activity that unlocks insurance cover and lowers the price (e.g. the user takes on the risk of that protocol). In this example, the outside protocol is using its own token to incentivize users to expand insurance offerings for the protocol, adding additional avenues for financial protection to an ecosystem where security and risk management may be the most desirable qualities and branding that a protocol can have.

While it is a superpower, cross-protocol mining also presents dangers that we don’t yet understand. Token incentive schemes can drive unexpected behavior, as we saw when Compound users piled into the riskiest assets to maximize their COMP earnings, and by combining mining schemes, these unintended consequences become harder to understand and anticipate. One can imagine a situation where an outside protocol creates incentives that — without any action of its own — can drive dangerous behavior in another protocol and ultimately result in cascading liquidations and user losses.

For better or worse, these experiments will be run in the wild and with real money at stake. There will be hacks, bugs, and losses, and an issue with one protocol can quickly cascade into issues with other protocols. However, the process of battle testing with real money will ultimately result in hardened systems with well understood risks.

Finally, these new DeFi tokens serve a purpose beyond value capture and stakeholder alignment. Namely, they are becoming a big part of the product of DeFi protocols. COMP yield farming brought in $500M in new deposits, growing the DeFi pie by over 30% in several weeks and hinting at how DeFi will cross the user adoption chasm into the mainstream: DeFi tokens capture value like equities but dodge regulation via decentralization, have 24/7 auditable financials, and provide sustainable and censorship-resistant platforms for financial services that will serve themselves initially. The first place a new token trades will be a permissionless AMM like Uniswap or Balancer. Volume on a permissionless AMM may very well become a precursor to a Coinbase or Binance listing. Similarly, credit markets for the token will first form on decentralized lending desks like Compound and Aave.

This is a tech-interested trader or financial analyst’s dream: a new asset class with real-time balance sheets and income statements, and the potential to disrupt financial systems all over the world by offering better access, more transparency, shared value creation, and unbeatable margins. And in order to get exposure early, you need to become a user of the protocols. If the new users and capital brought in by COMP is any indication, the coming wave of DeFi tokens is going to grow the market by orders of magnitude.

Thanks to the Blockchain Capital research team (and Spencer Bogart and Andrew Yang in particular) for helpful feedback and conversations on these topics.

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