Decentralized finance applications, “DeFi”, have seen an increasing wave of interest over the last year as new apps launch to support the market with a focus on lending and derivatives trading. As new DeFi platforms are released, new tokens tied to these platforms have launched. On the back of this growing interest, DeFi tokens have seen a considerable increase in price and market cap. In this report we examine the DeFi space, yield farming, and in particular the possible value capture of these tokens.
Amount of collateral deposited in DeFi apps rises
The amount of ether deposited across various decentralized finance applications rose to a near record high this past week, while the total value deposited in terms of USD reached an all-time high (primarily as a result of the rising ether price).
Many DeFi lending and margin trading platforms require collateral in the form of a digital currency in order to back loans and other financial products. Because a majority of these products are built in the Ethereum ecosystem, most require collateral in the form of the ecosystem’s native token, ether. In the figure below we diagram the amount of ether deposited across DeFi platforms over time.
Market cap of DeFi tokens hits all-time high
The market capitalizations of the leading DeFi tokens have hit an all-time high recently. While many of the larger cap DeFi tokens were launched a few years ago, such as Maker Dao, investor enthusiasm has increased considerably in recent weeks. In the figure below we diagram total market cap over time of the leading DeFi tokens.
DeFi tokens have seen a run-up in demand as the platforms behind these token offer considerable yields. Yield bearing tokens have outperformed over the year as investors have clamored for yields in the digital currency space that are often magnitudes higher than in the traditional world.
For instance, earlier this year Coinbase and Kraken offered staking yields for the first time on a yield bearing token, Tezos (XTZ). XTZ is up more than 130% over the past one year period and offers an ~7% yield. In our report earlier this year, we highlighted the difference in yield bearing products in the digital currency space in comparison to traditional equity and bond markets.
With the FED keeping interest rates near zero, traditional financial products offer abysmal yields. As mentioned in reference to Tezos above, there now exist various digital currency products that offer fixed and variable yields–often times hundreds of basis points higher than in the traditional markets. At time of publication, 6-month certificates of deposit (CDs) offer a mere 0.16%.
‘Yield farming’, as it is colloquially called, allows users of decentralized financial applications to perform services and in return receive a fixed or variable yield on the collateral they provide. One growing area that allows users to capture yield is in liquidity providing to decentralized exchanges. In return for their capital that users provide to automated market makers on autonomous DEXs, users receive trading fees in the form of a yield.
Other applications include validating transactions and other routine tasks in order to receive transactional fees, often in the form of new tokens issued (which merely allows users to capture the inflation rate of their asset). While yields can vary, with some offering over 100% per annum, in any case, yields vary with risk assumed. In many instances, in order to capture heightened yields, users must take substantial collateral risk. That being said, the low effort strategy of simply lending a stablecoin (which by definition should maintain its value), yields on some platforms more than 8% a yr–still well above rates offered in traditional financial markets.
Compound token analysis
Among the DeFi tokens, Compound’s newly launched governance token, COMP, has seen the greatest increase in interest and trading activity. Compound’s platform, which serves as a lender/borrower for digital currency markets, has seen the greatest amount of ETH deposited on its platform as well as the greatest market cap of any DeFi token. Additionally, Compound’s loan originations have grown at an incredible pace, and the platform has now originated more than $350 million in loans YTD.
Last week, Compound distributed the first wave of tokens to early platform adopters, including investment funds with an equity stake in the Compound company. After initial distribution, various exchanges listed the token which has seen its price rise considerably. On Coinbase, at time of publication, COMP changed hands at $211 per token–giving COMP a current market cap of nearly $550 million and a fully diluted market cap of over $2 billion.
As of today, the COMP token simply acts as a governance token, allowing COMP holders to vote on different protocols for the platform. In the future, however, COMP holders could vote to initiate a buy-back and burn schemta or a dividend distribution plan to token holders. Exchange-like platforms that include buy-back and burn or incentive distributions are common, such as Binance, FTX, Huobi, and others.
To give a sense of what value accretion could occur back to the COMP token holders if such a schemata were implemented, we constructed a rough, approximate financial model of the COMP token. Platform fees would be used to fund token repurchases, similar to existing centralized exchange tokens in the buy-back process.
Assumptions include aggressive growth in origination volumes, interest rates that stay near current levels, and a discount rate of 20%. As demonstrated, approximate intrinsic market valuation is considerably lower than current and fully diluted market cap. However, as DeFi grows, origination volumes could grow at a rate higher than projected and alternative token incentives could be initiated whereby the token reaches a considerably higher intrinsic valuation, inline with current market cap.