Legend: The active supply of the Basic Attention Token (BAT), from June 20th to July 6th, 2020. Active supply is the total supply that has changed hands on-chain within the last 30 days.
Last week, it was the most used coin in DeFi.
The Unintended Consequences of Compound’s Reward Mechanism
The sudden spike in BAT activity on decentralized finance (DeFi) apps is all due to Compound’s short lived reward mechanism.
Compound is a DeFi lending and borrowing protocol built on Ethereum. Users can go on it to borrow tokens by depositing another token as collateral. At the same time they earn interest for supplying liquidity.
This was all very vanilla until June 15th, when Compound decided to give away extra COMP tokens. The stated goal was to decentralize control over the protocol, i.e. if more people own COMP (which is Compound’s governance token), then more people can participate in governance. Think of it as shareholders ultimately controlling publicly traded companies.
All of a sudden, users started earning COMP based on the amount of interest they earned or paid (or both, in most cases).
As a result, tokens with high interest rates became extremely lucrative. Which is how BAT, whose annual percentage yield (APY) stood at 30% to borrow and 28% to supply, gained so much inorganic activity.
The Issue this Poses for Liquidity
According to data from DeFi Rate, $319 million worth of BAT out of the $391 million in liquid supply got locked in Compound.
That means 82% of BAT’s supply is used for inorganic activity, i.e. most people who were borrowing BAT were just resupplying it on the protocol so they could earn COMP both ways. We found that $300 million worth of BAT was borrowed, 85% of which was resupplied to the protocol by the same users.
This all came to a halt on July 2nd.
Notice the large back and forth between users and DEXes (Decentralized Exchanges) in the bubbles above. The amount traded keeps increasing until July 2nd, when it reaches $1.4 billion being withdrawn from DEXes.
The bar graph above, which looks at the daily level of activity on exchanges, clearly highlights this anomaly. We can see the net outflow from exchanges during the start of the BAT farming craze (Jun 20), followed by net inflow to exchanges as it wound down (Jul 02).
This is because Compound changed how COMP was getting distributed. On July 2nd, users started earning COMP on the dollar value of assets they borrowed, and no longer on interests earned.
The dollar value is also split evenly between suppliers and borrowers. Since there were more suppliers than borrowers, they were getting proportionally less.
So users withdrew their BAT from Compound, to buy a different token that had a more stable dollar value. The DAI stablecoin became the new winner.
⇒ For a more in depth understanding of DeFi yield farming and why it’s risky, check out this podcast hosted by Laura Shin, with our very own Data Scientist Will Price!