Compound Caps Borrowing Levels for 10 Assets to Reduce Risk

Another DeFi lending protocol is reducing risk a day after Aave passed a proposal to freeze 17 of its lending pools.

Holders of Compound Finance’s COMP token voted unanimously to cap the borrowing level of 10 assets supported by the protocol.

The reductions are significant. Five tokens, including WBTC, will soon have new borrow limits while caps on the other five tokens will drop by 80% or more depending on the asset. None of the newly-capped assets are stablecoins.

Less Liquid

More conservative borrowing limits may help minimize the bad debt in a protocol. Rapid swings in token prices, especially in less liquid assets, can increase unsustainable debt. This is because liquidation mechanisms usually give a discount to liquidators who buy a user’s debt denominated in the token that a user owes — if that token moves sharply in either direction, the protocol may not have enough time to liquidate the position.

By reducing its exposure to volatile assets, Compound’s governance has battened down the hatches for wild price swings.

“Just like in any super-down market, you have to adjust your frame of reference,” said Tarun Chitra, founder and CEO of Gauntlet Network, the firm that authored the Compound proposal. “And I think effectively ours is always the most conservative in this community because our goal is generally to try to make sure things are safe.”

Gauntlet works with many DeFi protocols, including Compound and Aave, to optimize their risk profiles and capital efficiency. The firm also wrote the proposal which passed on Nov. 27 and froze 17 lending markets on Aave V2.

Bad Debt

The catalyst for Compound’s and Aave’s risk reduction is the trade put on last week by Avraham Eisenberg, which saddled Aave with $1.6M in bad debt. Eisenberg, an influential crypto trader, deposited $39M of the dollar-pegged USDC and then borrowed CRV, which is the token issued by Curve Finance, a large decentralized exchange (DEX).

The trader then dumped the CRV, driving down its price. CRV ultimately rebounded, liquidating Eisenberg’s position as the borrowed tokens’ value outstripped the USDC collateral, but the price swung quickly enough that Aave liquidators couldn’t keep up.

Total Borrowing

This has led to proposals like the ones Compound and Aave just passed, as there is a concern these sort of attacks could be repeated.

Paul Lei, protocol program manager at Gauntlet, emphasized that stablecoins constitute roughly 96% of the value borrowed on Compound in a forum post outlining the now-passed proposal. This indicates that the additional caps on non-stable assets will likely have limited impact on total borrowing.

Chitra also added that the attack on Aave didn’t necessarily make economic sense in terms of whether Eisenberg actually made money on the trade. He said that Gauntlet’s models primarily address the potential actions of rational actors, rather than those operating outside that paradigm.

Compound is the ninth largest DeFi protocol with $1.47B in value locked in its smart contracts, according to The Defiant Terminal.

Compound’s total value locked took a sharp hit on Nov. 23. Source: The Defiant Terminal

The Compound proposal reached quorum only an hour before voting closed. A quorum is the minimum number of votes required to validate a proposal, regardless of whether the majority votes for or against it.

Columbia University’s student-run blockchain organization, pushed voting past quorum with its 50,000 COMP tokens.

Down 28% in the past month, COMP’s token has been highly correlated with Ether during a period which saw FTX’s collapse buffet crypto prices across the board.

The price of COMP skidded 28% in November. Source: The Defiant Terminal

Despite the changes to the lending protocol’s parameters, Chitra emphasized that risk can’t, and perhaps shouldn’t be eliminated. “To earn revenue, you have to take some risk,” the Gauntlet founder said. “And the risk you’re taking is how much you’re losing out on the liquidations.”

Chitra added that Aave has been successful relative to centralized lenders like the now-bankrupt BlockFi, which didn’t even liquidate any party to recoup its losses. The Gauntlet founder added that banks lose a certain percentage on their loans and that the $1.6M of bad debt that Aave absorbed constituted a manageable amount relative to its revenue.

“For all the CeFi people, their loss ratios were infinite,” he said. “All their loans defaulted because they were to the same five people.”