πŸ” Compounding Lock-In β€” Issue No. 62

πŸ“°News

The Dharma Protocol team announced this week that they're shifting the vision of their product. Concurrently, they released a new beta of their software which reflects the pivot. The new version eschews Dharma's original goal of building a peer to peer lending protocol from the ground up. Instead, they've chosen to build on top of Compound. Compound itself is a decentralized lending protocol built with Ethereum smart contracts. It has become the second largest project in the nascent decentralized finance space (as measured by funds held). Dharma's new product adds a smart contract and user interface layer on top of Compound. The goal is to provide a seamless user experience, including: fixed interest rates on US dollar stablecoins, smooth on/off ramps to fiat, and semi-custodial wallets that don't require special software like MetaMask. In short, the company's new vision is to provide an experience equivalent to having a savings account with a US bank, but available to everyone in the world with an internet connection. Link.

Dharma's shift is interesting for a number of reasons. One of them is the timing. Dharma raised funds to build their original product in February. Investors included high profile players such as Coinbase. At the time, Compound was only a few months old, and had about $17 Million worth of assets in its contracts. In the months since, Compound's assets have grown by more than 5x, sitting at nearly $110 Million at the time of this writing. Just as importantly, Compound's mindshare has grown in the DeFi ecosystemβ€” it's the go to for decentralized lending. The rate of change is emblematic of how fast things move in crypto: in the six months it takes your company to build a product, the ground can shift out from under you, and the ecosystem may be moving in a totally different direction by the time you launch. Link.

In related news, it was also announced this week that Compound completed a security audit conducted by the team at OpenZepplin. One would guess that Dharma's announcement was timed to coincide with this news. The audit found no critical issues, but two issues that were labeled "High Severity" were revealed. One included an attack that a malicious miner could carry out. It would allow them to siphon money out of the system by taking out many tiny loans. This might sound bad, but both issues were found to have mitigations, and to be difficult to exploit. Overall, the results of the audit were positive for Compound. Link.

I found this story interesting for a number of reasons. One, which I've already mentioned, is the way it demonstrates how fast the crypto ecosystem can change. Let's unpack some of the other interesting tidbits.

Something that caught my eye in Dharma's blog post was their commentary around the signals their initial user base was sending them. To their surprise, it turned out many of their users were people outside the developed world who wanted access to US dollar savings. I've argued before that crypto's killer app may be providing global access to western financial products, like the dollar, through decentralized synthetic assets, like Dai. This hints that Dharma was seeing demand for exactly this, and they're pivoting to make this use case accessible to more people. Keep an eye on this.

Another point worth noting is the apparent strength of Compound's network effects. This is something I've long expected to see: specific smart contracts themselves taking on the characteristic of a "standard" or a protocol, and gaining powerful lock-in as a result. I believe this happens for a number of reasons.

First, in financial protocols like this, liquidity is king. A peer to peer lending protocol is only useful if their are...peers. Compound's large lending pool attracts more borrowing, which attracts more lending, and the self reinforcing feedback loop takes it from there.

Second, security remains a huge concern with smart contract systems. The longer a smart contract is live on mainnet and in heavy use, the more confidence would-be new users can have in the system. Thus, trust around a smart contract's security becomes another self reinforcing feedback loop.

A final reason for smart contract money protocols to see strong network effects is interoperability. As more applications are built to interact with Compound, it gains more liquidity and more mindshare. Dharma's choice to build on Compound further cements Compound's early lead, and makes it more likely that other will choose to build on Compound as well.

In many ways, these network effects can be looked at as good things. They allow industry standards to emerge in a bottom up way. Once a primitive is in place, such as Compound for peer to peer lending, it allows developers and entrepreneurs to focus on building at a higher level of abstraction. This unlocks new possibilities for the ecosystem, and the cycle can repeat ad infinitum.

In some ways, though, the lock-in is also a bit scary. As these on chain protocols grow in importance, and in the funds they hold, they might introduce systemic risk. They become too big to fail. This risk can propagate throughout the ecosystem, up to and including to the level of the main Ethereum chain. The attack vector found in Compound's audit gives an example of why: if a mining based attack on a specific smart contract becomes profitable enough, it could put the security of the entire network into question.

Despite all this talk of network effects, it's also important to remember, these are early days. It could turn out that all the experiments we see in DeFi today end up being case studies. Today's Maker and Compound may teach important lessons to the teams that end up building future systems. Those may be the ones that end up sticking around for decades. As usual, only time will tell.
 

πŸ“ŠStatistics

10 Million. The amount of ETH stolen by the PlusToken ponzi scheme. At current market prices, it is worth $1.7 Billion. Amazingly, the scheme also stole large amounts of other currencies, including Bitcoin. This story is truly wild. Link.
 

πŸ“ΊVideo

This week, I recorded an informal chat with Anthony Lusardi. We discussed the nature of full nodes, especially the differences between fast sync nodes and fully validated ones on Ethereum. This conversation was sparked by a renewed debate on "Crypto Twitter" about the importance of validating nodes, and what makes a node "full" or not. Check it outβ€” you might find it interesting. Link.