In finance, the word ‘Compound’ refers to money’s ability to grow exponentially over time. The reinvestment of profits earned from an original sum results in compounded returns with each cycle.
In the world of cryptocurrencies and decentralized finance (DeFi), Compound is also the name of a decentralized open-source platform. This particular project offers investors the opportunity to grow their crypto investments exponentially without a middle man.
Compound Finance is an innovation that brings the lending and borrowing capabilities of legacy money markets to crypto.
Built as an autonomous money market on Ethereum’s network, Compound Finance uses blockchain technology to cut costs and improve efficiency. The platform’s algorithm is designed to allow both individuals and institutions to earn interest on their digital assets by supplying liquidity to their markets. Users seeking to get a loan can borrow directly from liquidity pools without negotiating with counterparties or authorities.
At its core, Compound Finance seeks to build a decentralized money market with efficient and frictionless operations.
How Does Compound Work?
Just like a bank, Compound Finance allows users to deposit their digital assets to earn interest. The core objective is to offer retail and institutional users an avenue to leverage their digital assets’ time value. Borrowers can deposit crypto as collateral to receive loans in other digital assets supported by the platform.
Compound employs smart contracts to store and manage the capital deposited to the platform. Because it is an open-source platform, anyone can connect to the protocol with a crypto wallet and immediately start earning interest on their crypto assets or start borrowing.
Unlike traditional banking, compound users do not have to go through any negotiations or background checks to access loans. For borrowers, loans are issued based on collateral. For lenders, profits earned are generated through the different interest rate fees that borrowers must pay depending on the crypto asset.
Both lenders and borrowers only need to interact with the protocol as the Compound Finance algorithm autonomously determines interest rates and manages crypto collateral for loans.
How the Lending and Borrowing Process Works
To earn interest on crypto assets, a user has to use a Web 3.0 crypto wallet such as Metamask. The user then links the wallet to the Compound platform and supplies liquidity to one of the available liquidity pools. This essentially entails locking your funds in their platform for a given period of time. Lenders can supply a variety of cryptocurrencies such as ETH, DAI, BAT, USDT, ZRX, and REP to mention a few.
Once liquidity is supplied, the platform’s Mint Function is executed to generate a token that represents a portion of the lender’s contribution to the liquidity pool. This is the cToken (more details on the cToken below). cTokens are sent to the lender’s account in exchange for the supplied liquidity. These determine how much interest one will receive.
On the other hand, borrowers can access loans from these pools by paying predetermined interest rates. These payments are then shared among liquidity providers based on the ratio of their contributions. The algorithm can detect real-time changes in every coin’s supply and demand and set each crypto asset’s interest rates accordingly.
Borrowers on Compound have to provide collateral in the form of another crypto asset to receive a loan. A collateral factor is then assigned to the borrower based on the assets they have supplied. For example, suppose a borrower supplied 100 BAT coins as collateral, and the collateral factor for BAT is 50%. In that case, the borrower will only be able to borrow another crypto asset with an equivalent value of 50 BAT. Every crypto asset on Compound comes with its crypto collateral factor. Borrowing more than your account’s collateral factor leads to the liquidation of your account.
When a borrowing account is liquidated for exceeding its collateral factor or failing to pay back a load, a liquidation incentive is put in place for other users to repay a portion of the outstanding borrowed amount in exchange for a portion of the collateral.
The liquidators who pay the outstanding balance receive the borrower’s collateral at an 8% discount. Upon payment of an outstanding loan, the borrower’s collateral is released and can be freely redeemed or transferred to other wallets.
cTokens are redeemable tokens native to the Compound Finance ecosystem that represent a portion of a liquidity pool. For example, if an individual deposits ETH into the protocol, the algorithm will convert ETH to cETH. Likewise, depositing Litecoin LTC will lead to a conversion of LTC to cLTC.
It is the cETH or cLTC that earns interest proportional to the amount of liquidity it represents in its pool. Because cTokens are ERC-20 tokens generated in the Compound protocol, the user’s actual digital assets (in this case ETH) never leave the lender’s wallet. However, within the time that liquidity is provided to the platform, the user will not be able to transfer the ETH to another wallet unless they exit Compound’s market.
The COMP token is another token on the Compound ecosystem and it is used as a governance token that gives holders the rights to make proposals and vote on the direction of the platform. With a total supply of 10 million tokens, about 42% of COMP is reserved to be earned by users of the platform. The COMP supply on the platform is split 50:50 among liquidity providers and borrowers. These can be earned through participation in voting and other governance activities on Compound.
Token holders with 1% COMP can delegate and propose various governance actions. Any address with voting power is allowed to participate in any proposal’s voting process on the platform. For a proposal to be implemented, it has to receive a minimum of 400,000 votes. The proposal gets dropped if it fails to achieve this minimum requirement.
Going forward, Compound Finance is moving towards a decentralized governance structure where COMP token holders can influence the listing of new cToken markets, update oracle addresses on the platform, and even update the platform’s interest rate model.
The Risks and Rewards of Compound Finance
With Ethereum leading the DeFi movement, Compound Finance stands as one of the largest lending and borrowing markets in the crypto space. Founded by Robert Leshner (a venture capitalist), Compound started as a centralized company and is now gradually changing its governance structure to a decentralized model through the help of the COMP token.
Compound is an integral piece of the DeFi movement featuring a beginner-friendly user interface that allows both advanced and new traders to leverage their assets for profits. However, even the most innovative platforms have their flaws. Even though Compound has been audited by reputable firms such as OpenZeppelin with positive reviews, unexpected vulnerabilities and bugs in the Compound algorithm present risks that still raise some concerns. However, with further growth and development as the platform moves towards decentralization, most of these risks can be mitigated.