Compound is a DeFi borrowing and lending protocol built on Ethereum that functions as the blockchain version of a money market.
At the most basic level, Compound is an autonomous protocol that calculates interest rates using algorithms. It is permissionless, meaning anyone can access the tools provided at any time. There is no verification process and no user identification mechanism.
For individuals, Compound is primarily used as a cryptocurrency borrowing and lending protocol. Users can deposit one of the supported tokens into a shared pool at any time and receive interest. Or, after depositing their tokens, they can borrow a smaller amount of tokens and pay interest. The amount of interest is determined by the supply and demand of tokens deposited.
There are two main actors in Compound: lenders and borrowers.
Lenders
Lenders deposit or lock their crypto into Compound to earn money at a dynamic annual interest rate. You receive income interest in tokens you lend. Thus, if you lend ETH to Compound, your interest compounds in ETH. Similarly, if you deposit USDT, you will get your compound in USDT.
To lend with this protocol, all you need to do is supply the cryptocurrency that you want to provide liquidity for. Lenders deposit tokens into a liquid fund. Once you do that, you will immediately start earning interest, which is controlled by the supply and demand of the currency.
When lenders put their cryptocurrency in the market, they receive an amount of cToken corresponding to the lend. For example, if you lock USDT in the protocol, you will get cUSDT tokens. These cUSDT tokens can then be used in apps on Ethereum. That way, your locked-up capital isn’t truly locked up like it would be if you were to lend to a borrower in a traditional system.
When a market is launched, the cToken exchange rate (how much ETH one cETH is worth) begins at 0.020000 — and increases at a rate equal to the compounding market interest rate. For example, after one year, the exchange rate might equal 0.021591. Each user has the same cToken exchange rate; there’s nothing unique to your wallet that you have to worry about.
When you need to make use of your cryptocurrency, all you need to do is pay back your cTokens, and you will receive your original tokens in return.
Borrowers
Borrowers can take a loan against their crypto balance in the Compound protocol. When you borrow money from a bank, they usually do a personal finance background check to determine credit ratings. However, Compound is keeping up with DeFi’s promise of anonymity and never inquires about personal finance. Thus, in order to avoid debt and bankruptcy, Compound only offers over-collateralized loans. This means that users who want to borrow have to have collateral that is more than what they want to borrow, that way the lender and the system are exposed to zero risk. The protocol sets a borrowing limit/collateral factor to determine how much a user can borrow. Their deposited amount is also called “borrowing power”. After acquiring that power, they will be able to borrow tokens equivalent to the amount of borrowing power that they have.
Since borrowers take money from the protocol, they need to pay Compound interest on it.
Borrowers should also note that the value of their collateral must remain above a certain value to be viable. If it doesn’t remain above that value, the collateral will be liquidated to pay back the loan. When a user’s collateral enters the liquidation event, other users will have the opportunity to pay the outstanding amount borrowed for a percentage of the collateral of the borrower. To incentivize this purchase, users can buy the collateral for a better price than the market price.
A note on liquidation: many who are wary of this term believe they will lose all of their funds upon liquidation. However, these concerned individuals should realize that they would still have their borrowed funds. For example, if I were to collateralize 100 and borrow 80, if my 100 was liquidated, I would still have 80 (excluding market movements), for a loss of 20, not 100.
The COMP Token
The COMP token is the governance token of Compound. COMP is also the rewards token for Compound’s liquidity mining. Whenever a lender adds cryptocurrencies to Compound’s liquidity pools or borrows from these pools, they get COMP tokens.
What Makes Compound Finance Stand Out
No Need For Negotiations
The great thing about Compound is that it eliminates the need for negotiations. Lenders to the market don’t have to negotiate terms as they would in a regular bank, or even in other DeFi apps.
Lenders and Borrowers only need to interact with the protocol to deposit or borrow cryptocurrency. The entire operation is governed by algorithms. Individuals do not hold the funds. The funds are held in smart contracts. There is no threat of unfair or preferential treatment and no threat of counterparty risk.
It Makes Investing Easier
Lenders aren’t the only ones who benefit from this arrangement. Borrowers who would like to go long on a particular asset can use Compound to do so.
For example, if a trader assumes that the price of ETH can increase exponentially in the long to medium term, he can use his existing ETH as collateral to borrow USDT, which can then be used to buy even more ETH.
If the trader is right, and the increase in their ETH is more than the interest on the USDT they borrowed, they can turn a healthy profit. However, if it doesn’t work out they will still have to repay the loan or be liquidated.