The Beginner’s Introductory Guide to Compound

The blockchain space has exploded over the past couple of years, largely due to the rise of decentralized finance (DeFi) among crypto investors. DeFi has become so popular because it has presented real-world use cases aimed at addressing key problems in the finance industry.

DeFi is a catch-all term for various financial products and services accessed in a decentralized, non-custodial and borderless manner. Currently, there are hundreds of projects in the fast-growing DeFi ecosystem, from derivatives trading and stablecoins to lending/borrowing and decentralized exchanges among others. However, we have top platforms offering users better opportunities for financial freedom than others.

Although the scope of the DeFi space is becoming increasingly broad, DeFi lending/borrowing has dominated the space from the early days to date. Through decentralized lending (and borrowing), it’s become much easier and accessible to obtain loans in the cryptoverse.

In this article, we’ll examine one of the top DeFi protocols, Compound. We’ll explain how it works and briefly look at COMP, its native token.

What Is Compound?

“Compound is an algorithmic, autonomous interest rate protocol built for developers, to unlock a universe of open financial applications,” the official website reads. In simple terms, Compound is an automated, decentralized protocol for lending and borrowing crypto assets. 

Picture Compound as a place where you can obtain loans or lend out your crypto assets while you maintain control of your funds. In plain English, you lend your crypto assets to other users and earn interest, or you take out loans by opening collateralized debt positions (CDPs) using your crypto as collateral — all without having to involve a third party.

Compound is one of the top DeFi protocols — sitting in the third position — with a total value locked (TVL) of $8.88 billion, at the time of writing. This makes sense, particularly when you realize lending protocols occupy the top three spots in the DeFi rankings.

Thanks to Compound (and other lending protocols), you can put your crypto holdings to work and earn interest or use your assets as collateral to take out loans, without opening a traditional bank account. No doubt, this is one of the strongest use cases of cryptocurrency, as evidenced by the massive growth of DeFi lending platforms.

How Compound Works

On the surface, Compound works similarly to a traditional bank providing credit to individuals or businesses. However, it’s drastically different from traditional lending solutions, majorly in terms of assets control and the lending model.

First, the protocol operates in a non-custodial manner: borrowers maintain control of their debt positions, while the deposited collateral is locked in a smart contract. In the same vein, anyone with an internet connection and a Web3 wallet (say, Metamask) can freely interact with the protocol. Your wallet simply connects to the platform, and you don’t have to deposit directly into the platform.

Moreover, Compound shares a similar model with popular lending platform Aave. You can deposit your crypto assets to the lending pool and you’ll be rewarded with interest on your deposits. And, just as with Aave’s aTokens, crypto assets deposited on Compound are converted to Compound tokens (‘cTokens’) — further explained below.

First, it’s noteworthy that Compund’s smart contracts are built on the Ethereum network, so you can only lend out (and borrow) ERC-20 tokens. At the time of writing, Compound’s list of supported assets includes ETH, USDC, USDT, WBTC, DAI, ZRX, BAT and REP. 

However, the protocol is scaling its blockchain interoperability efforts with the proposed launch of Compound Chain, a distributed ledger for cross-chain transfer of value and liquidity between various chains. According to a CoinDesk report, the application-specific blockchain will “provide money market services across multiple [blockchain] networks.”

cTokens

cTokens form the backbone of the Compound ecosystem, ERC-20 tokens which represent crypto assets deposited in Compound. By depositing supported assets in the smart contract, you’ll receive an equal amount of cTokens.

For instance, depositing $1500 worth of WBTC would get you the equivalent in cWBTC. The cWBTC you received will automatically generate interest (as determined by the rate), and you can redeem it for your initial WBTC deposit with the accrued interest.

cTokens play a key role in the Compound protocol and the larger DeFi ecosystem. Since they’re ERC-20 tokens, they can be freely traded and used in other Ethereum-based dApps. Although they’re issued as equivalent amounts of the deposited asset, they don’t represent the asset itself but rather an interest-generating claim on the asset.

Lending and Borrowing on Compound

Instead of centralized order books, Compound facilitates lending through algorithmic trading robots known as AMMs and liquidity (or lending) pools controlled by a smart contract.

Each asset type has its liquidity pool where anyone can deposit the corresponding assets and earn liquidity provider (LP) rewards. No approval is needed, and certainly no KYC, either. Even more, Compound’s developers cannot control your holdings since they’re locked in smart contracts.

To lend on Compound, you’ll have to get cTokens. The only way you can get cTokens is to deposit supported tokens into the liquidity pool. For example, if you deposit DAI, it’ll be converted to cDAI, and if you deposit both ETH and DAI, then you’ll earn interest depending on each asset’s interest rate.

Borrowers are assigned a collateral factor, a value between 0-90%. The collateral factor acts as a credit score on the blockchain and it depends on the value of supplied assets. This percentage determines how much you can borrow at a time. In practice, crypto assets with large liquidity (e.g., USDT, ETH, DAI) usually have a maximum collateral factor of around 75% while assets with less liquidity are capped at about 30-35%.

The amount borrowed cannot exceed the value of the collateral and its collateral factor. For example, depositing $100 of USDC enables borrowing of up to $75 of another asset listed on the Compound protocol.  If the borrowing limit is exceeded, the supplied collateral is liquidated. In addition, interest rates typically vary, as they’re based on current demand and supply (i.e., borrowers and lenders, respectively).

The catch with Compound is, loans need to be overcollateralized as a precaution against credit risk. This provides lenders with some security, in case a borrower defaults on loan repayment and ‘skips town’. Hence, if a debt position isn’t sufficiently collateralized, it’s automatically liquidated and your principal is paid back.

Compound Token, $COMP

It’s now a common practice for lending protocols to maintain a decentralized platform through governance tokens. The Compound protocol started the trend back in June 2020, when it launched its native token COMP. Back then, the COMP token launch famously spurred the yield farming boom.

By holding COMP tokens, you’ll be entitled to participate in the governance process. Each COMP token counts as a vote, and holders can suggest changes or vote on key decisions regarding the protocol.

Compound originally began as a startup with VC funding, however, it’s become largely decentralized thanks to its governance token. In the future, the protocol will maintain decentralized control through community governance by COMP token holders.

Ultimately, Compound aims to create an open economy on the blockchain where participants can easily lend and borrow using crypto assets. On this platform, lenders can put their digital assets to work and earn interest while borrowers can get access to loans without worrying about unnecessary paperwork and third-party regulators.

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