What is Compound: A Deep Dive into the DeFi Lending Platform

Compound Finance is a decentralized finance (DeFi) protocol built on the Ethereum blockchain that allows users to lend and borrow cryptocurrencies. Its innovative approach to decentralized lending and borrowing has made it a cornerstone in the DeFi ecosystem. This article will guide you through the journey of understanding Compound, its key features, and how it works.

Key Takeaways
  • Compound Finance is a DeFi platform for lending and borrowing crypto assets.
  • The protocol operates autonomously using smart contracts.
  • The native COMP token plays a vital role in governance and rewards.
  • Compound supports various assets and offers flexible interest rates.
What is Compound Finance?

Compound Finance is an autonomous protocol built on the Ethereum blockchain that enables you to lend and borrow cryptocurrencies. It is permissionless, meaning anyone can access the tools provided without the need for verification or user identification. Users deposit supported tokens such as DAI, ETH, USDC, ZRX, USDT, WBTC, BAT, REP, and SAI into a shared pool and receive interest or borrow tokens, paying interest. The interest rates are calculated using algorithms based on the supply and demand for the specific cryptocurrency.

History and Development of Compound Finance

Founded in 2017 by Robert Leshner and Geoffrey Hayes, Compound Finance has rapidly grown into a leading DeFi platform. The protocol launched in 2018, introducing an innovative way for users to earn interest on their crypto holdings and borrow assets against their collateral. Key milestones include the introduction of COMP governance tokens in 2020, which further decentralized the platform’s decision-making process and enhanced its community involvement.

How Does Compound Finance Work?

Crypto Lending and Borrowing: To lend with Compound, users only need to supply the cryptocurrency they want to provide liquidity for. Lenders deposit tokens into a liquidity fund, earning interest controlled by the supply and demand of the currency. When lenders put their cryptocurrency in the market, they receive cTokens, which represent their share in the pool and accrue interest over time. For example, if you supply USDC, you will receive cUSDC, which will hold the encoded information for the interest owed on top of the value of the underlying crypto asset. Once you decide you want your lent assets back, you just need to return the cTokens.

Borrowing on Compound requires first depositing collateral to gain so-called “borrowing power.” Only then can borrowers take out loans in any supported cryptocurrency against this borrowing power. As with other DeFi lending and borrowing protocols such as Aave, the principle of overcollateralization applies. Borrowers can take loans with lower value than the collateral they have locked in. This ensures that loans are secure and minimizes the risk of default. If the value of the loan and the interest goes above a certain threshold of the value of the collateral, a liquidation is automatically triggered by the protocol to be able to pay the loan back to the lender. The borrower will, however, keep the borrowed funds.

Interest rates on Compound are dynamic and fluctuate based on the amount of crypto available in each market. Higher liquidity leads to lower interest rates as the protocol is programmed to make the assets more lucrative to borrow. Conversely, lower liquidity in a liquidity fund will result in higher rates, incentivizing lenders to supply their assets and earn more. In this way, the pools are balanced programmatically. Interest accrues every 15 seconds as each Ethereum block is mined.

Liquidity Pools and cTokens: Understanding Compound’s liquidity pools is crucial as they are at the heart of Compound’s lending and borrowing ecosystem. These liquidity pools or liquidity funds are smart contracts that pool together user-supplied funds of the same type. All user interactions, whether lending or borrowing, are executed by algorithms as long as the input criteria are met. Meaning, if you deposit DAI in the DAI pool, you will automatically receive cDAI. Your cDAI token will automatically start to accrue interest. The same applies to the borrowing process. The system ensures there is no preferential treatment, no counterparty risk, and anybody can use it no matter who you are or where you are from, as long as you have access to the internet.

Another interesting aspect of the system is the cTokens. As mentioned earlier, they hold the user claim to the supplied tokens and accrue the interest on them. This interest is paid out based on the share of the funds in the pool once you return your cTokens. However, while these tokens appreciate in value, they do not need to sit idle. Users can actually transfer, trade, or program them into other DeFi applications, providing flexibility, utility, and additional earning opportunities.

Compound V2 and V3: Compound has evolved significantly since its launch. Compound v2 introduced community governance through the COMP token and the aforementioned cTokens which accrue interest. Compound V3, or Comet, simplified the protocol by focusing on a single base asset that can be borrowed — USDC. That means that no matter what currency you supply as collateral, you can only take out loans in USDC. This change improved capital efficiency and reduced exposure to multiple volatile assets.

Yield farming: Lenders who offer USDC loans to borrowers can earn rewards on their deposits, with the reward rate determined by governance and adjustable based on market conditions. The interest paid by borrowers for the base asset follows similar guidelines. Moreover, lenders and borrowers might receive additional rewards in the form of COMP tokens, depending on the prevailing market conditions.

How to Earn Yield on Compound Finance

Yield farming on Compound Finance is rewarding, but becoming a lender can be a prohibitive process that necessitates various steps and tools. Return Finance offers an easy way to start earning yield via a mobile and web app. With just a few clicks, you can supply USDC to Compound V3 on the Base. Return Finance simplifies the process, allowing you to earn interest without the hassle of managing multiple steps and tools.

Governance and the Role of COMP Tokens

The COMP token is central to Compound’s governance model. COMP holders can propose and vote on changes to the protocol, influencing the platform’s future. Governance proposals are executable code, subject to community voting. If a proposal is passed, it takes effect after a waiting period, allowing users to adjust their positions. COMP tokens have a capped supply of 10 million to ever be minted.

Risks and Rewards of Compound Finance

While Compound offers numerous benefits, it also comes with certain risks. Market volatility can affect the value of collateral, and smart contract vulnerabilities could pose security risks. Additionally, liquidity providers face the risk of impermanent loss, and the interconnected nature of DeFi protocols can amplify risks related to composability and interdependency. However, the potential rewards, including earning interest and yield farming opportunities, make Compound an attractive option for many users. Understanding the risks and rewards of using Compound for crypto loans is crucial for making informed decisions.

Conclusion

Compound Finance is a big contributor to the adoption of decentralized finance by offering secure and efficient lending and borrowing services. Its unique features, dynamic interest rates, and community-driven governance make it a standout platform in the DeFi space. Whether you’re a seasoned crypto investor or a beginner, Compound provides a robust and flexible solution for managing your crypto assets.

About Return Finance

Return Finance streamlines the process of earning passive income through DeFi platforms like Compound, MakerDAO, and Curve Finance. By offering a familiar banking app user experience, Return Finance simplifies complex DeFi operations, making them accessible to everyone. Putting transparency at the forefront, Return Finance users can easily track and verify their investments directly within the smart contracts of the respective DeFi platforms. Return Finance is an authorized Virtual Asset Service Provider in the EU and an SRO membership with the Financial Services Standards Association (VQF) of Switzerland.