Compound Finance is one of the core money market protocols in all of Decentralized Finance. It allows users to deposit cryptocurrency into lending pools, which in turn can be accessed by borrowers. Lenders then earn interest on the assets they deposit, while borrowers pay interest against their overcollateralized loan. And all that can be done autonomously without the need for an intermediary.
But brushing it off as a savings account where you deposit assets to earn interest without trusting a third party with your funds isn’t a testament to its true value. So in this article, we hope to shed some light on the question of “how does Compound crypto work”, as well as its advantages in comparison to its traditional finance counterpart. Without further ado, let’s dive right into it!
What Is Compound?
Compound Finance is a decentralized software application that serves as an open financial marketplace running atop the ETHereum blockchain. It facilitates the lending and borrowing of cryptocurrencies by connecting two counterparties without involving a third-party. In replacement of an intermediary, it utilizes smart contracts that are self-executing computer programs stored on the blockchain to automate the storage and management of capital that is added to the Compound platform when predetermined conditions are met.
With this DeFi protocol, any user can connect to Compound using a Web 3.0 wallet such as Metamask, and deposit their crypto assets to earn interest or borrow against them as collateral at an interest rate payable. This is why Compound is a permissionless protocol – it means that anyone with a crypto wallet and an Internet connection can freely interact with it.
How Does Compound Work?
Now, onto the big question: how does Compound crypto work?
Upon users connecting their Web 3.0-enabled wallet like Metamask, the Compound App’s interface will display an overview of its Supply and Borrow Markets comprising all supported cryptocurrencies available for lending or borrowing. Thus, the two main users of the platform are:
Lenders – Anyone wishing to lend a cryptocurrency on Compound can send their tokens to an ETHereum address controlled by Compound to earn interest.
Borrowers – Anyone who posts collateral on Compound in the form of a cryptocurrency. In return, they are allowed to borrow a specific cryptocurrency supported by Compound at up to the posted collateral’s value.
Lending
Lending is quite straightforward whereby users enable the asset that they wish to supply liquidity for, then sign a transaction through their wallet to start supplying capital. The asset is instantly added to the pool, and starts accruing interest in real-time. This is when the supplied asset is converted to cTokens, that are ERC-20 tokens tracking the user’s position and represent his claims to a portion of that asset pool on Compound.
For example, if you deposit ETH into Compound, it's converted to cETH. If you deposit the stablecoin DAI, it's converted to cDAI. If you deposit multiple coins, they'll each earn interest based on their individual interest rates as they are adjusted according to supply and demand. In other words, cDAI will earn the cDAI interest rate, and cETH will earn the cETH interest rate.
Each cToken can be transferred or traded without restriction, but it is only redeemable for the deposited cryptocurrency locked in the protocol. This entire process is automatic and handled by the underlying code, meaning lenders can withdraw deposits from Compound at any time.
Borrowing
Borrowing is a bit more complicated. First, users deposit funds to collateralize their loan. In return, they earn "Borrowing Power," which is required to borrow on Compound. Every asset that is available for supply will add a different amount of Borrowing Power, which users can then borrow based on the amount of BP that they hold.
Second, similar to many other DeFi lending protocols, Compound works on the principle of overcollateralization by assigning each asset a “Collateral Factor” that determines how much a user can borrow. That means borrowers have to supply more value than they wish to borrow – if the collateral factor for ETH were to be 0.75 or 75%, the borrower can only borrow up to 75% of the value deposited.
And on an ongoing basis, the collateral factor has to be monitored and maintained on the outstanding loan in order to avoid liquidation. When the asset borrowed increases in value and becomes more valuable than the posted collateral, the borrower has to either pay down the loan or top up the collateral. Otherwise, the collateral will be liquidated up till the loan is once again overcollateralized (back below the collateral factor).
What Is Compound’s Token (COMP)?
COMP is Compound’s native network and governance token (ERC-20), which means it gives its holders special voting rights. Holders will be able to propose and vote on any network decision, from the amount of COMP rewarded for network usage, to the types of assets accepted by the platform.
To incentivize network activities, Compound rewards users with COMP tokens every time they interact with a Compound market (by borrowing, withdrawing or repaying the asset). For example in the case of lending activities, Compound rewards lenders with COMP tokens proportional to the amount of cTokens held in their wallet based on a varying interest rate dependent on the available supply of that asset.
Why is Compound Useful?
The main benefit is in lenders and borrowers not having to negotiate the terms as they would in a traditional setting. Both sides interact directly with the protocol, which manages the collateral and adjusts interest rates algorithmically according to market conditions. In addition, no counterparties hold funds since the assets are held in smart contracts called liquidity pools.
Thus, no centralized entity is able to set arbitrary interest rates or freeze deposited funds at any time.
Closing Thoughts
The question of “how does Compound crypto work?” has grown considerably as Compound has emerged as one of the most popular lending and borrowing solutions in the Decentralized Finance ecosystem. As of July 2022, it also stands as one of the largest DeFi protocols in terms of the Total Value Locked (TVL) in its smart contracts amounting to a massive US$2.77 billion.
While complex, Compound’s model has so far proved adept at attracting users and encouraging other DeFi cryptocurrencies to adopt its model. And without a doubt, Compound could further strengthen its ranking in DeFi with the passage of time, once its governance becomes fully decentralized.
