What is Compound Finance
All of us know the idea of borrowing and lending, whether it’s money, mortgages, or even purchasing other assets. Lenders supply funds to borrowers with the expectation that the borrowed funds are returned with additional interest to provide instant access to funds.
The process of matching borrowers with lenders is usually done by financial institutions like banks. But with decentralized finance (DeFi), the process has become much easier and faster and allows a seamless transaction that does not require submission of financial documents in person.
One notable DeFi platform in the borrowing and lending space today is Compound Finance. The platform works by allowing users to deposit into a pool that borrowers can then withdraw from without any third party.
In this article, we will dive deep into the basics of Compound Finance, how it works, and why more people are preferring to use it than traditional lending service providers.
Defining Compound Finance
At the most basic level, Compound Finance 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. This real-time interest rate calculation can be used for a variety of financial applications.
For individuals, Compound Finance 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 and borrowed in the pool.
How lending works in Compound Finance
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 the native token of Compound called a “cToken.” The token value of the cToken is equivalent to the token that was placed in the liquid market. The value will increase as the interest on that cryptocurrency appreciates. The value of the cToken will also fluctuate with the value of the token in the market, of course.
For example, if you lock X amount of USDT in the protocol, you will get X amount of cUSDT tokens which will then begin growing in value. 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 setting. You can still use it.
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.
If you are a non-technical user, you can interact with the Compound Dapp using interfaces like a Coinbase Wallet, or Argent.
How borrowing works in Compound Finance
Borrowing is a bit more complicated. First of all, borrowers have to deposit collateral to get something called “borrowing power”. After acquiring that power, they will be able to borrow tokens equivalent to the amount of borrowing power that they have.
Borrowers can then borrow from that fund whenever they want, for as long as they want, at an interest rate determined by an algorithm monitoring the supply and demand of the tokens being borrowed. Like many DeFi projects, Compound also operates on the principle of over-collateralization. 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.
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 will be given an 8% discount on the collateral. That is, they will get the collateral at 8% lower than the market value.
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, for a loss of 20, not 100.
Why Compound Finance stands in the DeFi lending-borrowing space
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. However, there are a number of other lending protocols that carry these same benefits.
Compound is currently considered a centralized application. While that might be true today, it’s certainly not going to be true in the long term. The COMP token, which is the native token of the protocol, grants governance rights to holders. As more users get into the protocol and start using the token, the protocol will continue to decentralize.
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.
It’s important to note that the only types of assets that Compound can support are currently 9 ERC-20 tokens.
There are many protocols right now that are trying to make it easier for users to lend and borrow assets. However, Compound Finance’s approach is certainly interesting, and it is often compared to Aave as one of the largest lending protocols available.
Considering the solid conceptual ground the protocol stands on, including algorithmic and non-negotiable interest rates, permissionless access, and non-custodial token management, there are many good reasons to consider this option.