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What is Compound Finance in Decentralized Finance (DeFi)?
2023-11-18 22:50 Update

Summary

You can lend and borrow cryptocurrencies at Compound Finance. Simply hold an Ethereum wallet and some funds to instantly borrow funds or earn interest.

Injecting assets into Compound is very simple, and these funds are never held by third parties. Interested in understanding how Compound works? Please read this article to find out.


Contents

  • Introduction
  • What is Compound Finance?
  • How does Compound Finance work?
  • What assets does Compound Finance support?
  • How is Compound governed?
  • Advantages and Disadvantages of Compound Finance
  • Summary


Introduction

Fund lending has always been a difficult problem in the field of decentralized finance (DeFi). Compound Finance is the premier cryptocurrency lending protocol in the DeFi space. In a sense, Compound is a savings account that earns interest without going through a trusted third party.

The user experience is very smooth, and the protocol is currently in the testing phase. Additionally, many liquidity miners use Compound to borrow assets and stake them in other DeFi protocols.

However, how does Compound Finance work? Let's find out.


What is Compound Finance?

Compound Finance is a DeFi lending protocol. In more technical terms, it is an algorithmic money market protocol. You can think of it as an open currency market. It allows users to deposit cryptocurrencies and earn interest, or use these currencies as collateral to borrow other crypto assets. It uses smart contracts to automate savings and manage funds deposited into the platform.

All users can use Web 3.0 wallets such as Metamask to connect to Compound and earn interest. Therefore, Compound is a permissionless protocol. This means that anyone with a cryptocurrency wallet and a connection to the network can freely interact with it.

Why is Compound useful? Unlike traditional markets, Compound’s suppliers and borrowers do not need to negotiate terms. Both parties can interact directly with the protocol that handles collateral and interest rates. Assets are deposited into smart contracts called "liquidity pools" and there are no counterparties holding funds.

Compound’s supply and borrowing rates are adjusted algorithmically. Therefore, the Compound protocol automatically adjusts based on supply and demand. In addition, COMP token holders also have the right to adjust the interest rate.


How does Compound Finance work?

Positions (supply assets) in Compound are anchored to Compound's native token "cToken". cToken is an ERC-20 token that represents the share of various tokens in the Compound capital pool.

For example, Ether will be converted to cETH after being deposited into Compound. After the stablecoin DAI is deposited, it will be converted into cDAI. If you deposit multiple tokens, you earn interest at their respective rates. In other words, cDAI earns cDAI interest rates, while cETH earns cETH interest rates.

cToken can be redeemed for its share of the pool, so that the supply assets will be deposited into the associated wallet. As money markets earn interest (more borrowed funds increase), cTokens also begin to earn interest and are redeemable for more underlying assets. This basically means that as long as you hold ERC-20 tokens, you can earn interest on Compound.

First, the user connects to a wallet that supports Web 3.0 (such as Metamask). Next, unlock the assets you wish to interact with. Once an asset is unlocked, users can borrow or lend it.

The principle of lending is very simple. Unlock the asset you wish to provide liquidity for, sign a transaction through your wallet, and start supplying funds. The assets will immediately enter the fund pool and start earning interest immediately. At this point, the asset is exchanged for cToken.

Borrowing is a little more complicated. First, the user deposits funds (collateral) to repay the loan. In return, they receive the "borrowing rights" needed to borrow money at Compound. Each supply asset will add a different amount of borrowing rights. Users can borrow funds based on their borrowing rights.

Similar to many other DeFi projects, Compound uses the over-collateralization concept. This means that the borrower must provide collateral worth more than what is being borrowed to avoid forced liquidation.

It is worth noting that each asset has its own borrow and supply annual percentage rate (APR). Borrowing and supply rates adjust based on supply and demand, so various assets have different borrowing and lending rates. As mentioned earlier, the interest rates earned on each asset vary.


What assets does Compound Finance support?

As of September 1, 2020, lending assets supported by Compound include:

  • ETH
  • WBTC (Wrapped Bitcoin)
  • USDC
  • DAI
  • USDT
  • ZRX
  • BAT
  • REP
  • Other tokens may be added in the future.


    How is Compound governed?

    Compound was originally a company founded by Robert Leshner and funded by venture capitalists. However, Compound Finance’s governance tends to be decentralized thanks to the COMP token. COMP tokens entitle holders to fees and governance protocols.

    Therefore, token holders can change the protocol through improvement proposals and on-chain voting. Each token represents a vote, and holders use the token to vote for proposals. In the future, the protocol may be fully managed by COMP token holders.

    What problems do COMP holders most often encounter when voting?

    • What are the cToken markets?
    • The interest rate and required collateral for each asset.
    • Which blockchain oracle to use.


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    Advantages and Disadvantages of Compound Finance

    What do users use Compound for? Earning interest is just a simple use case, and Compound’s user experience is very beginner-friendly. For experienced traders, Compound is an excellent way to increase the leverage of your positions.

    For example, suppose a trader goes long Ethereum and supplies Ethereum to the Compound protocol. They then use the supply of ether as collateral, choosing to borrow USDT and buy more ether. If the price of Ethereum rises, you can make a profit by earning more than the interest rate you paid on the borrowed funds.

    However, the risks also increase. If the price of Ethereum drops, their Ethereum collateral may face forced liquidation in order to pay it off with interest.

    What other risks are there? Compound has been audited by companies such as Trail of Bits and OpenZeppelin. While these auditing firms are generally reputable, flaws and vulnerabilities can breed unexpected problems, and no software is immune.

    Before investing funds in smart contracts, all risks should be fully considered. No matter what type of financial product you invest in, never risk more money than you can afford.


    Summary

    Compound is the most popular lending solution in the DeFi space. With many other products integrating their smart contracts into applications, Compound will become an important part of the DeFi ecosystem.

    As a core money market protocol, Compound can solidify its position in the DeFi field once governance is fully decentralized.

    Do you have any other questions about Compound Finance and DeFi? Please visit our Q&A platform Ask Academy, where members of the Binance community will patiently answer your questions.