The evolution of blockchain and cryptocurrencies has created a completely new ecosystem with many investors, traders, and enthusiasts. The ecosystem involves regular exchange of multiple blockchain assets. On the other hand, the sophistication of financial markets has not evolved as expected. Participants have limited capabilities for trading the time value of assets.
Interest rates serve an important role in addressing the differences between people with additional assets, which they could not use, and people without assets. This is where the Compound protocol comes in. The following discussion offers you a detailed overview of Compound and how it is an integral part of the emerging DeFi ecosystem.
Before moving to the Compound DeFi connection, it is important to reflect on the origins or background of Compound. Blockchain-based assets encounter two major setbacks in present times such as,
Centralized exchanges offer the facility for trading blockchain assets with in-built borrowing markets in the exchange. However, centralized exchanges bring the element of trust alongside restrictions for specific customer groups. On the other hand, peer-to-peer protocols can provide collateralized and uncollateralized loans among market participants. However, decentralization could lead to prominent costs and conflicts for users. Therefore, the Compound blockchain emerged as a solution for enabling frictionless borrowing and lending of Ethereum tokens.
With a brief understanding of DeFi, you can find out how the Compound protocol aligns with the larger crypto landscape.
Cryptocurrencies are known for acting as decentralized money with respect to payments. Bitcoin (while many now consider it to be more a store of value similar to gold) is still of course the first and best example. Alice can pay Bob in bitcoin without going through a bank or other financial services intermediary, instead going through the Bitcoin network, a decentralized network of independent nodes to validate the transaction.
However, financial services go way beyond payments to services such as checking and savings, borrowing and lending, insurance, taxes and accounting and so on. The idea behind DeFi should now be fairly apparent: to decentralize all financial services using blockchain protocols and cryptocurrencies.
The main backbone of today’s DeFi movement is Ethereum, a decentralized blockchain that enables smart contracts upon which other decentralized blockchain-based applications (dApps) with native cryptocurrencies can be built. The Compound protocol is primarily concerned with the financial services of borrowing and lending your crypto.
Compound or Compound Finance is basically a decentralized marketplace for crypto investors which offers functionalities for lending and borrowing digital assets. Compound crypto is basically a decentralized protocol developed over a blockchain.
Users have the privilege of dictating governance precedents for the Compound protocol with the help of the COMP token.
From a technical perspective, you can think of Compound as a system of smart contracts developed on Ethereum with open accessibility.
The protocol emphasizes enabling borrowers to take loans and lenders to offer loans through locking their crypto assets in the protocol.
Interestingly, the supply and demand of each crypto asset help in determining the interest rates that borrowers and lenders could pay and receive. The mining of each block leads to generation of interest rates. Furthermore, borrowers can pay back the loans at any time alongside the flexibility for withdrawing locked assets.
The next important concern in understanding the answer for ‘What is Compound in DeFi?’ points towards the uniqueness of Compound.
The compound may look like just another decentralized lending protocol that leverages crypto assets as collateral for borrowing additional crypto assets.
but, Compound has a unique highlight in the fact it enables tokenization of assets locked in the system by using
COMP tokens or cTokens are just ERC-20 tokens providing representation of a user’s funds in the Compound blockchain. When you put ETH or any other ERC-20 token such as USDC, you would get the equivalent amount of cTokens. The tokens would then automatically earn interest for you. Users can choose to redeem their cTokens for normal tokens alongside the interest paid in the tokens.
It is also important to note that every asset has a specific market and the supply or demand of the asset in the market plays a crucial role in determining the interest rates.
Compound leverages web 3.0 wallets such as Metamask, Argent, or Coinbase Wallet for access. Once connected, users are brought to the Account Overview section. From here, users can select any asset(s) and unlock the market they wish to interact with. After an asset has been enabled, users are then able to supply or borrow said assets.
The process for lending assets is pretty straightforward. Simply enable a supported asset and sign a transaction approving the amount of capital you wish to supply capital to Compound. Assets are instantly added to the global supply pool with interest being tracked in real-time.
Every asset has a unique Supply and Borrow APR, both of which change frequently relative to supply and demand at any given time. When supplying assets to the protocol, users receive cTokens – Compound’s native tokens – which represent claims to a portion of any given asset pool.
cTokens can be redeemed at any time, with borrowed funds instantly becoming available in the connected wallet to be freely sent to wherever the user chooses. In order to borrow assets, users must first supply collateral to earn “Borrowing Power”. Every asset has a unique Collateral Factor, meaning some assets may enable more Borrowing Power than others.
To start borrowing with Compound, head over to the borrowing dashboard.
To claim COMP, navigate to the Voting Dashboard and press Collect. Alternatively, COMP can be automatically claimed whenever you withdraw any amount of assets from the platform.
On the other side of the equation is borrowing. Once you’ve locked your crypto to Compound, you are able to borrow against it. Compound does not require a credit check so anybody anywhere in the world with crypto has the ability to borrow. Compound determines how much you are allowed to borrow based on the quality of the asset. So, for example, if you sent 1000 BAT worth $500 and Compound has set the borrowing limit (aka collateral factor) for BAT at 50%, you can borrow $250 worth of any other crypto that the Compound protocol supports (see list above). And, just like borrowing money from a bank, you need to pay interest on the money you borrow.
So, we have lending and we have borrowing, both of which concern themselves with interest rates. For lending, you earn interest. For borrowing you pay interest. Let’s take a minute to talk about how those interest rates are calculated and automatically implemented by the Compound protocol.
As you can notice how lending and borrowing works on Compound with the help of Compound token or cTokens. However, the common element in the lending and borrowing applications of Compound refers to the interest rates. In the case of lending, you would earn interest, and in the case of borrowing, you have to pay interest. Let us take a look at how the interest rates for borrowing and lending vary in the case of Compound.
Irrespective of borrowing or lending functions on Compound blockchain, users have to lock their crypto assets in Compound. Upon locking your crypto in Compound, you would get the equivalent amount of Compound token or cTokens. The cTokens provide representation for balance of your crypto assets. cTokens are basically ERC-20 tokens on Ethereum and serve exceptional value of innovation in a blockchain-based crypto money market.
You can transfer, trade, or programmatically integrate cTokens in other dApps in the DeFi landscape, just like other Ethereum tokens. At the same time, you would also earn or pay interest depending on whether you lend or borrow on Compound. Users can control the Compound token with their public and private keys, like any other digital asset on Ethereum blockchain.
The interest rates in Compound DeFi are basically a function of the liquidity of crypto in each market. Therefore, it can vary in real-time according to the supply and demand of the asset for aligning with existing market conditions. The interest rates on Compound are evident as annual interest rates, which accrue with every instance of mining Ethereum blocks. The value of cTokens increases by a margin of 1/2102400 of the quoted annual interest every 15 seconds.
Another critical highlight in understanding how Compound Finance works would refer to the working of Compound liquidity pools. When you lock large pools of crypto in Compound, the interest rates become low as there is plenty of crypto for borrowing. However, you wouldn’t get favorable interest rates by adding to the concerned crypto pool in Compound protocol.
However, if the pool is small, you could earn more with higher interest rates. Fluctuation in the interest rates could ensure incentives for lending new crypto assets to smaller pools for earning higher interest rates. At the same time, you can repay borrowed crypto into small pools while borrowing from large pools for lesser interest.
Whether you borrow or lend from Compound, you have to lock in your crypto assets. In the case of borrowing, you must lock an amount of crypto in Compound, which has more worth than the amount you intend to borrow. As a result, the loan you borrow from Compound blockchain is over collateralized.
Furthermore, you should also notice that the crypto deposited as collateral has higher volatility and could experience value drops. When the value becomes closer to the value of crypto borrowed, a Compound token or cToken smart contract closes the position. Such a process is referred to as liquidation, where you can get the amount you have borrowed and lose collateral.
The final aspect in understanding Compound DeFi would obviously point towards the governance implications. Compound Finance leverages COMP as its governance token, with a specific amount distributed among lenders and borrowers on Compound regularly. With every Ethereum block mining process, COMP distributions are an inevitable occurrence.
The distribution of COMP token is directly proportional to interest accumulated with each asset. Holders of COMP token can offer proposals and make votes on modifications for the protocol. At the same time, COMP also enables privileges for monitoring the treasury and reserves of the Compound protocol. Each COMP token provides representation for one vote, and it could be delegated to other parties on your behalf.
The governance proposals in Compound are generally available as executable code with a three-day voting timeframe. Community approval for governance changes in the protocol could take around two days to come into effect. The native COMP governance token offers the value of blockchain for lending and borrowing applications in a massively expanding DeFi ecosystem.
One of the downsides to compound interest is that its benefits apply to financial institutions and consumers. Lenders and credit card issuers can apply compound interest to the repayment of student loans and credit card debt. This interest can grow out of control over time, especially for consumers paying the minimum monthly amount on these bills.
One of the drawbacks of taking advantage of compound interest options is that it can sometimes be more expensive than you realize. The cost of compound interest is not always immediately apparent and if you do not manage your investment closely, making interest payments can actually lose you money.
Missing a regular interest payment by a day may mean that your rate decreases due to the compound interest being calculated before your payment is recorded. This could cost you a significant amount depending on the size of your regular payments. To avoid this, you will need to carefully time your monthly payments and stay on top of your payment schedule.
Compound interest helps your account funds increase quickly because the rate of growth is calculated based on the money you accumulate over the years in addition to the original principal amount. Compounding interest helps your money increase exponentially as your original investment and the profits that you have earned increase together.
As an example, let’s say Jane saved $50 per month for 10 years in a savings account. If she does not invest it or earn interest from it, she will have $6,000 at the end of the 10 years. However, if she invests $50 per month for 10 years and earns 10% per year on her investment, she would have a final amount of $10,518. Therefore, she will have more than double her original amount.
After a clear understanding of ‘what is Compound in DeFi?’ you would definitely look for information on how it works. As you have noticed, Compound is basically a decentralized borrowing and lending platform based on Ethereum. So, how does one borrow crypto from the Compound blockchain or earn interest on their crypto with it? Let us take a deeper look at how Compound Finance works for lending and borrowing services.
The Compound protocol supports lending and borrowing of a particular selection of cryptocurrencies. As of now, Compound supports the following crypto tokens.
Any individual with these crypto-assets could easily lend and borrow crypto on Compound without investing time, money, and effort in dealing with intermediaries. If you own these cryptocurrencies, then you could deposit, lock, lend or send any amount in the Compound protocol. When you lock your crypto in the Compound protocol, it is similar to depositing money in a savings account. However, you would not be sending your crypto to a bank. On the contrary, your crypto goes to the Compound wallet. Subsequently, you can earn interest on your crypto just like you would get interested in your savings account deposits in banks.
The interest earned on your crypto comes in denominations of the same token you have locked in the Compound blockchain.
For example, if you have locked USDC in the Compound wallet, you would earn interest in USDC.
When you send crypto to Compound Finance, it goes into a giant pool of similar tokens in a Compound protocol smart contract.
Where does the pool come from?
Many other people all over the world would also lock in their crypto assets in Compound, thereby leading to the creation of the pools.
As you can see, the Compound protocol is basically another DeFi solution that helps users in lending and borrowing crypto. Based on Ethereum, Compound leverages the use of smart contracts functionality for lending and borrowing transactions. Users have to lock a specific amount of crypto in Compound Finance, and they could lend or borrow crypto assets.
However, Compound offers support for a selected assortment of cryptocurrencies. From a broader perspective, the Compound DeFi protocol could simplify access and control over the money you earn and save.
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