The idea of borrowing and lending has been around for thousands of years and has now become an integral component of the financial industry. However, the process of matching borrowers and lenders wasn’t always easy. Traditionally, leading institutions like banks take up the task.
Compound Finance is one of the Decentralized Finance (DeFi) protocols that offer significant improvements to traditional lending and borrowing while retaining their basic concepts. By the end of this article, you would understand what Compound Finance is and how it improves lending and borrowing.
What Is Compound Finance?
Compound Finance is a permissionless DeFi lending protocol that allows lenders to earn interest from their crypto holdings. The deposited assets are held in smart contracts known as liquidity pools and interest rates are adjusted algorithmically based on supply and demand.
The protocol is built on smart contracts which automate the calculation of interest rates and issuance of loans, eliminating the need for intermediaries. At its most basic level, Compound Finance serves as an open marketplace where lenders meet borrowers, without third-party intervention.
How Does Compound Finance Work?
To put it simply, Compound Finance allows users with crypto assets to deposit as lenders and for borrowers to take out loans. The Compound protocol is built with smart contracts that combine the assets provided by lenders into liquidity pools for each supported cryptocurrency. On the protocol, borrowers can take out funds from any of these liquidity pools, but not directly from lenders.
Compound is a permissionless protocol, allowing anyone with access to the internet to lend or borrow from the platform. In addition, Compound protocol bypasses most of the processes involved in taking out a traditional loan. All users need are the crypto assets and one of Compound integrated wallet apps, including MetaMask, WalletConnect, Tally Ho (tally.cash) or Ledger.
Compound uses smart contracts to manage the assets lenders have deposited to the liquidity pools. The price of each asset in the liquidity pool is fed into the Compound protocol using Open Price Feed, a system based on Chainlink (LINK) oracles that source crypto price data from various exchanges.
The Compound protocol uses algorithms to track the changing supply and demand of crypto assets to decide the interest rate for each asset based on the liquidity in the market. The higher the borrowing demand for a particular crypto, the higher the interest rate will be.
Crypto Lending on Compound Finance
Crypto lending on Compound Finance, or locking your assets in a liquidity pool is called “supplying.” Locking your crypto asset in the Compound protocol is similar to depositing your money in a savings account. However, instead of a bank account, your crypto is sent to the Compound wallet.
As lenders supply assets to the liquidity pools their funds are temporarily converted into cTokens (an Ethereum-based ERC20 token issued by Compound) at a ratio of 1:1. The value of cTokens issued to lenders represents the value of the asset they supplied to the liquidity pool.
Lenders can redeem the cTokens for their underlying assets at any time. Compound also allows lenders to exchange the cTokens for other supported crypto assets. The interest lenders receive for the assets supplied are also paid in cTokens which are redeemable at an exchange rate relative to the asset they supplied.
Crypto Borrowing in Compound Finance
In order to take a loan out on Compound protocol, borrowers would first need to deposit funds (collateral) to cover their loan. The Compound protocol ensures that loans taken out of the liquidity pools are overcollateralized.
After depositing their collateral, borrowers get "Borrowing Power" in the form of cTokens, which is required to take loans from the Compound liquidity pools. The Borrowing Power determines how much loan a borrower can take from a pool at any given time. This ensures the safety of the liquidity pools as borrowers are the only party who would take a loss from not paying back the loan.
Interest Rates in Compound Finance
Compound protocol rewards lenders with its native cTokens instead of the underlying assets they initially deposited. These rewards are based on two factors: the number of cTokens the lender has in their wallet and a fluctuating interest rate that is dependent on the available supply of that asset.
The Open Price Feed contract of the Compound protocol aggregates the interest rate of supported assets using their live exchange rates. The more liquidity a particular token has, the lower the interest rate generated. The algorithmic interest rates on the Compound protocol can reach up to 15%.
Compound Finance does not charge its users to deposit or withdraw funds from the protocol. However, users pay a transaction fee and a miner fee when they mint, borrow, liquidate, transfer, repay or redeem a loan on the protocol.
Yield Farming on the Compound Protocol
Yield farming, one of the hottest trends in the world of decentralized finance (DeFi) , was triggered by Compound Finance. In June 2020, the protocol began incentivizing both lenders and borrowers that use the platform with their COMP token.
Yield farming on Compound is facilitated through InstaDapp. Within the app, there is a feature called “Maximize $COMP mining” that gives users up to 40 times increased return in COMP tokens. InstaDapp offers these high returns by granting users access to multiple DeFi platforms from a single interface.
What Does the COMP Token Do?
Compound (COMP), is the ERC-20 standard token launched to be the native cryptocurrency for Compound Finance. Voting rights in the governance of Compound Finance are attached to COMP.
For flexible governance of the protocol, Compound allows token holders to either delegate voting rights to themselves or any other address of their choice. COMP allows holders to make decisions on all key changes to be effected in the protocol.
Holders of COMP tokens can also offer proposals to make changes to the Compound Finance protocol. Every proposal on the protocol has a 3-day voting period after which voting rights stay in Timelock for at least two days before they are implemented. The time lock feature was added to prevent proposals from being implemented without them being approved by the necessary channel.
To buy the COMP tokens, first, you need to have a wallet or an account with a cryptocurrency exchange. OKX wallet offers industry-standard security practices and anti-phishing codes for maximum security of COMP and other crypto assets.
Pros and Cons of Compound Finance
Here are the pros and cons of the Compound Finance protocol.
- A range of earning opportunities: Compound offers users a range of earning opportunities with various liquidity pools, all of which have different rates of return. Compound Finance pays out interest to lenders every 15 seconds. In addition, lenders and borrowers can use the yield farming option for greater rewards.
- Compound interest: another reason why lenders look to Compound is the presence of compound interest. The interests lenders earn on Compound Finance can be left to compound, leading to greater returns on their assets.
- Low barrier to entrance: Unlike many lending protocols on the Ethereum blockchain, Compound does not have a minimum requirement for borrowing or lending. This opens up the protocol to everyone looking to earn interest or participate in yield farming.
- A safe platform for lending and borrowing: the compound protocol is one of the safest lending platforms in the DeFi space. The Compound protocol has been subjected to several high-profile security audits and deemed a reliable and safe network for lending and borrowing.
- No trading fees or slippage: the absence of trading fees and slippages on Compound Finance makes it a more attractive option than the competition.
- Limited options: compared to other DeFi lending protocols, Compound Finance has a lower number of supported cryptos. The 20+ cryptos supported on Compound are much lower than many of the competitor platforms offer.
- Not as user-friendly: compared to other lending protocols, Compound Finance is not particularly geared toward newer crypto users. The Compound protocol has a steep learning curve making it difficult for new crypto users to navigate the platform.
Compound Finance Leading the Future into Decentralized Banking
Compound Finance is one of the leading DeFi solutions for lending and borrowing within crypto. The protocol offers crypto asset holders great options to reap passive income resting dormant in their wallets. The time-tested business concept and over-collateralization model are poised to help the Compound protocol remain in the DeFi space for a long time.
What Is Compound in DeFi?
Compound Finance is an Ethereum-based DeFi protocol that allows users to lend and borrow crypto assets without going through any intermediary.
Is Compound DeFi Safe?
Compound Finance is one of the oldest and safest DeFi lending protocols. Although the protocol has been breached once, Compound offers insurance on loans via Nexus Mutual and Opyn, making it a more reliable platform.
Is Compound a Good DeFi?
Compound Finance is a good DeFi protocol for crypto holders looking to earn a passive income from the interest on their assets sitting idly in a wallet. It offers a smooth, highly secure, and easily accessible platform for lending and borrowing crypto..
How Does Compound DeFi Make Money?
The Compound team generates revenue through different means. Firstly, there is a reserve of COMP tokens the protocol uses to pay for development and research. The protocol also has a Treasury targeted toward big firms that earn Compound Labs 4% interest on every loan collected on the platform.