What Is Compound Finance?

Compound is a decentralized protocol designed to provide loan services to crypto holders. The goal is to enable a trustless and transparent means of borrowing and lending cryptocurrencies. In this article, we’ll go over what is Compound Finance and how they’re trying to revolutionize traditional finance.

For the most part, COMP shares similarities with standard lending services since users have to deposit collateral to either earn interest or take out a loan. The difference is that Compound exists on the Ethereum blockchain and only supports crypto-denominated collateral. Also, it does not involve all the bureaucratic and intermediate processes you will normally encounter in a traditional banking system. 

Borrowers also do not have to undergo credit checks before they can access loans on Compound Finance. It features a transparent and decentralized means of setting lending and borrowing rates. This is unlike what we have in traditional alternatives, where the service provider has sole control over how much interest users receive or get to pay on loans. 

Like most DeFi protocols, Compound has adopted a model that allows users to have a say on vital governance decisions. This is where COMP comes to play. 

You must be wondering: What is COMP? Simply put, COMP is the native ERC20 digital asset of the Compound ecosystem, which allows users to participate in core governance processes. By holding COMP, you automatically become eligible to vote on decisions involving the interest rates offered to users and the digital assets added to the protocol's list of supported coins. 

What Is Compound?

• Compound is a decentralized protocol for lending and borrowing digital assets.
• Users must deposit crypto-denominated collateral to access loans or generate interests.
• Although Compound does not impose credit score requirements on users, borrowers still have to adhere to the borrowing limits of each supported coin. 
• To meet these requirements, borrowers have to track the value of their collateral and ensure that it does not go below a specified threshold. 
• COMP is the digital token that anchors the decentralized governance system at play on Compound. 

How Does Compound Work?

Now that you have an idea of what this lending protocol does, the question is: How does Compound work?

The Lending Operation

Compound is a lending and borrowing protocol. In essence, it provides two core services that work in tandem. On the one hand, we have the lenders looking to deposit into Compound's pools for a chance of earning interests. On the other hand, borrowers take out the funds deposited by lenders as loans. While lenders receive yields, borrowers pay interests on their loans. 

The exciting bit about this lending and borrowing model is that it is fully automated and decentralized. As a lender, all you have to do is deposit your crypto in the appropriate pool to start generating interest on the deposited fund. Note that each pool in the Compound ecosystem is designed to hold a single cryptocurrency. It is from these pools that borrowers get to access crypto-denominated loans.

For instance, a USDC pool solely holds all USDC tokens deposited by lenders. As such, if you plan on depositing USDC into the Compound protocol, you will have to deposit your fund in the USDC pool. 

Once you deposit funds into these pools, you will receive special tokens called cTokens. Examples of cTokens issued to lenders on Compound are cDAI, cETH and cUSDC. The value of the cToken you are eligible to receive is equivalent to the amount you deposited into the pool. For example, if you had deposited $100 worth of USDC, you will receive $100 worth of cUSDC. You can trade or transfer your cToken as you deem fit. However, note that you can only withdraw the coin fund deposited into Compound pools when you redeem your cTokens. 

The Borrowing Operation 

To access loans, you must deposit collateral just as you would when borrowing money from a traditional loan service. However, unlike what we have on conventional solutions, Compound receives only crypto as collateral. 

Also, it is worth mentioning that the protocol expects users to maintain an overcollateralized position. In other words, depending on the coin you wish to borrow, you need to deposit collateral valued higher than the amount you wish to take out as a loan. For example, if Compound has imposed a borrowing limit (also called a collateral factor) of 50% on a particular token, the amount you can borrow is half the value of your collateral. In essence, if you deposit $500 worth of collateral, the highest amount you can borrow for that specific coin is $250. 

Note that this collateral factor exists to negate the impact of the volatility of crypto prices. Knowing fully well that the prices of digital assets are susceptible to volatility, Compound has set borrowing limits to ensure that the value of collateral does not fall below the value of the corresponding loans. Once the value of the collateral falls below the borrowing limit, the borrower becomes susceptible to liquidation risks. In other words, the protocol will sell off the collateral to repay the loan. 

In light of this, the valuation of your collateral must stay within the prescribed limit. Once the price of the locked cryptocurrency falls below the accepted range, you are expected to deposit more coins in order to adhere to the predefined collateral factor. 

Compound Interest Rates

Compound operates two interest systems. The first is the Supply APY which indicates the interest rate offered to lenders when they lock their assets in a pool. The second is the Borrow APY. As its name implies, these determine the interests borrowers are expected to pay. 

However, unlike what we have on traditional lending solutions, the interest rates on Compound are not fixed. Instead, the rates are constantly adjusted based on the demand or supply of each supported token. When the supply of a token can not cater to borrowing demand, the protocol automatically increases the coin's Borrow and Supply APYs. By doing this, lenders are increasingly incentivized to provide the liquidity required to meet the borrowing demand for such a coin. 

The reverse happens when the borrowing demand drops and the supply remains high or continues to grow. In this case, the borrowing APY reduces so that more users opt to borrow the coin due to low interest rates. In turn, the rate offered to lenders decreases, thereby making the coin a lot less attractive to depositors. 

Where Is COMP Used?

Now that you have a deep understanding of how Compound works, you must be wondering: What is COMP used for?

Recall that COMP is the ERC20 token that anchors the decentralized governance system of the Compound protocol. Like most DeFi solutions, Compound has adopted a community-based model of reaching consensus regarding both core and minor operations. When you hold COMP, you become eligible to vote on governance proposals and help shape the future of the Compound protocol. With this governance system, you can vote proposals, including those determining the next set of cryptocurrencies that will be added to the protocol's list of supported coins. The ecosystem also relies on the input of COMP holders when fixing collateral factors for each supported digital asset. 

You can as well delegate your voting power to a specific address. It is common for wallet addresses looking to create governance proposals to request other users to delegate their COMP tokens to them. Addresses that have at least 25,000 COMP delegated to them can create governance proposals. By putting it to a vote, COMP holders can decide to either reject or accept such proposals.

Apart from the above-mentioned governance utility, COMP is also viewed as a potential investment asset because its supply is capped at 10,000,000 tokens. Also, since Compound has established itself as one of the reliable DeFi solutions out there, users tend to expect the sustained viability of Compound to rub off on long-term COMP price trends.. Hence, holders, as they would with other investment assets, usually monitor Compound price movements to determine when to invest and the appropriate time to exit their positions. 

Compound's Founders and History

The Compound protocol was co-founded in 2018 by Robert Leshner and Geoffrey Hayes. Before launching Compound, Leshner and Hayes previously held executive roles in Postmate, an America-based food delivery service. The co-founders currently hold executive positions in Compound Labs, Inc., the company responsible for developing the Compound Protocol. Presently, Leshner is the CEO of Compounds Labs, while Hayes serves as the firm's CTO. 

Compound Labs relinquished control of the Compound protocol to the Community in 2020, following the introduction of the decentralized governance mechanism, which also coincided with the launch of COMP tokens. Since the Compound ecosystem has established a decentralized governance mechanism, the development team can only implement upgrades based on the developmental proposals adopted by COMP holders. 

COMP's Tokenomics

Having explained the history and features of Compound, you must be wondering: What is Compound doing to ensure that COMP tokens are fairly distributed?

Like most crypto projects, Compound has opted for a capped supply for its governance token as only 10 million COMP can ever exist. Below is the breakdown of the allocation of COMP:

• The shareholders of Compound Labs Inc. received 2,396,307 COMP.
• 2,226,037 COMP was allocated to the founding team 
• 372,707 COMP was set aside for the future development team
• 4,229,949 COMP was used to fund the user reward mechanism 
• 775,000 COMP was reserved for the community to fund other means of enabling a sustainable governance system.

At the time of writing, 7,198,184 COMP tokens are already in circulation, meaning over 70% of the coin's total supply is in the market. 

How Is COMP Mined/Staked?

As you must have noticed, there is no dedicated mining or staking feature available for COMP on Compound since the total supply of the governance token has been premined. Rather than have users mine or stake their coins to receive COMP, the Compound utilizes a user reward system that ensures that users earn COMP tokens by simply interacting with the lending and borrowing protocol. In other words, whenever you deposit coins on Compound or take out loans, you become eligible to earn COMP tokens. 

Since every user becomes eligible to earn COMP, you may be wondering: What is Compound offering as the standard daily user reward allocation?

Recall that 4,229,949 COMP has been set aside to reward users. Initially, approximately 2,880 COMP was shared among active users per day. Over time, this daily reward allocation shrunk to 1,139 COMP. Half of this daily distribution is shared among lenders, while the remaining half is allocated to borrowers. 

Based on this distribution model, the protocol has supplied 1,825,109 COMP to users, which means that 2,679,839 tokens are remaining. 

Compound's Competitions and How It Fares

At this junction, you may be wondering, What is Compound doing to remain prominent in an increasingly competitive market?

Notably, decentralized lending has become one of the most popular applications in the space. As such, Compound has faced stiff competition ever since it launched. Some of the prominent projects dominating the DeFi lending conversation along with Compound are Maker and Aave. Notably, all three exist on the Ethereum blockchain, which makes it even more critical to compare their performances and successes. 

From the table above, it is clear that Maker has the largest TVL, despite operating a lending solution that solely focuses on providing DAI-denominated loans. In contrast, Aave and Compound support multiple cryptocurrencies both on the borrowing and lending side of their protocols. 

Another important detail that is worth discussing is the chain supported by each of the highlighted protocols. While Compound and Maker still restrict their operations within the Ethereum ecosystem, Aave has opted for a more diverse ecosystem such that versions of the protocol now exist on other blockchain networks, including Avalanche and Fantom. With this system, Aave, unlike Maker and Compound, can target a larger market that extends beyond the Ethereum landscape. As regards governance tokens, AAVE boasts the largest market cap, followed by MKR. 

Compound's Partnerships and Investors

In May 2018, Compound raised $8.2 million worth of seed funding to build its crypto lending solution. Prominent investors that led this funding round include Polychain Capital, Andreessen Horowitz and Bain Capital Ventures. Some of the other participants are Transmedia Capital, Danhua Capital, Coinbase, Compound Ventures and Abstract Ventures. 

The following year, Compound raised $25 million via another fundraising round led by Andreessen Horowitz’s crypto investment fund called a16z. Other investors that partook in this round include Paradigm Capital, Polychain Capital and Bain Capital Ventures. 

Compound's Strengths, Weaknesses, Opportunities and Threats

Strengths

Compound's decentralized lending protocol utilizes smart contracts to eliminate intermediate processes that may require users to lock their funds into centralized platforms or wallets. Here, you deposit your funds into a self-executing protocol and automatically become eligible to earn interests or take out loans. The absence of intermediate processes means that users do not need to pay unnecessary fees to execute transactions. This, in turn, allows Compound to offer borrowing rates that are considerably low compared to what most traditional lending solutions are offering. 

Also, there is the added yield-earning advantage that comes with using Compound. Active users are guaranteed a share of the daily COMP tokens distributed as rewards. Hence, as a lender, you are not just earning interest when you lock up your coin on Compound but also receive COMP tokens as rewards. 

Weaknesses

One of the major pain points associated with Compound centers around the need to ensure that loans are overcollateralized. Notably, it is a bit of a hassle for users to keep monitoring the value of their collateral and confirming that it does not fall below the predefined borrowing limit, knowing fully well that the prices of crypto assets tend to rise and fall spontaneously. In cases where the prices of tokens fall abruptly, users become susceptible to liquidity risks. 

Another risk is with smart contract-dependent protocols. Historically, smart contract-based protocols are known to experience bug issues when upgrades are being implemented. Compound, in particular, recorded a bug-induced security incident that caused the protocol to erroneously distribute 280,000 COMPs to users. Although users' funds were not affected in this case, similar incidents have, over the years, caused significant losses in the DeFi scene. 

Opportunities

Compound has shown, time and again, that it is pursuing a future where users can access more functionalities. In tandem with this goal, Compound Labs announced the launch of an institutional client-focused product, called Compound Treasury. This solution allows users to earn interest on USD deposits. If all goes as envisaged, Compound could establish itself in the traditional financial landscape and, in the process, attract significantly more users. 

It is also worth mentioning that untold opportunities are waiting to be unraveled if Compound makes significant progress in its pursuit for cross-chain functionalities. Already, the development team is working on enabling cross-chain features that will allow users to lock funds denominated in Ethereum-based tokens and borrow tokens that exist in a completely different blockchain. 

Threats

The biggest threat to Compound long-term viability is the high competitiveness of the DeFi lending market. Compound must stay on its toes and keep innovating if it plans to remain prominent in this space. 

Compound Roadmap

Before deciding to purchase COMP, you should ask: What is Compound Labs' working on to improve the overall user experience of Compound?

Notably, Compound does not have an official roadmap. In a Medium blog post published in 2019, Robert Leshner highlighted three core goals driving the development of the Compound ecosystem at the time. They are:

• The creation of collateral factors for each supported coins
• The creation of smart contract pools for each supported coins
• The establishment of a decentralized governance system

A year later, Leshner authored another blog post where he noted that Compould Labs would take a step back and hand over control to the community since it has achieved all the goals listed above. In essence, it may seem that Compound is one of the few decentralized protocols that have been completed. However, as mentioned earlier, that has not stopped Compound Labs from kicking off new projects, including the cross-chain solution and the Compound Treasury service introduced in 2021. 

Compound's Updates, News and Highlights

One of the biggest updates implemented in the Compound ecosystem was the launch of the platform's governance system in 2020. This upgrade also brought about the launch of COMP and the user reward distribution initiative in June 2020. A month after the launch of the COMP yielding initiative, the community opted to review the method used to distribute COMP tokens to users. While the previous method considers the amount of interest paid or received by each user, the new rule focuses on the dollar value of funds deposited into or borrowed from the protocol. 

In March 2021, Compound Labs launched the prototype of its cross-chain solution called Gateway. This major launch was followed by the introduction of Compound Treasury in June 2021. 

Where To Buy COMP

Like most digital assets, you can purchase COMP on either centralized or decentralized exchanges. Notably, using a centralized exchange like OKX is an ideal choice for those new to the crypto world as it offers user-friendly and conventional means of purchasing your favorite digital assets. For instance, you can buy COMP with your credit or debit cards and over 168 other conventional payment systems. Another option is to buy COMP via the platform's P2P solution or through the website's trading interface, where you can exchange your BTC, USDT, and USDC coins for COMP tokens. 

How To Store COMP

The best storage options for digital assets, including COMP, are non-custodial wallets like Ledger and Trezor. You can as well opt for a non-custodial software wallet like Metamask if you intend to interact with the DeFi ecosystem actively. A third option is the OKX wallet service, which is ideal for those looking to hold COMP in the short term or capitalize on the interest-yielding opportunities on OKX.

How To Stake COMP

Although there is no official COMP staking option on the Compound Protocol, third-party solutions like exchanges may provide interest-yielding services targeted at COMP holders. A similar solution, named OKX Earn, exists on OKX as COMP holders can opt to deposit their funds on the platform and capitalize on a low-risk and interest-yielding opportunity. 

FAQ About Compound

How Secure Is the Compound Protocol?

The first thing you should have at the back of your mind is that Compound relies on Ethereum's blockchain security infrastructure to ensure that all transactions executed on its protocol are valid and irreversible. That said, the major point of concern is the susceptibility of Compound to software errors that can expose users' funds to risks. Since Compound launched in 2018, it has recorded one such bug-related software security incident that put $80 million worth of COMP at risk. And although users were not affected during this incident, it brings to light the potential risks associated with smart contract-based solutions. 

What Is COMP Used?

COMP primarily functions as the governance token of the Compound ecosystem. Hence, holders get to have a say in core decision-making processes that may shape the future of the protocol. COMP is also considered a potential investment asset by some traders looking to generate profits when COMP price fluctuates. These individuals tend to track and analyze short-term and long-term Compound price movements for possible monetary gains. 

How Can I Earn COMP?

You can earn COMP by actively participating in the Compound ecosystem as a lender or a borrower. Another option is to take advantage of the interest-yielding service, OKX Earn, which allows users to generate interest on their idle COMP holdings. 

What Are the Requirements for Borrowing Cryptocurrency From Compound?

The first requirement is that users need to deposit collateral denominated in any of the platform's supported coins. Also, you ought to ensure that you adhere to the collateral factor of the coin you intend to borrow. 

Is Compound Available on Multiple Blockchains?

At the time of writing, it is only possible to lend and borrow coins on Compound on the Ethereum blockchain. In the future, the project's development team plans to launch a product that allows users to access cross-chain functionalities.