What is Compound Finance? DeFi's Top Lending Platform Explained

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.

Compound's Founders and History

Compound Finance was co-founded in 2018 by Robert Leshner and Geoffrey Hayes. Before launching the organization, Leshner and Hayes previously held executive roles at Postmate, an America-based food delivery service. The co-founders hold executive positions at Compound Labs, Inc., the company responsible for developing the Compound protocol. Leshner serves as the CEO of Compound 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. The governance mechanism's arrival 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.

How Does Compound Finance Work?

To put it simply, Compound Finance allows users with crypto assets to make deposits 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, the Compound protocol bypasses most of the processes involved in taking out a traditional loan. All users need are the required crypto assets and one of several mainstream Web3 wallets, including MetaMask, WalletConnect, Tally Ho (tally.cash), or Ledger.

Compound uses smart contracts to manage the assets lenders have deposited into 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 ERC-20 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

To take a loan out on Compound protocol, borrowers 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 what's called "borrowing power" in the form of cTokens, which is required to take loans from the Compound liquidity pools. The borrowing power determines the size of the loan a borrower can take from a pool at any given time. This preserves the safety of the liquidity pools, as borrowers are the only party who'd take a loss from not paying back the loan.

Interest Rates in Compound Finance

The 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's 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 doesn't 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 has become one of the prominent trends in the world of DeFi, and many in the space credit Compound Finance with kickstarting interest in the method. In June 2020, the protocol began incentivizing both lenders and borrowers that use the platform with their COMP token.

Yield farming on Compound takes place through InstaDapp. Within the app, there's a feature called "Maximize $COMP mining" that gives users up to 40 times increased gains in COMP tokens. InstaDapp offers these high APYs 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 as 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 affected 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 three-day voting period after which voting rights stay in Timelock for at least two days before they're implemented. The time lock feature was added to prevent proposals from being implemented without approval from the necessary channel.

To buy the COMP tokens, first you need to have a wallet or an account with a cryptocurrency exchange. Many mainstream Web3 wallets offer industry-standard security practices and anti-phishing codes for maximum security of COMP and other crypto assets.

COMP Tokenomics

Now that we've explored the history and features of Compound, what's the organization doing to make sure that COMP tokens are fairly distributed?

Like most crypto projects, Compound has opted for a capped supply for its governance token, with 10,000,000 being the total supply of COMP. 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.

Over eight million COMP tokens have been circulating in the market, meaning over 80% of the coin's total supply is in circulation.

Pros and Cons of Compound Finance

Pros

A Range of Earning Opportunities: Compound offers users a range of earning opportunities with various liquidity pools, all of which have different APY rates. Compound Finance pays out interest to lenders every 15 seconds. Meanwhile, 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 interest lenders earn on Compound Finance can be left to compound, leading to greater gains on their assets.

Low Barrier to Entry: Unlike many lending protocols on the Ethereum blockchain, Compound doesn't 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 considered to be one of the safest lending platforms in the DeFi space. The protocol has been subjected to several high-profile security audits and has been deemed a reliable and safe network for lending and borrowing.

No Trading Fees or Slippage: The absence of trading fees and slippage on Compound Finance makes it a more attractive option to many when compared to the competition.

Cons

Limited Options: Compared to other DeFi lending protocols, Compound Finance has a lower number of supported crypto. The 20+ crypto supported on Compound are much lower than many of the competitor platforms offer.

Not as User-Friendly: When put side by side against other lending protocols, Compound Finance isn't 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.

The Final Word

Compound Finance is one of the leading DeFi solutions for lending and borrowing within crypto. The protocol offers crypto holders attractive options to reap passive gains from the assets resting dormant in their wallets. The project's time-tested business concept and over-collateralization model are poised to help the Compound protocol remain in the DeFi space for a long time.

FAQ

What is Compound Finance? How does it work?

Compound Finance is a decentralized lending protocol enabling users to deposit cryptocurrencies and earn interest or borrow assets. It operates via smart contracts on blockchain, automatically matching lenders and borrowers without intermediaries, using algorithmic interest rates.

How to borrow, lend and earn interest on Compound?

Deposit your crypto assets into Compound to earn interest automatically. Borrow other assets by providing collateral, paying interest rates determined by supply and demand. Your deposits earn yield while borrowers pay interest, creating passive income opportunities in this decentralized lending protocol.

What are the risks and security considerations of using Compound Finance?

Compound Finance involves risks including smart contract vulnerabilities, oracle price manipulation, liquidation risks from collateral value drops, and token callback function impacts. Users should carefully manage collateral ratios and borrow positions to mitigate exposure.

What is the purpose of COMP tokens and how to earn COMP rewards?

COMP tokens enable governance participation, pay/receive interest, and borrow assets on Compound. Token holders earn additional COMP rewards through active governance involvement. COMP has a fixed total supply.

What is the difference between Compound and other DeFi lending platforms such as Aave and MakerDAO?

Compound pioneered yield farming, rewarding users with COMP tokens. MakerDAO focuses on DAI stablecoin generation through over-collateralization. Aave offers flexible interest rates, diverse collateral options, and unique features like flash loans. Each platform serves distinct DeFi needs.

How much yield can I earn by depositing crypto assets on Compound?

On Compound, depositing crypto assets typically generates annual yields of 8% to 10%, depending on the specific asset and current market conditions. Rates fluctuate based on supply and demand dynamics. Check Compound's platform for real-time rates.