What Is Compound Finance in DeFi?

TL;DR

Compound Finance is a place where you can lend or borrow cryptocurrencies. All you need is an Ethereum wallet, some funds, and you can borrow or earn interest right away.

Supplying assets for Compound is quite simple, and your funds are never held by any third party. Interested in how Compound works? Let's read on.

Introduction

Borrowing and lending in Decentralized Finance (DeFi) have never been easier. Compound Finance has been one of the leading protocols for lending and borrowing crypto in the DeFi space. In some sense, Compound is a savings account where you can earn interest without having to trust a third party with your funds.

The user experience is quite smooth, and the protocol has been tested in the wild for a while. In addition, many yield farmers use Compound to borrow assets and supply them to other DeFi protocols.

But 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's an algorithmic money market protocol. You could think of it as an open marketplace for money. It lets users deposit cryptocurrencies and earn interest, or borrow other cryptoassets against them. It uses smart contracts that automate the storage and management of the capital being added to the platform.

Any user can connect to Compound and earn interest using a Web 3.0 wallet, such as Metamask. This is why Compound is a permissionless protocol. It means that anyone with a crypto wallet and an Internet connection can freely interact with it.

Why is Compound useful? Well, suppliers and borrowers don't have to negotiate the terms as they would in a more traditional setting. Both sides interact directly with the protocol, which handles the collateral and interest rates. No counterparties hold funds, as the assets are held in smart contracts called liquidity pools.

The interest rates for supplying and borrowing on Compound are adjusted algorithmically. This means that the Compound protocol automatically adjusts them based on supply and demand. In addition, COMP token holders also have the power to make adjustments to interest rates.

How does Compound Finance work?

Positions (supplied assets) in Compound are tracked in tokens called cTokens, Compound's native tokens. cTokens are ERC-20 tokens that represent claims to a portion of an asset pool in Compound.

For example, if you deposit ETH into Compound, it's converted to cETH. If you deposit the stablecoin DAI, it's converted to cDAI. If you deposit multiple coins, they'll each earn interest based on their individual interest rates. In other words, cDAI will earn the cDAI interest rate, and cETH will earn the cETH interest rate.

cTokens can be redeemed for the portion of the pool they represent, which makes the supplied assets available in the connected wallet. As the money market earns interest (borrowing increases), cTokens earn interest and become convertible to more of the underlying asset. This basically means that earning interest on Compound is simply holding an ERC-20 token.

The process starts with users connecting their Web 3.0-enabled wallet, such as Metamask. Then they can select any asset to unlock that they want to interact with. If an asset is unlocked, users can both borrow or lend it.

Lending is quite straightforward. Unlock the asset that you wish to supply liquidity for, and sign a transaction through your wallet to start supplying capital. The assets are instantly added to the pool, and start earning interest in real-time. This is when the assets are converted to cTokens.

Borrowing is a bit more complicated. First, users deposit funds (collateral) to cover their loan. In return, they earn "Borrowing Power," which is required to borrow on Compound. Every asset that is available for supply will add a different amount of Borrowing Power. Users can then borrow according to how much Borrowing Power they have.

Similarly to many other DeFi projects, Compound works with the concept of overcollateralization. This means that borrowers have to supply more value than they wish to borrow to avoid liquidation.

It's worth noting that every asset has a unique borrow and supply Annual Percentage Rate (APR). Since the borrow and supply rates are adjusted based on supply and demand, each asset will have a unique interest rate for both lending and borrowing. As we've discussed before, each asset will earn different interest rates.

What assets are supported by Compound Finance?

As of 01/09/2020, the supported assets for lending and borrowing on Compound include:

ETH
WBTC (Wrapped Bitcoin)
USDC
DAI
USDT
ZRX
BAT
REP

Additional tokens will likely be added in the future.

How does Compound's governance work?

Compound started as a company founded by Robert Leshner and funded by venture capitalists. However, Compound Finance's governance is being gradually decentralized thanks to the COMP token. The token entitles token holders to fees and governance rights over the protocol.

As such, token holders can make changes to the protocol through improvement proposals and on-chain voting. Each token represents one vote, and holders can vote on proposals with their token holdings. In the future, the protocol may be completely governed by COMP token holders.

What are some of the most common issues that COMP holders vote on?

What cToken markets to list.
Interest rates and required collateralization for each asset.
What blockchain oracles to use.

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Compound Finance pros and cons

What do users use Compound for? Well, earning interest is a simple use case, and Compound's user experience is quite beginner-friendly. But Compound can also be a good way for more advanced traders to increase leverage on a position.

For example, let's say a trader is long ETH, and they supply that ETH to the Compound protocol. Then, they borrow USDT against the ETH they provided and buy more ETH with it. If the price of ETH goes up and the profits earned are more than the interest paid for borrowing, they make a profit.

However, this also increases the risks. If the ETH price goes down, they'll still have to pay back the borrowed amount with interest, and the ETH they put up as collateral might get liquidated.

What are some of the other risks? Compound has been audited by firms such as Trail of Bits and OpenZeppelin. While these are generally considered reputable auditing firms, bugs and vulnerabilities can bring unexpected problems, and they are part of any software.

You should carefully consider all the risks before sending funds to a smart contract. But regardless of the type of financial product, you should never risk more funds than you can afford to lose.

Closing thoughts

Compound is one of the most popular lending and borrowing solutions in DeFi. As many other products integrate their smart contracts into their applications, Compound is an integral piece of the DeFi ecosystem.

Once governance is fully decentralized, Compound could strengthen its place in DeFi as one of the core money market protocols.