What is Compound Finance?

Compound Finance is an algorithmic, open-source protocol that allows for the creation of money markets on the Ethereum blockchain. Individuals and institutions are able to earn interest on digital assets that they supply to the protocol. Whilst those that are seeking to borrow digital assets can do so directly from the protocol itself, without having to negotiate with a counterparty or peer. The Compound Finance protocol can also be thought of as being a DeFi (decentralized finance) project, because the protocol seeks to innovate upon existing financial money markets, by constructing a novel market model that is frictionless, efficient and decentralized.

A core objective of the Compound Finance protocol is to provide individuals with the ability to ‘trade the time value’ of a digital asset. This derives from the financial concept, ‘the time value of money’, which stipulates that money in the present is worth more than the identical sum of money that is received in the future. This is due to the earning capacity of money received in the present; money received in the present can be invested, thus, enabling that money to earn a return and generate a larger sum of money in the future. One way to generate such a return is by lending a given amount of money, upon which the lender can then earn a return in the form of an interest rate that is attached to the loan.

It is by innovating on the lending and borrowing process that Compound Finance seeks to address a problem found with holding digital assets, which is financial yield. Yield is the income that is returned on an investment. For example, yield for traditional assets would be the dividends that are received from holding shares in a company, coupon payments on a bond, or rental income from a leased property. Yield is separate to investment return (also known as total return), which is the financial gain or loss on an investment over time. Yield that is generated from an investment does not require one to sell in order to unlock the underlying value of an asset.

According to the Compound Finance whitepaper, one major flaw that exists with blockchain assets is that:

‘Blockchain assets have negative yield, resulting from significant storage costs and risks (both on-exchange and off-exchange), without natural interest rates to offset those costs. This contributes to volatility, as holding is disincentivized.’

The Compound Finance protocol seeks to address this problem by attempting to bridge the gap between lenders that are seeking to earn a return on non-yielding digital assets, and borrowers that are seeking to use borrowed assets for productive or investment use.

Compound Finance Protocol

Compound is the protocol that establishes money markets on the Ethereum blockchain. In traditional finance, money markets are where financial instruments with high liquidity and short maturities are traded. Money markets are primarily used by large institutions and corporates as a means for borrowing and lending in the short term. In the context of the Compound Finance protocol, money markets are pools of tokens with algorithmically determined interest rates that are based on the supply and demand of the token in a given money market. Money markets on the Compound protocol also contain a transparent and public balance sheet that keeps a record of all transactions and historical interest rates.

Participants of the protocol can largely be placed into two groups, suppliers and borrowers. Suppliers will supply (or lend) their funds to the protocol, and in return, be rewarded in the form of interest rate payments. Whilst those who wish to borrow can do so from the digital assets that have been supplied to the protocol. Participants can choose to supply or borrow from any money market that is supported by the protocol, which at the time of writing is: BAT, DAI, REP (Augur), WETH (Wrapped Ether) and ZRX (0x).

Compound Finance: Supplying Tokens

The lending mechanism for the Compound Finance protocol differs to other peer-to-peer platforms in that, with the Compound Finance protocol, a user’s token is not matched and lent to another user. Instead, those wishing to lend, will lend to the protocol itself. The compound protocol then aggregates the supply of lent funds, resulting in a high level of liquidity for that money market. This lending mechanism also means that users that do decide to supply funds to the protocol are able to withdraw their tokens at any time. They do not have to wait for a specific loan to mature in order to recover their lent funds. Assets that are supplied to the protocol will accrue interest based on the supply interest rate that is unique to that particular asset.

Compound Finance: Borrowing Tokens

The borrowing mechanism implemented by Compound differs to alternative peer-to-peer platforms. In these platforms, borrowing will often be accompanied by negotiation with the counterparty. For example, negotiating the maturity date or funding period. With the Compound Finance protocol, users are able to borrow an asset directly from the protocol by simply specifying the asset that they wish to borrow. Each money market will also have a floating interest rate that determines the cost of borrowing an asset.

The Compound Finance protocol also enforces a rule that stipulates that a user’s account must have a balance that more than covers the amount of borrowed funds. This rule is known as the collateral ratio, and a user cannot initiate action, for example borrowing or withdrawing assets, that would bring a user’s account value below the collateral ratio.

The Compound Finance protocol also utilizes a ‘Price Oracle’, which keeps track of the current exchange rate of each supported digital asset on the protocol. The responsibility of setting the value of assets on the protocol is delegated to a committee, which pools the prices of supported assets from the top 10 exchanges in the cryptocurrency space. These exchange rates are used by the protocol to determine the borrowing capacity and collateral requirements for an account, and any other function that requires calculating the value equivalent of an account on the protocol.

What is a price oracle?

A price oracle, generously speaking, is anything that you consult for price information. When Pam asks Dwight for the cash value of a Schrute Buck, Dwight is acting as a price oracle.

On Ethereum, where everything is a smart contract, so too are price oracles. As such, it’s more useful to distinguish between how the price oracle gets its price information. In one approach, you can simply take the existing off-chain price data from price APIs or exchanges and bring it on-chain. In the other, you can calculate the instantaneous price by consulting on-chain decentralized exchanges.

Both options have their respective advantages and disadvantages. Off-chain data is generally slower to react to volatility, which may be good or bad depending on what you’re trying to use it for. It typically requires a handful of privileged users to push the data on-chain though, so you have to trust that they won’t turn evil and can’t be coerced into pushing bad updates. On-chain data doesn’t require any privileged access and is always up-to-date, but this means that it’s easily manipulated by attackers which can lead to catastrophic failures.

How to borrow on Compound

When borrowing from Compound, aside from a Web3 digital wallet, the only other thing a user requires is the cryptocurrency to be deposited as collateral. Compound, like many other DeFi protocols, works on an over-collateralization basis, which means that the amount deposited as collateral must be higher than the borrowed amount.

For example, at the time of writing, the limit for most assets on Compound is currently 80% — which means a user can borrow 80% of what was deposited as collateral. If you deposited $100, you would be able to borrow a maximum of $80.

The borrowing limit is calculated automatically for users based on their deposited funds. The protocol won’t allow a user to go over that borrowing limit.

Thanks to the over-collateralization and the decentralized system, there’s no need for credit checks or income statements.

To borrow, a user must first supply cryptocurrencies to the platform. Please review the section on supplying assets on Compound above. A unique feature of Compound is that regardless of the asset supplied to the protocol, the user can borrow any other cryptocurrency asset.

Interest Rates

The interest rate that is set when a user supplies the protocol, or when a user borrows from the protocol, is one that is determined algorithmically, which is based on the supply and demand of the asset in a given money market. As a result, when there is a lot of liquidity in a particular money market (high supply and low borrowing demand), then interest rates in that market will be low. Conversely, when there is a shortage of liquidity (low supply and high borrowing demand), then interest rates will likely be high. This interest rate mechanism differs to alternative peer-to-peer lending platforms, where individual suppliers or borrowers usually have to negotiate over terms and rates of loans.

Liquidation

If the total value of a user’s supplied assets, divided by the value of their outstanding borrowing, declines below the collateral ratio, then the user’s account is subject to liquidation by other users of the protocol. If liquidation occurs, then the liquidator may repay some or all of an outstanding borrow on behalf of the individual that is being liquidated (also known as the liquidatee). This has the effect of bringing the liquidatee’s borrow balance back in line with the collateral ratio. In return for initiating a liquidation, the liquidator receives a discount that is known as the ‘Liquidation Discount’. This discount represents the percent value that a user receives when initiating a liquidation.

Liquidations and the borrowing limit

The Compound Finance protocol uses over-collateralization to ensure no KYC or credit checks are required by borrowers before they take out a loan. Over-collateralization means that a user must deposit more than the loan required. If a user cannot repay a loan, then the protocol can use some of the collateral to pay it off instead.

When borrowing through Compound, it is always advisable to stay well beneath your borrowing limit. The price of cryptocurrency assets can change quickly so the collateral provided to Compound may decrease in value against the assets borrowed. If this occurs and the borrowing limit is reached, the account will move into negative account liquidity or liquidation.

At this stage, Compound will sell some of your collateral to move the account back into positive liquidity. To avoid this scenario, it is always worth having a comfortable buffer within your borrow limit.

What does the COMP token do?

The COMP token is the native cryptocurrency to the Compound Finance protocol. The token was launched in 2020 to incentivize the use of the platform and to decentralize governance.

Compound Finance is a decentralized protocol and is governed by holders of the native COMP token. COMP token holders can vote on items such as the direction of the platform, interest rate decisions and the development of additional protocols. This ensures no one entity has control over its use or development.

Alongside the governance use case, the COMP token holds value in its own right and is therefore an incentive for lenders and borrowers of the platform. COMP can be exchanged for other cryptocurrency assets at any time.

COMP tokens can be purchased via an exchange, or they can be earned through lending or borrowing on the Compound Finance protocol. Users that lend and borrow digital assets are rewarded a proportion of the daily minted COMP token that is proportionally distributed to users based on the amount held in the platform and the interest rates at the time.

Holders of the COMP token can view their balance either through their digital wallet or on the Vote tab on the Compound Finance dashboard.

Should you use Compound?

Compound Finance is a very easy, and extremely user-friendly platform for cryptocurrency investors looking to earn interest on their cryptocurrency holdings. Not only does it offer the option to obtain a return on investments but in comparison to traditional financial models interest payments can be significantly higher.

The platform is one of the oldest among the DeFi protocols and has a high reputation among users. Although highly reputable, the protocol still utilizes smart contract technology and is still integrated within the larger DeFi ecosystem, so the risks of lending with Compound should still be assessed.

Even if slightly limited in variety, there are still plenty of popular cryptocurrency tokens for the average investor looking to put their assets to work.