Compound is a leading DeFi protocol that enables users to lend and borrow cryptocurrencies easily. By locking assets into its smart contracts, users earn interest or access loans without intermediaries, all governed by the COMP token for protocol decisions.
Lending protocols like Compound are a cornerstone of the DeFi ecosystem, providing critical infrastructure alongside DEXs, yield farming, and stablecoins. They allow users to earn passive income by supplying liquidity or to access capital without selling their assets.
In traditional finance, lending and borrowing involve intermediaries like banks or financial institutions. Lenders deposit funds, which banks then loan out to borrowers at a higher interest rate, generating profit from the spread. Borrowers must meet strict requirements, such as credit checks and collateral, and the process is often time-consuming and centralized.
Compound revolutionizes this concept by automating lending and borrowing through blockchain technology. As a decentralized platform, Compound eliminates intermediaries, allowing users to lend or borrow cryptocurrencies directly via smart contracts. Lenders supply assets to liquidity pools, earning interest determined by supply and demand. Borrowers can access these funds instantly by providing collateral, all without the need for credit checks.
Users can supply assets to Compound’s liquidity pools, and receive cTokens in return. These cTokens represent their share of the pool and can be redeemed at any time for the underlying assets. As lenders, users earn interest that accrues with each Ethereum block. The protocol algorithmically adjusts interest rates based on supply and demand dynamics.
Unlike most DEXs that require that liquidity is added in pairs, on Compound users add single-asset liquidity into the pool.
Interest on Compound is distributed through the appreciation of cTokens relative to the underlying asset, allowing lenders to earn additional value automatically. The supply APY (Annual Percentage Yield) reflects the projected annual return for lenders, factoring in compound interest. This dynamic rate changes with market conditions, often offering higher APYs for assets with lower liquidity to incentivize lending.
Compound Finance enables users to borrow crypto assets by depositing cryptocurrencies as collateral. The borrowing limit is determined by a collateralization ratio, ensuring loans are over-collateralized to reduce risk. For example, depositing $10,000 in ETH with a 60% borrowing limit allows up to $6,000 to be borrowed. Borrowers pay interest on the borrowed amount, known as Borrow APY, which fluctuates dynamically based on supply and demand and accrues continuously.
Maintaining a healthy collateralization ratio is essential to avoid liquidation. The ratio represents the value of the collateral relative to the borrowed amount and typically must stay above a protocol-defined threshold, such as 150%. If the ratio falls below this threshold, the protocol triggers liquidation. During liquidation, a portion of the collateral is sold to repay the loan and restore the required ratio. Borrowers must monitor their positions closely, especially during market volatility, to prevent forced liquidations.
Compound employs a decentralized governance model where COMP token holders play a key role in shaping the protocol's future. Governance decisions, such as adjusting interest rate models, adding new assets, or upgrading the platform, are proposed and voted on by the community.
Token holders can either vote directly or delegate their voting power to others. Proposals require a minimum threshold of COMP tokens to be submitted and must pass a majority vote to be implemented.
Compound offers numerous benefits, making it an attractive option for users seeking DeFi services. It provides significantly higher interest rates compared to traditional savings accounts, allowing users to earn competitive returns on their crypto assets. The platform operates 24/7, granting users unrestricted access to lending and borrowing services without being limited by banking hours or geographic boundaries.
Blockchain technology ensures complete transparency and robust security, with all transactions and operations recorded on an immutable ledger and executed via tamper-proof smart contracts. Compound eliminates the need for intermediaries, reducing costs and avoiding fees commonly associated with traditional banking.
Using platforms like Compound comes with risks that users should carefully consider. Smart contract risk is an example. While Compound has undergone multiple independent smart contract audits, there is always a small threat of hacks.
Market volatility also significantly impacts lending and borrowing activities. Rapid price changes can alter collateral values, increasing the likelihood of liquidation for borrowers. In highly volatile markets, maintaining a healthy collateralization ratio becomes even more crucial to avoid losses.
