Compound (COMP) is one of the most established and vital protocols in the world of Decentralized Finance (DeFi). It is an algorithmic money market protocol, built on the Ethereum blockchain, that allows users to deposit their cryptocurrencies to earn interest (lending) and to take out loans (borrowing) by providing collateral.
In the traditional banking system, you deposit your savings with a bank for interest, and the bank then lends this money to others. Compound performs this function entirely through smart contracts, without any intermediary institution, creating a transparent and open-access system.
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How the Decentralized Lending and Interest Mechanism Works
The foundation of the Compound protocol lies in the liquidity pools where users deposit various cryptocurrencies (ETH, USDC, DAI, etc.). These pools act as an intermediary for both lenders and borrowers.
Lending and cTokens
When users deposit supported crypto assets into the Compound protocol, they receive special ERC-20 tokens called cTokens in return (e.g., cETH for an ETH deposit).
- Earning Interest: The cTokens represent the user’s share of the underlying asset in the pool. The interest earned by the pool (the interest paid by borrowers to the protocol) is continuously reflected in the increasing value of these cTokens. In other words, as long as you hold the cToken, the exchange rate of the cToken to the underlying asset increases over time. This appreciation constitutes the interest earned by the user.
- Instant Withdrawal: Lenders can instantaneously redeem their cTokens back to the protocol at any time to withdraw their original assets and the accrued interest. This means the funds are always liquid within the pool.
Borrowing and Collateral
Compound enables you to borrow other cryptocurrencies by using your own crypto assets as collateral. In this process:
- Collateral: To borrow, you must first deposit a certain amount of crypto assets as collateral into the protocol. The amount you can borrow is limited to a percentage of the value of your deposited collateral. This ratio is determined algorithmically based on the asset’s risk and managed by a control layer called the Comptroller.
- Interest Rates: Unlike traditional banking, borrowing interest rates are determined algorithmically based on the balance of supply and demand and are updated in real-time—sometimes with every new block. The higher the demand to borrow an asset, the higher the interest rate will rise.
- Liquidation Risk: If the market value of your collateral falls below a specific threshold (due to the borrowed asset’s value increasing or the collateral’s value decreasing), a portion or all of your collateral may be liquidated. This mechanism is vital for ensuring the security of lenders and maintaining the protocol’s solvency. Liquidators are incentivized to repay the debt in exchange for receiving a discounted portion of the collateral.
The COMP Token and Governance
The COMP token is the native cryptocurrency of the Compound protocol and primarily functions as a governance tool.
- Voting Power: COMP holders have the right to vote on all decisions regarding the future and operation of the protocol. This includes critical matters such as interest rates, collateral factors, the addition of new cryptocurrencies to the protocol, and protocol upgrades.
- Decentralization: The COMP token ensures that the protocol is managed in a fully decentralized manner. One COMP token represents one vote.
- Delegation: If users do not wish to actively participate in the decision-making processes, they can delegate their voting power to another address or user they trust. This allows even passive users to play an indirect role in the protocol’s development.
- Liquidity Mining: The distribution of the COMP token, particularly through the “liquidity mining” model launched in 2020, garnered significant attention. Users are proportionally rewarded with COMP tokens as they interact with the protocol by depositing assets or taking out loans. This incentive system helped Compound grow rapidly and become a key player in the DeFi ecosystem.
Compound’s Significance in the Crypto World
Compound, founded in 2017 by Robert Leshner and Geoffrey Hayes, played a pioneering role in the popularization and mainstream adoption of the Decentralized Finance (DeFi) concept.
- The Future of Finance: Compound provides a tangible example of the future of finance by shifting the historical functions of banks and other financial intermediaries (lending and interest earning) to a code-based, transparent, and permissionless system.
- Transparency: All transactions, interest rates, and collateral pools are publicly viewable on the Ethereum blockchain. This offers a revolutionary level of transparency compared to the closed-door dealings of traditional finance.
- Open Source and Permissionless: The Compound protocol’s smart contracts are open source, and anyone, anywhere in the world, can interact with the protocol, deposit assets, or borrow funds without needing permission.
Risks
As with every crypto and DeFi project, using Compound carries certain risks:
- Smart Contract Risk: The protocol could be exploited due to code bugs or security vulnerabilities.
- Liquidation Risk: Users may lose their collateral if its value drops significantly.
- Market Risk: Interest rates can change rapidly based on market conditions.
- Oracle Risk: Issues in external price feed systems (Oracles) that provide the protocol with accurate price information could lead to incorrect transactions.
In conclusion, Compound (COMP) is one of the fundamental pillars of the DeFi ecosystem, offering the opportunity to earn passive income from your crypto assets and take out collateralized loans.
