What Is Compound Finance in DeFi?

The decentralized finance industry has given rise to many new and innovative projects. One of the biggest service providers in the space is Compound Finance. As a lending and borrowing solution, it can pave the way for broader global financial inclusion.

Time To Meet Compound Finance

For those who are new to decentralized finance, the name Compound Finance may not mean much. As one of the “top” DeFi platforms, this project focuses on making loans more accessible to cryptocurrency users. Additionally, it creates incentives for existing crypto-asset holders to loan their holdings and earn an interest rate in return. In essence, this creates new liquidity streams for borrowing and lending. 

Compound Finance is intriguing because existing crypto-asset holders can earn interest without giving up control over their funds. Serving as a non-custodial solution is paramount in this industry. If you do not control your cryptocurrency wallets’ private keys, you are not in any position of power. DeFi intends to empower users; thus a non-custodial approach is mandatory. 

Since its inception, Compound has gained a loyal community, thanks to its intuitive user interface. Additionally, this service serves as a gateway to borrow assets used in other DeFi protocol, compounding one’s potential earnings. Exploring this latter option is only advisable for experienced users, though.

How Does It Work?

As a DeFi protocol, Compound Finance can best be described as a money market protocol with an open market model. More specifically, anyone can contribute their cryptocurrencies to earn interest when others apply for loans. It is equally possible to use one’s existing crypto-assets as collateral to borrow new assets and use those to enter new positions across the many decentralized finance protocols. 

Under the hood, Compound uses smart contracts to automate storing and managing any capital being added to the platform. There is no need for managers or other intermediaries who may try to bar specific users from accessing these services through this technology. As long as one has crypto-assets supported by the platform, one can unlock all of the functionality with ease. 

Connecting to Compound Finance is straightforward: using a Web 3,0 wallet or a hardware model can be done with ease. This is one of the key benefits of permissionless DeFi protocols like these, as there are no roadblocks to contend with. With an internet connection and compatible cryptocurrency wallet, anyone can interact with this new financial paradigm. 

Decentralizing Borrowing And Lending?

To the average person on the street, it may not seem useful to provide lending and borrowing services to those who can access them through banks and other intermediaries. In reality, things are a bit different, as the Compound Finance approach removes the need for negotiating terms, handling paperwork, or trusting counterparties with your funds. 

Moreover, Compound’s interest rates are algorithmic, ensuring users will always experience the best rates. These changes occur based on the ongoing rebalancing of supply and demand for crypto-assets. It is also possible for holders of the native COMP token to adjust interest rates if the need arises. 

The Standard introduces decentralized borrowing through its native S-EUR stablecoin. Users can borrow against existing assets – precious metals or crypto assets – and gain instant liquidity in S-EUR. However, the user doesn’t need to sell the assset to gain liquidity, as they can reclaim it after paying back the borrowed S-EUR. Due to inflation, there will be times when it is cheaper to pay back the loan.

Peeking Under The Hood Of Compound Finance

To understand this DeFi protocol’s inner workings, it is pertinent to grasp how smart contracts handle assets. 

Lending

Every time a user supplies assets to Compound, they will have their contribution tracked as a cToken. Compound uses this token standard to represent claims to a portion of the assets in their asset pool. Otherwise, it would not be possible to reclaim your original assets after a while. 

Assuming you deposit Ethereum into Compound, you will receive cETH tokens in return. Once obtained, users will accrue interest on these cTokens based on that asset’s interest rate in the pool. As Compound supports most assets and tokens on the Ethereum blockchain, there are a few different options to explore to maximize your potential earnings. 

Users will always be able to redeem cTokens for the portion of the Compound pool they represent. However, the value of that cToken may be subject to impermanent loss, depending on its overall price performance since depositing. All interest will accrue automatically and be eligible for withdrawal whenever the user chooses to exert this option. 

Borrowing

The borrowing aspect of Compound Finance works a bit differently, As a more complex procedure, users need to provide collateral to convert their loan first and foremost. Doing so grants them access to “Borrowing Power”, which depicts how much one can borrow on the platform. Different assets have unique amounts of Borrowing Power, which is something to take note of. 

In the DeFi industry, it is common for lending platforms to enforce “over-collateralization”. More specifically, borrowers need to put up a lot more value than they are borrowing. Implementing this requirement ensures borrowers can avoid liquidation, but only if they take the necessary steps to correctly repay the loan. 

Contrary to what some may think, there is no way to acquire “free capital” in the cryptocurrency space. Without providing collateral, you will not be able to receive a loan in decentralized finance. This over-collateralization aspect also ensures users can never borrow more than they will be able to pay back.  

Today’s Supported Assets

Considering how there are over 7,000 cryptocurrencies, tokens, assets, and stablecoins today, Compound Finance only supports nine markets. These include:

  • ETH (Ethereum)
  • DAI (Dai)
  • WBTC (Wrapped Bitcoin)
  • USDC (USD Coin)
  • USDT (Tether)
  • UNI (Uniswap)
  • ZRX (0x Protocol)
  • COMP (Compound Governance Token)
  • BAT (Basic Attention Token)

Every market has its own supply and borrow APYs, giving users many options to optimize their borrowing and lending strategy. The higher the supply of an asset is, the lower the supply APY becomes. However, this may also provide a lower Borrow APY, enticing more users to borrow funds through this DeFi platform. 

Taking The Standard as an example, it goes one step further. While the protocol supports various crypto assets, it enables support for precious metals too. Supporting real-world assets is crucial to take DeFi into the mainstream. Moreover, community members holding The Standard Token can vote on enabling support for more crypto assets and metals, creating democracy in decentralized lending.

Compound Finance Governance Explained

In the list above, we mention COMP as the Compound Governance Token. Similar to other decentralized finance platforms, Compound has a native token that is subject to theoretical value. Additionally, it provides governance rights to token holders, allowing them to make decisions to keep pushing the platform forward. COMP Holders also earn fees from the borrowing and lending activities on the platform. 

To exert governance rights, users need to put forward proposals or vote on existing ideas. Governing this DeFi platform may help achieve different fees, listing new cTokens, adjusting interest rates and collateralization requirements, and so forth. This entire process occurs through on-chain voting, with every COMP token representing one vote. 

Investing in any DeFi token to participate in the governance aspect is often ill-advised. As these tokens primarily serve as speculative tools, they don’t always make for the best investment. However, if one is passionate about a project, using COMP to participate in voting and earning fees may prove worthwhile in the long run. 

Benefits And Drawbacks Of Compound Finance

As is often the case in the decentralized finance industry, no solution is without risks or drawbacks. Although Compound Finance may offer many benefits in terms of lending and borrowing, there are always some trade-offs to consider. In this regard, DeFi isn’t too different from centralized finance, even if all intermediaries are removed from the equation. 

The Pro’s of Compound

The first advantage of using this Defi solution is how it makes it easy for crypto-asset holders to earn interest. Although most of the supported markets offer relatively low earnings, it is still better than keeping money in a savings account. For most users, this may not be sufficient reason to interface with Compound Finance’s smart contracts, though.

Advanced users may look at this platform as a way to leverage their position in the crypto market. If you expect the price of 0x to keep rising, you can supply any other asset to the platform, borrow USDC/USDT/ETH – for example – and buy more 0x. 

Assuming the price goes up, your profit from selling the 0x again, paying off the loan, and withdrawing your initial assets may be much greater than otherwise. Exploring this option requires a thorough understanding of crypto markets, trading, and indicators. 

Potential Drawbacks Can’t Be Ignored

When borrowing volatile cryptocurrency assets, there is always a chance prices will go down. If you borrow Ethereum from Compound Finance and its price drops by 20%, you still need to pay back the loan and the interest. Doing so may prove problematic if the prices keep going down, as it will be challenging to get back in the green. Failure to repay a loan will result in your supplied assets facing liquidation.

Second, you cannot underestimate the importance of audits and external testing. Users are trusting lines of code to keep their money safe, yet there are no guarantees the smart contracts will work as advertisers. Compound’s code has undergone multiple audits, yet new bugs and vulnerabilities can cause significant problems. A loss of funds can always happen, regardless of how firms perform regular audits.

Even though Compound Finance isn’t the only platform suffering from this problem, the rising Ethereum fees make it infeasible to regularly explore borrowing and lending. Platforms like these are not designed to quickly get in and out of positions, as Ethereum’s fees will instantly negate nearly all profit. Paying $70 for a transaction to deposit or withdraw funds is far from ideal and may hinder Compound’s ongoing growth. 

Several Forked Projects Exist

The concept of Compound Finance has given way to multiple projects putting their own spin on the open-source code. Notable forks include Cream Finance, PercentFinance, Yam Finance, and others. It is often very difficult to operate on the same level as the original, and all of these forks warrant fundamental analysis before making any investments. 

Forking code is a common approach in the cryptocurrency industry. Many cryptocurrencies have some elements of Bitcoin’s code in them. It is only normal to see a similar policy in the DeFi industry. When something works, it is easier to copy it and make further improvements rather than starting from scratch. 

Closing Thoughts

Decentralizing borrowing and lending funds is a crucial step on the road to providing alternative financial solutions. As loans are an essential aspect of the financial industry, removing the intermediaries from the equation will provide broader economic equality. Although the platform requires users to own crypto-assets before obtaining a loan, the concept certainly has some degree of potential.

Additionally, Compound has had its concept integrated into more complex DeFi protocols and projects, confirming a genuine interest in this approach.

As the governance aspect of this protocol becomes more decentralized with the help of COMP token holders, there may be some intriguing changes on the horizon. What those changes will entail remains unclear, but this money market protocol is worth keeping tabs on. 

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