A Deep Dive Into Compound: A Lending Protocol In DeFi

Tiny Crypto Labs
3 min readNov 4, 2022

What is a Compound Lending Protocol?

Compound is a decentralized protocol on the Ethereum blockchain that establishes money markets for the borrowing and lending of assets.

These assets are popular cryptocurrencies such as ETH, DAI, and Tether. Compound’s digital currency provides access to the crypto-loan market, where the system sets interest rates.

The Compound Finance whitepaper was published in February 2019 by founder Robert Leshner and co-founder Geoffrey Hayes. It introduced a decentralized protocol that algorithmically set interest rates based on supply and demand, establishing money markets.

The Compound was the first to offer permissionless lending pools, enabling users to earn interest on their crypto deposits.

What are cTokens?

cTokens are the Compound’s native tokens. Users who supply assets to the Compound protocol receive tokens representing claims on the asset pool.

They are similar to other Ethereum ERC 20 tokens and can be transferred, traded, programmed by developers, or redeemed at any time. So, a user’s balance in a specific Compound market is represented in tokens.

A user can “mint” more tokens by supplying more assets to the protocol, or they can redeem tokens for their underlying assets already deposited.

Each money market has its particular token that can increase in value as the specific market continues to accrue interest. This amount is based on the lending rate, which is on borrowing demand. So, one can earn interest simply by hodling.

However, the number of tokens in a user’s account won’t increase — it stays the same. Over time, each token can be exchanged for an ever-increasing amount of its underlying asset.

Compound Governance

Participation in governance starts with the COMP token (the Compound Governance Token), which allows holders to vote on essential protocol decisions like listing new token markets, changing an asset’s collateral factor, and changing a market’s interest rate model.

At the start, Compound Governance was handled by centralized authority figures, but it is continually transitioning to community governance so the protocol can evolve in new and better ways.

People who hold over 100,000 Comp tokens are the only ones that can propose.

How Does It Work?

Like most DeFi protocols, crypto collateral must be provided before users can do anything on the system. Supplied asset balances are referred to by tokens issued at 1:1, representing the underlying asset that earns interest and serves as collateral.

Supplying assets involves additional confirmation transactions and gas fees, as do withdrawing them and claiming earned COMP. During times of high ethereum demand, gas fees can spike, making the platform very expensive for small transactions.

Borrowing rates on these collateral tokens depend on which token it is; some have better values than others. These newly minted tokens act as an IOU and redemption token, permitting the holder to redeem the original tokens.

Their value increases through the interest earned on the original collateral tokens, so cashing them out (or converting them back) usually yields more than the underlying assets.

Borrowing on Compound requires cTokens to be deposited as collateral, the factor of which and the amount that can be borrowed varies depending on the token.

For example, if a user supplies 100 DAI as collateral, and the collateral factor for DAI is 75%, then the user can borrow at most 75 DAI worth of other assets at any given time. The protocol sets aside 10% of interest paid as reserves, and the rest goes to collateral suppliers.

Is Compound safe?

Many find Compound Finance to be a trusted protocol for lending and borrowing. Their code is publicly verifiable, and security professionals offer bug bounties for reporting vulnerabilities.

Bottomline

The Compound has always been second to MakerDAO in the DeFi space. The goal of Compound is to remove intermediaries and reduce the cost of financial transactions, which allows people who do not have access to banks to use decentralized banking services.

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