What is Compound Finance? We keep hearing this question from DeFi newcomers on a daily basis, which is nothing strange given that Compound is the leading lending platform in the market. In order to understand what makes it stand out in comparison to platforms like Aave, we’ll inspect Compound Finance and figure out how it works.
Compound Finance is a trailblazing decentralized finance protocol enabling anyone to lend or borrow cryptocurrency assets.
Why the effusive use of the trailblazing adjective here?
Because in many respects, Compound Finance directly kicked off the entire DeFi movement as we know it today.
Compound was the first to enable and popularize the use of crypto-collateralized loans in a watershed moment for the cryptocurrency space. However, it also played a central role in creating the yield farming niche along with Synthetix.
Nowadays, Compound sits atop the world of DeFi protocols with billions of dollars worth of tokens locked into the protocol.
This Compound Finance explainer will help guide you through understanding and using Compound to lend or borrow cryptocurrency assets safely and easily.
Simply put, Compound is a platform for decentralized borrowing and lending of cryptocurrency assets.
Traditionally, getting a loan is a complicated process involving KYC (know your customer), credit, and employment checks.
Besides having to jump through these hoops, the process is slow, cumbersome, and expensive (interest rates are generally extremely high and profit the bank immensely).
In contrast, Compound enables anyone to get an instant cryptocurrency loan using nothing but cryptocurrency assets already under ownership as collateral.
The advantages of such an arrangement are mind-bogglingly diverse, but for starters, Compound makes it possible to receive instant loans without selling the crypto you already own.
Another and perhaps more important way to look at Compound is it puts your assets to work for you by generating more value from what you already own.
Let's use two simple cases to explain the Compound DeFi lending platform.
Deposit your supported cryptocurrency assets, then borrow more cryptocurrency, including BTC and stablecoins, against their value.
By depositing your crypto and borrowing against it, you maintain your existing positions while squeezing more value out of them. You can use your crypto loan to buy other cryptocurrencies, farm yields on other DeFi platforms, or cash it out for real-world uses.
When you deposit cryptocurrency to the Compound protocol to use it as loan collateral, you simultaneously become a lender, too. This means you'll earn APY (annual percentage yield) earnings that work to offset your loan’s interest rate.
Even if you have no intention of receiving a cryptocurrency loan, depositing your cryptocurrency to Compound is much better than holding it in a crypto wallet that doesn't generate interest.
When you deposit cryptocurrencies to the Compound platform, they automatically begin accruing APY interest paid in both the deposited asset and COMP tokens. As such, your cryptocurrency assets get put to work rather than sitting idle in your wallet.
Getting a Bitcoin loan — or a loan of any of the other supported crypto assets — using Compound Finance is an extremely beginner-friendly process.
Essentially, all you need to do is supply the Compound app with cryptocurrency from your wallet, enable it as collateral, then borrow against it. Doing so is very different from applying for a loan. In this case, you aren’t applying for a loan since, owing to your deposited collateral, the protocol has already secured your means of repaying.
The key point to understand about how Compound crypto loans work is this: You are quite literally borrowing from yourself.
Therefore, if you choose not to repay your loan, or if your deposited assets drop in value to the point that your loan to value ratio is exceeded, the same outcome is met. The Compound smart contract holding your collateral will liquidate the amount required to cover the defaulted or liquidated loan amount.
That’s also why lenders sleep well at night, knowing their deposited assets aren’t simply going to walk away. Compound’s smart contracts are secure, immutable, and automatically respond to market conditions and changes in crypto prices.
To get a cryptocurrency loan on the spot using the Compound crypto lending platform, you need a few simple requirements.
Once you have the above requirements in order, the next step is to decide how much you want to borrow. Keep in mind that unless you plan to use stablecoins like USDC as collateral, cryptocurrency prices are volatile.
This means if you deposit $10,000 worth of ETH, a drop in ETH prices may mean your ETH is worth $7,000 only a few days later. As such, it’s important to keep a low loan-to-value ratio to account for price swings. A safe LTV ratio generally begins at the 50% mark, but a recommended starting point is closer to 20% to 30%.
Keeping your crypto loan LTV ratio low means less stress, less maintenance, and greater insulation from market volatility. It also means that you may need to come up with more collateral than expected, depending on how much you are looking to borrow. However, this is ultimately a good thing because you’re forced to hold your crypto assets through thick and thin while also maintaining a low-risk crypto loan.
That’s it! After the second transaction confirms, the amount you’ve borrowed will show up in your crypto wallet.
If you're new to Compound, the COMP token might be confusing you. After all, it isn't immediately clear exactly what the token is or what type of value it entitles holders to.
Currently, the COMP token is strictly a governance token. Since the Compound Protocol is fully decentralized and run by users, COMP tokens represent voting & governance rights within the network.
COMP token holders can create proposals, vote on proposals, and help decide how funds from the Compound treasury are spent.
Are you wondering where the value for COMP comes from if it's only used for governance (so far)? Compound Protocol has several billions of dollars worth of cryptocurrency locked into the protocol at the time of writing. Because COMP represents a stake in the network (or a seat at the table, if you prefer), the token is precious.
Additionally, it's expected that COMP token holders will vote to accrue value from the protocol back to wallets at some point in the future. Today, a16z and Polychain Capital, two of Coinbase's largest investors, hold the most COMP tokens, and therefore the most voting weight. We'll call that a vote of confidence in Compound's future.
If you want to get COMP tokens in your wallet to participate in governance or speculate on the protocol's future, you can buy COMP tokens at Coinbase.
However, it might interest you to know that there's a way to earn COMP tokens for free. Well, almost. You see, every time you lend or borrow assets on Compound, you earn a distribution APY paid in COMP tokens.
For instance, depositing USDC in Compound today earns 3.62% distribution APY, meaning you'll earn 3.62% of your deposit amount back in COMP tokens over a year.
Pro-tip: Sometimes, you may find yourself profiting even when you borrow on Compound. How is that possible? To borrow, you need to lend, entitling you to both Supply APY and Distribution APY. Then, when you borrow against your loaned crypto, you earn another round of distribution APY. If you're lucky, your supply and distribution APYs will cover your borrow APY and then some.
Compound runs on Ethereum. This means that, yes, network congestion and high gas fees are an issue. Additionally, Ethereum being a non-interoperable blockchain, Compound is limited to working with ERC-20 tokens.
For these reasons and more, the Compound dev team is building out Compound Chain, a standalone blockchain for cross-chain asset compatibility. Apart from integrating with other blockchain protocols like Polkadot, Cosmos, and Solana, Compound Chain will also focus on stablecoins like Facebook's Diem and central bank digital currencies.
During a recent governance call, the Compound team confirmed that Compound Chain will have its own token ($CASH) and will retain COMP as the entire ecosystem's governance token.
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