Crypto Compound Finance 101: Here’s Everything You Need to Know
The crypto space has, in recent times, witnessed a surge in decentralized finance platforms with crypto compound finance being the latest innovation, and that has grown incredibly in the past year. In the crypto space, compound finance refers to an algorithmic, open-source protocol that allows for the creation of money markets, currently mostly on the Ethereum blockchain. In other words, a compound can be defined as a fully automated, decentralized money market protocol. Compound finance allows users and applications to access the financial platform remotely from any location, and at any time, and borrow against their assets.
Additionally, individuals and institutions can earn interest on digital assets supplied to the protocol. Compound finance users can also borrow digital assets directly from the protocol without a central authority.
In many ways, the Compound Finance protocol has been compared to DeFi (decentralized finance) projects as they serve the same purpose- develop the existing financial money markets into a decentralized, efficient and frictionless financial system. This guide will delve into compound finance, looking at its core objective, protocol, supplying tokens, borrowing tokens, interest rates, liquidation, among other topics relating to the subject.
Compound Finance Overview and Core Objective
Compound Finance protocol was created by Compound Labs, Inc.-a company that designs and develops software and has its base in the United States. The company is registered with the U.S Security and Exchange Commission and is incorporated in the state of Delaware. Compound Finance’s protocol is based on Ethereum and can be accessed using several interfaces such as Coinbase and Huobi wallets selected by the community. Compounds Labs Inc. poses the Ethereum address 0x8b8592e9570e96166336603a1b4bd1e8db20fa20, which functions as the primary admin of the protocol allowing the platform to add resources, update the oracle of the price feed, update the interest rate models and also update the risk model of the protocol.
Compound Finance assumes the form of a “liquidity pool,” which allows users to take loans. The platform also offers liquidity to an entire market, whereby users obtain loans from the market itself or earn interest by providing liquidity.
On the protocol, interest is algorithmically determined based on the market supply and demand, as well as the interest accrued in each new Ethereum block. Additionally, the platform doesn’t have predefined durations or terms as users can use the compound protocol for a limited period during the duration of a single new block or indefinitely with an option of repaying the loan at any time.
The platform calculates interest rates according to the liquidity available in each market, which also fluctuates in real-time based on demand and supply. The interest rates fall when the cash is abundant and similarly increases when liquidity becomes scarce. A rise in interest rates stimulates the repayment of loans and also stimulates new supply. Below are tables illustrating Compound Finance Overview:
|Borrows Assets||ETH, DAI, USDC, BAT, REP, ZRX, WBTC|
|Rate Variability||Medium Variable|
|Loan Amounts||$1 – $100,000|
|Receive Funds||Stablecoin: Instant, Crypto: Instant|
|Repayment Type||Interest Only|
|Available Loans||Stablecoins, Crypto|
|Accepted Collaterals||ETH, DAI, USDC, BAT, ZRX, REP|
|Collateral LTV||50% – 75%|
|Margin Call LTV||80%|
|Platform Fees||.02% Of all Interest Incurred|
|Token Benefits||NO TOKEN|
|Platform Type||Decentralized Lender|
|Supported Regions||All Countries|
|Excluded Regions||Sanctioned Countries|
|Borrow Asset||APR Rate|
|Basic Attention BAT||4.29%|
|Collateral Asset||Collateral LTV|
|Basic Attention BAT||60%|
Regarding the project’s core objective, Compound Finance’s primary goal is to provide individuals with the ability to ‘trade the time value’ of a digital asset. The financial concept inspires the project’s primary purpose, ‘the time value of money,’ which means that money presently owned holds more value compared to an identical sum of money that is set to be received in the future. Present cash is worth more as it can be invested, for example, through lending to earn a return and generate a more substantial sum of money in the future.
The major problem with holding digital assets or some time to generate profit is financial yield, which is the income returned on investment. Digital assets have negative economic yield attributed to substantial storage costs, as well as, financial risks experienced both on-exchange and off-exchange. The accrued interest is used to offset these costs, thus resulting in negative yield. Compound Finance protocol aims at solving this enormous problem by bringing together lenders that are looking to earn a return on non-yielding assets and borrowers that are seeking to use borrowed assets for investment purposes or any other productive use.
Compound Finance: The Mechanism of Borrowing and Supplying Tokens
The borrowing token on Compound Finance protocol is quite different from other peer-to-peer platforms. In the protocol, a user’s token is not matched and lent to another user. Users who wish to lend, do not give directly to the lenders, instead, the protocol itself. The compound protocol then aggregates the supply of borrowed funds, resulting in a high level of liquidity for a specific money market. The mechanism also allows lenders to withdraw their tokens from the protocol at any time. They, therefore, do not have to wait for the loans to mature before withdrawing their lent funds. The borrowed funds accrue interest based on the supply interest rate unique to a particular asset.
When it comes to the borrowing mechanism, borrowing tokens are usually accompanied by negotiation with the counterparty regarding the maturity rate or funding period. The protocol allows users to borrow from the platform rather than lenders directly. Borrowers are simply required to specify the asset they wish to borrow, and the protocol will automatically use the floating interest rate to determine the cost. Borrowers must also have a certain amount of balance in their account to cover for the amount of borrowed funds, i.e., the collateral ratio.
Compound Finance employs the ‘Price Oracle’ to keep track of the current exchange rate of each supported digital asset on the protocol. A committee is given the task of setting the value of assets after pooling the prices of supported holdings from the top 10 exchanges in the crypto space. The protocol uses the exchange rates to determine the borrowing capacity and collateral requirements for an account.
Interest Rates and Liquidation
When a user borrows, the interest rate on the protocol or supplies is determined algorithmically based on the supply and demand of the asset provided in a given money market. High liquidity, therefore, leads to low interest rates and vice versa.
Regarding liquidation, a user’s account is subject to liquidation when the total value of their supplied assets, divided by the cost of their outstanding borrowing, is below the collateral ratio. In the event of a liquidation, the liquidator is required to repay some if not all of the outstanding borrowed amount on behalf of the user, i.e., liquidate. This functions to reconcile the borrower’s balance with the collateral ratio. The liquidator is also awarded a discount referred to as the Liquidation Discount in the event of a liquidation.
Pros and Cons of Compound Finance Protocol
- No time limitation. Users are allowed to borrow or lend assets for an indefinite period.
- High liquidity amounting to over $150M. Users can access this liquidity within minutes
- Available globally. Users are free to lend or borrow assets from anywhere in the world. No country or location is restricted.
- Developers find it quite easy to make more developments of the platform since both the protocol and API are readily available.
- High level of privacy. The protocol doesn’t allow KYC checks or personal account registration
- Well-funded by top blockchain findings, including Coinbase Ventures, Bain Capital Ventures, Andreesen Horowitz, and Ploychain capital.
- The Compound Finance protocol is not regulated by traditional finance authorities and thus does not maintain insurance for user balances.
- Funds could be at forecasted risk since the protocol is entirely new in the crypto space.
- The protocol supports native Ethereum assets only, thus not ideal for users with other tokens not based on the Ethereum protocol.
The Compound Finance protocol is an excellent financial innovation in the crypto space that allows users to exchange the temporal value of digital assets without really incurring negative economic yield synonymous with digital assets. The protocol has eliminated intermediaries in the financial markets, replacing them with open-source protocol, in turn, creating more liquidity markets and eliminating the direct relationship between debtor and creditor. Creditors can also retrieve their lent tokens from the protocol at any time even before the loan matures, thus creating efficiency and the much-needed financial flow. Going forward, the protocol will create more liquidity markets allowing crypto enthusiasts to profit from their digital assets without much hassle or risks.