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Compound Protocol Deep Dive | Notum

By Notum

May 22, 202312 min read



Cryptocurrency is a digital asset that has found many uses in the modern world. While people outside of crypto think that it is only used for online payments, there is a whole world called Decentralized Finance. DeFi is an alternative to the traditional financial system and offers the same banking financial instruments without the need to involve third parties. Also, unlike traditional financial institutions, decentralization makes the process as transparent and safe as possible for everyone. The evolution of blockchain and the emergence of DeFi has been a huge breakthrough in the world of financial services,  and the combined total value locked (TVL) in DeFi platforms is over $49 billion as of May 2023.

DeFi also found its way into lending, as there was a need to create applications where anyone could quickly and easily get funding. Despite the existence of a huge number of different platforms and exchanges, Compound is one of the leading DeFi protocols now with TVL of $1.75 billion, according to DeFiLama. This blockchain-based dApp allows users to increase liquidity by lending their cryptocurrency and earning interest on it. If the user, on the contrary, needs money and has funds in crypto, he can take a loan secured by them. Borrowers and lenders are matched automatically without the intervention of third parties, and interest rates are adjusted based on supply and demand. Today we will offer you a detailed crypto Compound overview, and talk about the operation of the platform, its uniqueness, and COMP token.

What Is Compound?

Compound is a DeFi protocol that uses cryptocurrency to provide various financial services and enables borrowing and lending without the need to go to an intermediary such as a bank or credit union. Compound is an Ethereum-based technology, which can be called a kind of decentralized market for investors. Users who want to earn income use Compound to deposit crypto into lending pools for borrowers and then earn interest on it. Borrowers can take a loan from Compound like a bank secured by their cryptocurrency. It is important to note that the demand and supply of each asset are different, which helps determine interest rates.

Compound Finance currently supports the following crypto assets:

Thus, if you own one or more of the cryptocurrencies mentioned above, then you can lend, send, deposit, or lock them at any time. The interest you earn will be expressed in the same cryptocurrency that you lend.

How Does Compound Work?

Compound crypto protocol works in much the same way as a bank and provides users with the ability to deposit cryptocurrencies and receive interest or borrow money at interest. However, the main difference between Compound and traditional financial institutions is that users actually send their own cryptocurrency and use the smart contract without having to interact with a third party. Thus, neither the bank nor other authorities can control how you use your funds. Since Compound is a DeFi protocol, there is no centralization, so the platform cannot be shut down.

In Compound, there is no direct interaction between the lender and the borrower. People wishing to become borrowers put their crypto into pools from which borrowers can borrow. Since the main users of the platform are lenders and borrowers, let's talk about each of them in more detail:

  • Lender. Any person who has cryptocurrency and lends it to Compound to earn is a lender. The user sends their tokens to an Ethereum address to receive a percentage reward. Simply put, the lender deposit or block their assets in Compound to receive APR. Thus, each token is stored in the liquidity pool of the same token using smart contracts. In addition, Compound lenders can also borrow in any compound-supported currency.
  •  Borrower. A user who places crypto-currency collateral on Compound to receive a loan is a borrower. So, users can borrow any Compound crypto supported by the platform at a percentage of the posted value. Unlike a bank that verifies the borrower's personal financial details, Compound as a DeFi protocol remains anonymous and only offers over-collateralized loans. Thus, Compound sets either a collateral factor or a borrowing limit for the borrower. There is also a borrower liquidation on Compound if the borrowed asset has become more valuable than it was at the time of borrowing.

Unique Features of Compound

If you want to become a lender on Compound DeFi platform, then after depositing funds into the protocol, you will receive a cToken (which is a deposit), such as cETH or cDAI. You can sell or transfer this token; however, it is important to remember that in the end you will only be able to exchange it for the crypto that was originally blocked in Compound.

This cToken exists so that users can receive interest, which is updated according to a complex algorithm and depends on supply and demand for a particular asset. Thus, the higher the demand, the greater the percentage for both parties. This is what encourages lenders to lend more crypto to Compound, and borrowers to repay. In addition, a nice advantage of Compound is that the whole process is automatic, and the lender can withdraw their assets at any time.

A user who borrows money on the platform must pay Compound interest (hence the name of the protocol). For example, if you deposit $1,000 worth of DAI into Compound and the borrowing limit is 65%, then you can borrow $650 worth of any crypto on the platform. However, in addition to this, you will need to pay interest on the borrowed amount. "Users can only borrow a USD value in crypto that is below the collateral they have supplied. The amount they can borrow depends on the liquidity and market cap of the collateral." - Cryptotimes.

COMP Token

To incentivize the protocol, Compound uses its own cryptocurrency, COMP. Thus, when using the platform, namely repaying, borrowing, or withdrawing, the user receives a Compound crypto token. The platform also rewards lenders with COMP tokens, and the reward varies depending on the number of cTokens stored in their wallet and the interest rate. 

Another feature of the Compound token is that with its help, people can influence the future of the protocol. 1 COMP is required to vote. In addition, users can make suggestions for changes to the protocol, however, for this they must own 1% of the total COMP supply. Once the proposal has been submitted, there is a three-day voting phase where 400,000 votes must be collected. If the offer is confirmed by users, then it takes effect in two days.

As of May 11, 2023, the COMP token price is $35.65, market capitalization is almost $266 million and the total value blocked (TVL) is $1,290,996,660.

Compound Pros and Cons

Before you start using Compound, it is important to pay attention to the advantages and disadvantages and make sure that the platform is the right solution for you.

Compound Advantages:

  • Safety. Compound is a decentralized blockchain-based protocol, which indicates a high level of security. The absence of a central authority and the presence of a collateral make the protocol one of the most secure in the crypto space.
  • Lending and borrowing amount. Compound differs from similar platforms in that it does not have a minimum amount criterion for borrowing and lending. This means that the protocol is available to a wider range of users who do not have many tokens.
  • Trading fees. Another nice feature of the platform is the absence of trading fees for completed transactions, which also distinguishes Compound from its competitors. There are also no slippage fees.
  • Earning options. Lenders can lend several types of cryptocurrencies to increase their income. Liquidity pools also have different returns depending on the token and coin. Another opportunity to earn high APY is in return is yield farming.

Compound Disadvantages:

  • Token options. The Ethereum-based platform only has a certain number of tokens that users can use for lending, which limits the use of the protocol.
  • Complexity. While Compound is a great option for an experienced investor, it will be difficult for a beginner to adapt due to the complexity of using the platform. Compound does not offer step-by-step training, which means basic crypto knowledge is required to use the protocol.

Final Word

The DeFi Compound protocol is a unique solution that allows users around the world to lend or borrow cryptocurrencies. Smart contracts make financial transactions on the protocol simple, secure, and transparent. To start working with the protocol, the user must lock a certain amount of cryptocurrency, after which he can make credit transactions with crypto assets. In this way, Compound helps to greatly simplify the control over lending without the need for the introduction of third parties, however, the protocol only offers certain cryptocurrencies with which you can interact.

To sum up, Compound is a great way to generate passive income if you have the right assets. The protocol helps to optimize investments, as well as to borrow crypto at the interest rate set by the protocol. The many features offered by Compound help it stay one of the most popular in the market but it’s important to do your own research before using the platform.

Disclaimer: Notum does not provide any investment, tax, legal, or accounting advice. This article is written for informational purposes only. Cryptocurrency is subject to market risk. Please do your own research and trade with caution.