What is Compound Finance?
Updated: Apr 15, 2021
Image Source - Compound.Finance
Once convinced of the technology, crypto enthusiasts have been buying and hodling cryptocurrencies, waiting for their value to go up. Unless they bought at the height of the ICO boom, they would be sitting on a good return. However, they want more.
If I hold US$, I’m not satisfied just by the fact that US$ has appreciated against the Peso or Euro or Rupee. I aim to maximize my returns by investing my US$ in yield-generating assets like bonds or stock or property.
Until recently, there were no similar options for earning passive returns in the Blockchain World.
Enter: blockchain-based money markets like Compound
Compound Finance is a leading blockchain-based money market, 2nd only to Maker in terms of Total Value Locked (TVL)
Image Source - DefiPulse
A traditional money market is a market in which corporations and institutions trade in highly liquid, short-term debt. In the blockchain version of money markets, the participants can be anyone with liquid holdings. Lenders deposit their holdings in liquidity pools and borrowers borrow from this pool. Terms like Loan-to-Value (LTV) ratio and rate of interest are algorithmically determined based on demand and supply. There are no middlemen like banks involved. (If this becomes mainstream, gone would be the days when politically connected persons could pressure/bribe bank management into issuing them loans).
Let’s go step by step
Lenders deposit their tokens in a Liquidity Pool of that token and get a cToken in return. So if I have Dai/ETH/WBTC, I deposit it in the Dai/ETH/WBTC Liquidity Pool and get cDai/cETH/cWBTC in return. The cToken represents my share in the Liquidity Pool. As the Liquidity Pool earns interest from being lent out, the value of my share in the Liquidity Pool goes up, or in other words, the value of my cToken goes up. This means that when I redeem my deposits by returning my cTokens, I will get back more than I initially deposited.
There is no fixed time period for the deposit and it can be withdrawn at any time. There is no ID verification or KYC requirements (whether or not that is a good thing, depends on which school of thought you come from - pro-privacy or pro-regulation). Custody of tokens is not with a counterparty but instead with a smart contract. This means that no centralized entity has control over your assets.
Anyone who wishes to borrow must first deposit collateral. In traditional finance, the Loan-to-Value (LTV) and interest rate are determined by one’s credit score, type of collateral, purpose of borrowing, etc. In Compound, LTV is called Collateralization Factor (CF) and is determined by the type of collateral. For example, Dai might have a CF of 75% while Basic Attention Token (BAT) might have a CF of only 60%.
Borrowers must be especially careful about the CF as cryptos are highly volatile. If the collateral value becomes insufficient (because the borrowed asset rises in value or the collateralized asset drops in value), then the borrower must immediately repay a part of the borrowing or add more collateral. If she is unable to do so, then the borrowing will be liquidated i.e. a liquidator will be brought in to repay all or part of the loan in exchange for all or part of the collateral.
The rate of interest is determined automatically by an algorithm that factors in demand and supply. If there is a lot of supply and not enough borrowing then the interest rates are low which incentivizes borrowing and de-incentivizes lending. On the other hand, if a large percentage of the pool has been lent out then interest rates are high to incentivize lending and de-incentivize borrowing.
At the time of writing, Compound had total supply of $2.5bn and borrowing of $1.4bn.
Image Source - Compound
Why would someone want to borrow?
* To short an asset - If a speculator has a bearish view on a token that she doesn’t own, she can deposit a token they own, borrow against it the token she wants to short, sell the borrowed token, later buy the shorted token after it (hopefully) falls in value and repay borrowing with newly bought tokens
* Take a leveraged position on a token they are bullish on- Say a speculator is bullish on ETH. She can deposit ETH as collateral, borrow a stablecoin like USDC and use the borrowed USDC to buy more ETH.
=> The above can be profitable but risky trades.
Let’s talk about money- COMP
The native token of Compound is called COMP. It gives holders the right to propose and vote on changes to the protocol. COMP holders can vote on things like listing a new cToken market, updating the interest rate model, updating oracle addresses, and withdrawing a cToken reserve.
To incentivize usage of the platform, Compound issues COMP tokens to lenders and borrowers. (Yes, you get paid even for borrowing).
The total supply of COMP tokens is 10 million. 42.3% is reserved for users. 0.5 COMP tokens are released in each Ethereum block. These are distributed among Liquidity pools in the ratio of interest generated. Within each Liquidity Pool, they’re divided 50:50 between lenders and borrowers. Since borrowing is less than lending, this should mean that borrowers get a higher amount per unit of borrowing.
How does Compound make money?
* A cut of the interest earned
* Spread between borrowing and lending
So what are the Risks?
* Bugs in the Smart Contracts- In all DeFi platforms, including decentralized money markets, decisions are taken not by humans but by code. There is a risk of there being errors in the code that could be exploited by hackers. In case you lose money because of a code error, there is no recourse for you. No government, no regulator, and no customer service department can help. => Compound is an open-source, well-audited platform with bug-bounties for spotting vulnerabilities. This makes it among the more robust platforms out there.
* Bank Run - In case of panic (whether or not based on real danger), lenders may rush to withdraw funds. Since, at any point, 50-70% of funds are likely to be lent out, in case of such a bank run, there may not be sufficient funds available to withdraw.
=> Having said that, this risk might be overstated. First of all, since all the borrowers have also deposited funds as collateral, they are not allowed to withdraw funds till they pay back their loans. Secondly, the incentive system is so designed that as the utilization rate increases, the rate of interest creeps up luring more depositors and discouraging borrowing. And finally, unlike banks which are secretive and adopt a condescending attitude towards their customers that they must be protected from the truth, DeFi is more transparent and issues become apparent before they become too big.
Compound compared to Aave
Compound has more TVL than Aave indicating its higher popularity. This is largely because Compound is more user friendly. Aave is more complicated to use but this might be because it has more advanced features. For a more detailed account of Aave, click here.