What is Compound?
May 6, 2021 - 5 min read
Compound is a decentralized algorithmic money market protocol running on the Ethereum blockchain that uses lending pools to facilitate loans in a variety of cryptocurrencies. Borrowers can take out collateralized loans, while lenders that make funds available to the lending pools can earn income on their deposits via specially-issued native tokens.
Compound was created by Robert Leshner and Geoffrey Hayes, through their company Compound Labs which is headquartered in San Francisco: the Compound protocol began development in 2018 and the currently used Compound v2 went live in May 2019. Leshner and Hayes’ vision was to address the speed and efficiency issues of the legacy financial system and to remove the constraints imposed by intermediary organizations, including the risk that a centralized exchange might be hacked by behaving improperly with user assets or that a run may start on an intermediary that uses fractional reserves. Between 2018 and 2019, Compound raised over $30 million in financing, and distributed over 4 million of its native COMP tokens upon launch.
The Compound protocol supports loans in a variety of cryptocurrencies by offering borrowers access to pools of crypto assets (lending pools). Lenders on the Compound network provide liquidity to the pools by depositing crypto assets, and borrowers take loans from the pools after depositing crypto assets as collateral.
Both lenders and borrowers on Compound deal directly with the protocol itself (rather than a central authority) which sets (and pays) the interest rate algorithmically and without any need for users to negotiate terms.
Lending: When lenders deposit into a Compound lending pool, they receive a generic token known as a ‘cToken’ that tracks the value of their underlying assets. cTokens essentially allow lenders to engage in yield farming: as the relevant Compound money market generates interest algorithmically, the cTokens generate passive interest for their holders.
cTokens are generic in the sense that they reference the underlying asset: users that deposit DAI receive cDAI, users that deposit ETH receive cETH, and so on. cTokens may be converted back into the underlying asset by their holders at any point.
Borrowing: In order to borrow from the Compound network, users must first deposit enough collateral to cover their loan: Compound loans are overcollateralized which means the value of a borrower’s collateral must exceed the value of the loan they take out. The amount of collateral a user deposits is used to establish their “borrowing capacity” which determines the amount they can borrow. If the value of a borrower’s loan approaches the value of the collateral, the collateral is liquidated automatically by the protocol.
Governance: The Compound protocol has another native token, the Compound Governance Token (COMP). Users that hold COMP can make network proposals and vote on issues such as the acceptance of new collateral types, borrowing capacities, choice of oracles, and interest rate models. COMP is a tradeable cryptocurrency token.
The more COMP a user holds, the more influence they have over the Compound network. A single COMP token translates to a single vote on proposed governance issues – only users that hold at least 1% of the total supply of COMP may submit new proposals on the network.
The Compound protocol currently supports loan markets in the following varieties of cryptocurrency:
- USD Coin
- Wrapped Bitcoin
- Compound Governance Token
- Basic Attention Token
In addition to providing passive interest income to lenders who deposit in supported cryptocurrencies, loans on the Compound network are particularly useful for speculative traders wishing to capitalize on short term opportunities. For example, a trader that believes ETH is going to rise in value may deposit ETH into a Compound lending pool as collateral for a loan in a more stable currency such as USDC. The trader can use it to purchase more ETH and then then pay back the loan with interest to reclaim the collateral ETH. If the price of ETH has risen during the loan period then the trader stands to make a profit (taking interest into account).
Compound is an open source network and encourages developers to create apps that integrate the protocol. Examples of decentralized apps that integrate with the Compound’s COMP token and cTokens include:
Compound continues to encourage developers to integrate the Compound protocol into apps and services, with the goal of creating more versatile financial infrastructure for users around the world. Meanwhile COMP token holders provide direction for the network, with stakeholders establishing consensus for important governance decisions.
One interesting development on the horizon is the Compound Gateway which allows for cross-chain interest rate markets.
Compound’s goal is to transition to a fully decentralized autonomous organization (DAO), with network control distributed entirely across the COMP stakeholder population. Robert Leshner has set out a roadmap to full decentralization in February 2020, and part of the COMP reserves are being distributed to protocol users through liquidity mining.