Over the past 2 months the new buzzword in crypto has been DeFi, with everyone in the space jumping on it, creating tokens ranging from the major successes to the typical scams. Compound has successfully staked its claim as a major player in the DeFi space with 1.75 Billion USD worth of cryptocurrency locked on the platform. So, what is it, what drove its success and how can you actually use it?
What is Compound
Compound is a platform based on the Ethereum blockchain that provides decentralised lending and borrowing to everyone without any KYC, accounts or any form of credit score or otherwise. All you need to start lending and borrowing is an Ethereum web3 compatible wallet (such as metamask) and that is it. You can then deposit from a selection of ERC tokens or Ether and use that as a collateral to borrow assets. As long as you have your tokens locked on Compound you gain interest on them (which differs per token and over time with the usage of each specific tokens), additionally you also gain the platform’s own COMP tokens as an additional reward for lending or borrowing. This means that Compound offers a thing for everyone, you can deposit your assets to gain interest on them overtime. Borrow assets to use as leverage or perhaps even lock in Ether or WBTC and take out USD, basically cashing out without selling your crypto just yet.
A deeper dive into Compound
When you supply assets to Compound you are adding to the pool of tokens on the supply side, and similarly when you borrow you are taking from that pool. More specifically, when you supply you get cTokens in return of your collateral. These cTokens are basically the proof that you own assets on Compound, and they are how you earn interest. Say you deposit 1000 USDC into Compound and let’s assume that currently 1 cUSDC is 1 dollar (meaning that 1 USDC = 1 cUSDC), you get back 1000 cUSDC. Now let’s assume the current interest rate is 5% and will remain at 5% for 1 year to simplify calculations. After 1 year you will still have 1000 cUSDC but can now withdraw 1050 USDC from Compound, this means that over the 1-year period cUSDC increased in price from $1 to $1.05 due to the interest rate, that is how interest is accrued on the platform.
Now let us look at the borrowing side. In order to borrow assets from the platform you must present a collateral so that you are not able to simply borrow money and run away with it. Each asset has a different collateral factor, meaning that each asset you supply can be used to borrow up to a percentage of its value. For example, USDC and ETH have a factor of 75% while WBTC has a factor of 40%, this means that if I deposit 1 ETH, I can borrow assets worth up to 0.75 ETH. Obviously cryptocurrency values change from time to time, this means that if your collateral drops in value (for example you are supplying ETH and borrowing USDC and ETH price falls) then you can be in risk of liquidation which I will talk about later in the article. When you borrow an asset, you need to pay back the original amount borrowed plus interest in order to unlock your collateral again, typical lending behaviour. You can then use the borrowed assets in any way you want, for example you can deposit ETH into Compound, withdraw USDC and use that to buy a new phone while keeping your original ETH and, due to the decentralised nature of Compound it also means that you are free to pay back this loan at any time you want at any pace you want with no additional penalties.
It is important to note that interest rates change dynamically over time based on supply and demand, the more an asset is supplied the lower the interest for supplying and borrowing is. The same applies for an increase in borrowing of an asset/decrease in supply, which increases the interest rate.
Compound tokens
Earlier I mentioned the COMP token and how it is supplied to users of Compound as an incentive. The Compound platform runs on a DAO, which is essentially like a decentralised governing body where users can vote on changes, additions or removals to the Compound platform. In order to vote you need to hold the platform’s COMP token. You can either acquire it by buying it from an exchange or by using Compound. Every Ethereum block that passes all users lending and borrowing on the platform gain some COMP, this means that if you are lending you gain interest on your asset plus an additional incentive in COMP, and if you are borrowing you are paying back interest but you also gain some COMP tokens which effectively reduces the interest rate on borrowing. You can either then withdraw these tokens to your wallet manually, or alternatively any action you take within the platform such as borrowing or repaying loans you are given your collected COMP if it is over the 0.001 limit.
What are the risks?
Naturally there is no investment without any risks involved, if there was one pretty much everyone would be rich, or you might gain only 0.001% from it. First off is the risk of liquidation which I mentioned earlier. Let’s take an example of supplying ETH to borrow DAI. You supply 1 ETH (which is currently around 400 USD), which means due to its collateral factor of 75% you can take out a maximum of 300 DAI. However, this might not be such a good idea. If the price of ETH falls down to 300 the next day then now your new max borrow limit is 225 DAI, but you already have borrowed 300 DAI. You are now in risk of liquidation, this means that any user on Compound can then come in, pay your debt of 75 DAI and take an equivalent amount of collateral from you + an additional amount for their efforts. In this example that would mean they would pay back your 75 DAI debt and take from you 0.25 ETH plus an additional amount that can range from 5-15% of the value of your debt, so they might take 0.3 ETH.
Of course, this is only the inherent risk of lending and borrowing and doesn’t apply if you only supply or leave a large room for liquidation (for example only using 50% of your borrow limit). As Compound is a smart contract on Ethereum it is susceptible to hacks like any other code. The contract has been audited by a number of large well-known auditing firms which adds confidence, however it is impossible to know if there are loopholes or bugs present in the code that no one has noticed, as such this is always a risk when dealing with smart contracts even if a small one at times.
Using Compound
Now it is time to actually understand how to use Compound and what you can do with it. To start out you will need a web3 compatible wallet, I recommend METAMASK (a browser extension available for most browsers), however, you are free to choose any wallet you prefer. You can then visit the Compound website and you will be greeted with the dashboard shown below.
On the right side you have the supply interest rates as well as the ability to use an asset as a collateral. Simply press on the collateral switch and after confirming a transaction you will be able to deposit the asset and borrow using your limit. Your borrow limit is shown as a bar under your balances, if it reaches 100% you are at risk of liquidation. On the right side you can borrow assets and repay them. Clicking on any of the assets gives you a more detailed overview of it. This includes COMP token returns, interest rate, how much you can deposit/withdraw and the ability to repay your debt. Below is the detailed overview for Ethereum both as a supplier and a borrower.
Note that for every asset you want to supply you will need to approve Compound to use it and turn on the collateral if you wish to use that. Once you select the asset you want to deposit, you can simply enter how much you wish to deposit and confirm the transaction through your wallet with a similar process for borrowing/repaying.
Thank you for checking out my newest guide on this hot DeFi platform with more coming soon.
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