DeFi 101: Compound Money Market and cTokens

By Michael @ CryptoEQ | CryptoEQ | 7 Feb 2024

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Compound is an open-source, decentralized application (dApp) built atop the Ethereum blockchain that creates permissionless money markets with algorithmically set interest rates based on supply and demand. It enables users to lend and borrow various digital assets with no maturity dates or restrictions while interacting with a smart contract rather than a company. COMP is the native ERC-20 governance token for the Compound protocol. Holders of COMP may debate, propose and vote on all changes to the Compound protocol.

Compound is a DeFi project that aims to provide financial services like lending and borrowing without an intermediary like a brokerage or bank. The goal of Compound is to create a decentralized, robust money market. Though money markets already exist in the world of traditional finance, they continue to be an innovative addition to the world of DeFi. 

In contrast to the traditional legacy companies, which determine the creditworthiness of an applicant through credit history, job status, etc., Compound does not require any identifying information. In this way, Compound (and DeFi in general) democratize access to loans and remove the need for trusted third parties. 

The risk(s) behind a centralized exchange include a potential hack or seizure of funds. Compound presents a solution in which users can deposit the asset(s) of their choosing into a decentralized liquidity pool, held by a smart contract as opposed to a centralized third-party, that borrowers can then withdraw if they provide sufficient collateral.

Compound also allows users to earn interest on their owned assets (through the minting cTokens when a user lends a supported token), short assets, and acquire assets by providing enough collateral to borrow them. Users interact in a peer-to-pool fashion meaning lenders deposit similar assets into a common pool where borrowers can then deposit collateral and directly borrow. This approach enables each party can immediately earn interest or receive funds. However, the terms of the loan are subject to variable interest rates based on supply and demand, rather than a fixed interest rate.

Central to understanding these platforms is the concept of money markets as smart contracts that manage assets. At their core, money markets in the context of DeFi, such as those implemented by Compound V2, primarily involve two assets: the underlying asset (for example, Ethereum (ETH), DAI, USDC, etc.) and its tokenized representation, often referred to as a cToken.

The process involves depositing an underlying asset into a smart contract, in return for a cToken that symbolizes the ownership and value of the original deposit. This token's value fluctuates based on the smart contract's rules, offering a transparent and programmable approach to interest accrual. Unlike traditional finance mechanisms, which rely on intermediary trust, DeFi money markets operate on-chain, providing trustless transactions. This fundamental difference highlights the shift towards more transparent and secure financial operations, where code dictates execution, and liquidity levels are openly verifiable.

cTokens play a crucial role in this ecosystem. They are essentially ERC20-compatible tokens with added functionalities tailored for the DeFi environment. Users mint cTokens by depositing the corresponding underlying asset into the smart contract, engaging with the DeFi space's liquidity pools. The design of cTokens allows for their value to incrementally increase, reflecting accrued interest on a nearly per-block basis. Additionally, these tokens can serve as collateral for borrowing within the Compound system or be utilized in other DeFi protocols, showcasing their versatility.

Liquidation mechanisms within these markets safeguard the system's integrity. If a user's account liquidity falls below the required threshold, they become susceptible to liquidation. This process allows other participants to repay part or all of an outstanding borrow on the borrower's behalf, receiving a portion of the borrower's collateral at a discounted rate as incentive. The concept of account liquidity, which indicates the dollar value a user is eligible to borrow, and the collateral factor, a percentage dictating borrowing limits based on asset stability and liquidity, are crucial for managing risk and ensuring system stability.

An illustrative scenario can help elucidate this mechanism. Consider Alice, who deposits 1 ETH (valued at $1,000) into Compound, with a collateral factor of 90%. This grants Alice an account liquidity of $900. If Alice borrows $900 in DAI, her account liquidity becomes zero. A decrease in ETH's price would lead to negative account liquidity, triggering eligibility for liquidation. However, the system does not guarantee liquidation but rather incentivizes participants to monitor and act on liquidation opportunities for financial gain.

In summary, DeFi money markets, through the use of smart contracts and tokenization, offer a new paradigm in lending and borrowing that is transparent, secure, and efficient. The introduction of cTokens as both a representation of underlying assets and a functional tool within the ecosystem exemplifies the innovative approaches being adopted in digital finance. As these platforms evolve, they continue to challenge traditional financial systems, offering insights into the future of finance where trust is placed in code and operations are executed on-chain.

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Michael @ CryptoEQ
Michael @ CryptoEQ

I am a Co-Founder and Lead Analyst at CryptoEQ. Gain the market insights you need to grow your cryptocurrency portfolio. Our team's supportive and interactive approach helps you refine your crypto investing and trading strategies.


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