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DeFi 101: What is Compound and How Has It Lasted So Long?!

By Michael @ CryptoEQ | CryptoEQ | 10 Oct 2023


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Overview

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.

Use Case

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) democratizes access to loans and removes 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.

For example, if a borrower wants to acquire ETH tokens then they are able to borrow 80% of what has been deposited as collateral. The protocol erases some of the outdated practices of traditional financial institutions, such as checking a user’s credit score, creating an interest rate, and centralized regulations that govern our current financial system. Compound’s borrowing and lending protocol are built on top of the Ethereum blockchain. In Compound’s whitepaperRobert Leshner (CEO and Co-Founder) and Geoffrey Hayes (CTO and Co-Founder) explain that each money market is uniquely attached to an Ethereum asset such as an Ether, Dai, or an ERC-20 utility token. This allows for a transparent and public ledger with a record of all the transactions made and previous interest rates established. Compound calculates the interest rate with an algorithm of supply and demand economics within the platform, so it fluctuates quickly over a period of time. The suppliers and borrowers of any asset interact directly with the protocol by earning or paying an interest rate, without the intermediary step of negotiating terms, “such as maturity, interest rate, or collateral with a counterparty”. Compound uses smart contracts in order to fulfill these processes. The three primary use cases for dApp consumers, traders, and developers are explicitly listed in the Compound Whitepaper

  • Without having to wait for an order to fill, or requiring off-chain behavior, dApps can borrow tokens to use in the Ethereum ecosystem, such as to purchase computing power on the Golem network.
  • Traders can finance new ICO investments by borrowing Ether, using their existing portfolio as collateral.
  • Traders looking to short a token can borrow it, send it to an exchange, and sell the token, profiting from declines in overvalued tokens.

These capabilities allow for a decentralized system in which frictionless borrowing of Ethereum tokens can create a safe and vibrant community for storing assets. 

Along with the Compound protocol, the team released the Compound token (COMP) in 2020. Whenever a user interacts with the Compound protocol, whether it is borrowing or lending, they earn COMP tokens. The token allows users to engage with the protocol by voting on future proposals or delegating votes to the user who they choose, which is discussed in greater detail in the Governance section. 

History

Compound v1: The Beginning

  • Purpose: Served as a proof-of-concept to establish the viability of a money market on the Ethereum platform. Emphasized on simplicity.
  • Features:
    • A single contract (MoneyMarket.sol) that handled lending and encapsulated all functionalities.
    • The treasury, accounting, and risk management (like collateralization checks) were united under one contract.
    • Pricing was fetched from oracles, but interest rates were determined by asset utilization.
    • Users interacted only with this unified contract.

Compound v2: The Yield Farming Pioneer

  • Launch: May 2019.
  • Objective: Functioned as a money market, where users could both lend and borrow assets.
  • Distinct Features:
    • Emphasized the use of the ERC20 standard for lending positions, promoting composability and enhancing interaction with other decentralized applications.
    • Introduced individual treasury contracts for each asset, decentralizing the treasury function.
    • Introduced cTokens to represent lending positions.
    • A singular contract, the Comptroller, maintained and executed risk management guidelines.
    • Separate interfaces were used for price and interest rate oracles.
    • Users needed to interact with multiple contracts for borrowing.

Compound v3 (Comet): Safety and User Experience

  • Launch: 2022.
  • Objective: A focus on improved risk management and optimizing gas costs. Aimed at creating a more user-friendly platform.
  • Distinct Features:
    • Introduced individualized liquidity pools for each borrowable asset to safeguard against oracle-based attacks.
    • Revamped the risk management and liquidation mechanics for enhanced safety and borrower experience.
    • Segregated interest rate models for both lending and borrowing.
    • Only lent assets were borrowable; collateral assets were off the table. This provided a security blanket for the depositors, reducing the risk of malicious attacks or governance discrepancies affecting collateral.
    • No returns on collateral deposits, possibly as a measure to ensure application safety after achieving significant liquidity in v2.
    • From a structural perspective:
      • Each money market became its own contract complete with treasury, accounting, and risk management.
      • Assets were spread out across the platform.
      • Borrowing and lending interest rates were determined internally, relying only on external price feeds.
      • Core operations like supplying, withdrawing, borrowing, and repaying were streamlined. For example, to withdraw a borrowable asset implied borrowing, while supplying it indicated either repayment or lending, contingent on the user's debt standing.
      • A new routing contract facilitated multiple operations in a single transaction, ensuring efficiency and reduced gas costs.

In Summary: Compound's journey from v1 to v3 showcases its adaptability and responsiveness to the evolving DeFi landscape. While v1 kept it simple, v2 pushed the boundaries by pioneering yield farming and tokenized lending. With v3, Compound went back to the drawing board, emphasizing safety and user experience while integrating lessons learned from its predecessors. This trajectory demonstrates not only the evolution of a single platform but also the broader progression of DeFi as an industry.

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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.


CryptoEQ
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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