Decentralized finance (Defi) is arguably the most promising application of Ethereum blockchain, and Compound Defi protocol is taking advantage of this potential. With Defi services, users are granted access to multiple financial services that were previously offered by banks and other traditional institutions.
Defi platforms like Compound leverage the features of smart contracts to offer accessible decentralized alternatives. This is the reason, it often refers as open finance. Some of the best-known uses cases of decentralized finance include lending protocols, decentralized exchanges, stable coins, and payment networks.
In traditional banks, once you have deposited your money, you can only earn interest but cannot use the money in any other way. Think about a situation where you can spend the money on your savings while still saving the money. This is exactly what Defi is trying to offer to its users. Compound Defi protocol is one of the companies working on providing such services.
In this article, we will explore how this Ethereum based project is trying to allow people access to their savings.
Compound Defi protocol is a lending protocol that runs on the Ethereum blockchain. It is a pooled algorithm money market protocol. Like other Decentralized Finance (Defi) protocols, Compound Defi protocol is a network that is an open-source smart contract.
The focus of the Compound is to allow borrowers to access loans and lenders to provide loans. The Compound is able to achieve this by locking their crypto assets into the protocol. Each crypto-asset determines the demines the interest rate. Every mined block generates an interest. Borrowers can pay back the loan at any time, while assets can also be withdrawn in the same manner.
The Compound decentralized fiancé protocol also has a native token (cToken) that allows users to earn interest on their money. Users can also transfer, trade, and use the money in other applications. On the surface, you may think that the Compound is completely designed like other Defi protocols. The Compound protocol differs in the tokenization of assets locked in the system. We will talk about the cToken later on in this article. The Compound protocol is completely open; hence there is no need for any paperwork or intermediary.
If you have an Ethereum-enabled wallet, you can be part of the Compound market. The Compound provides users with three main services:
As a market player on Compound, you are not guaranteed a fixed interest because there is no duration to your participation. As a lender or borrower on the platform, you can only know what the interest rate is at that moment. The interest rate can change at any point. The design of the Compound protocol ensures that there is no counterparty risk. However, it would be best if you didn’t forget that there is also the risk of code vulnerabilities.
When we consider the interest rates on the Compound, we will undoubtedly see an interesting pattern. On the platform, it is obvious to see that it is attractive to supply Dai, Sai, or USDC stable coins compared to other crypto assets. By supplying Dai, you could earn an interest of up to 8% every year. This is contrary to the paltry 0.01% interest you earn when you supply Ethereum.
It is glaringly to us that stable assets are the most desirable assets to supply on the Compound protocol. If you borrow volatile assets on the Compound protocol, the amount you will have to repay becomes more uncertain. Therefore, you will have to consider both the unstable interest rates and the volatile value of the crypto asset. Hence, making a prediction on your repayment would be very tricky, if not difficult.
The Compound tokens (cToken) are ERC-20 tokens that represent a user’s fund deposit on the Compound protocol. When a user puts another ERC-20 coin like the USDC in the protocol, the user gets an equivalent amount of cTokens. For instance, when you lock up USDC in the protocol, it generates cUSD tokens. These cUSD tokens automatically earn interest for you.
Whenever you want, you can redeem your cUSDC for the normal USDC, including the interest paid in USDC. The cTokens act as twins of the original Compound token. When a user supplies Dai or any other crypto assets to the Compound protocol, their balance will be represented in cTokens. This is how the interest rates are calculated on the Compound Defi protocol.
For example, when Dai gets supplied to the Compound protocol, the wallet is represented in cDai. Meanwhile, the interest is represented by the Dai token, which increases in price relative to Dai. All the received Dai tokens will be pooled together by the Compound’s smart contract. Over time, the exchange rate between cDai and Dai increases, just as the total borrowing balance also increases.
When a user withdraws his/her balance from the Compound protocol, the process automatically converts cDai into Dai at the current rate. This transaction also includes the additional interest rate. The cTokens always appreciate their counterparts.
Although Defi implies that there is no single point of failure, however, that is not practically the case, all decentralized finance (Defi) projects are developed by companies who also retain full control of the smart contract development. By a simple flip of a switch, the entire protocol can be turned off, and the Compound is not excluded.
The idea behind such a scenario is to have failsafe in situations like unexpected blockchain forks, black swan events, and smart contract hacks. However, Defi with all its highlighted flaws is far better than traditional financial institutions. Recently, Compound announced the release of a new governance token (COMP), which aims to remove the largest point of failure in the protocol. The Compound team is seen as the largest point of failure in the system, and anyone with at least 1% of the total COMP token can vote for proposals. These proposals are executable code that is subject to a three-day voting period.
The fact that Compound aims to have a zero counterparty risk means that borrowers will have to deposit collateral before borrowing from Compound. The ability to maintain excess collateral ensures that there is a near-zero chance of a borrower defaulting with payment.
For example, if you want to borrow Dai, you will have to deposit ETH as collateral. Each borrowing position is over collateralized; therefore, the value you borrow will be less than what you will deposit. Meanwhile, the underlying collateral is also volatile and could drop below a certain threshold. If it drops, the smart contract trigger will close the position (liquidation).
In this instance, the borrower gets to keep the borrowed asset but loses the collateral. For a user to get back his/her collateral, the user will have to repay the credit, and that includes the outstanding interest.
It is akin to a typical cash account where you earn by leaving your money in the bank. In Compound, you will need to deposit your crypto asset before you can earn interest. You can withdraw your asset at any time since there is no duration lock, and you won’t get penalized.
Compound Defi protocol wants to help you have more control over the money you save and earn. Although the Compound project has its shortfalls, the long-term goal is to become completely decentralized.
To learn about DeFi Categories, read our article on Decentralized Finance Categories Explained.
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