Understanding Compound, the DeFi Money Market Protocol

Compound, a decentralized finance protocol establishes money markets by algorithmically setting interest rates based on supply and demand

By · Aug 11, 2020 . 10min read

What is Compound

The advent of cryptocurrencies through Blockchain and Decentralized ledger technologies presents interesting opportunities. Asides from speculating on the price of digital assets by traders much more are possible. While traditional banks would not provide cryptocurrencies and digital asset owners loans using their holding as collaterals, solutions built on the blockchain can. The need for asset holders to earn interests from their holding exists. Also, a counterparty who may have this need necessitates a decentralized finance solution. This is why a frictionless borrowing of Ethereum tokens comes in handy. However, this must come without the rigidity of mutually negotiating competitive interest rates. To serve this need, a credible DeFi solution like Compound Finance exists.

What is Compound Finance?

Compound Finance is a DeFi money protocol for the easy borrowing and lending of cryptocurrency and digital assets without any middleman. In a nutshell, Compound, a decentralized finance protocol establishes money markets. And it does this by algorithmically setting interest rates based on supply and demand.

Who Invented It?

Robert Leshner started developing the Compound protocol in 2017. Consequently, he raised $25 million Series A round in November 2019 from Andreessen Horowitz, a venture capital firm.

How Does it Work?

Compound uses a smart contract, one of the applications of blockchain to

  • Provide liquidity,
  • Avoid credit risk and
  • Ensure frequent adjustment of interest rates

As earlier pointed out, interest rates are not mutually negotiated by borrowers and lenders on Compound. Consequently, it is not a peer to peer protocol. Also, as a lender (liquidity provider), you do not lend directly to a borrower. Rather, you provide liquidity to the Compound protocol, which acts as an aggregation pool. Therefore, this pool is secured by smart contracts and not human administrators.

As a Borrower, to use the Compound protocol, you need to deposit collateral. Accordingly, this collateral must be higher in value as when you compare with the value you seek to borrow. Hence, this ensures Compound removes counterpart risk. To get back your locked collateral, you must repay your borrowed amount.

As for Lenders, you earn interests for providing liquidity to the protocol. Interestingly, there is no set duration for the assets you provide as liquidity to the protocol. You can liquidate your asset any time without and there is no penalty for that.

What Makes Compound DeFi Money Protocol Special?

Compound, like other DeFi protocols, is a radical attempt at remedying some of the weakness of centralized platforms. These include banks as well as centrally controlled digital asset exchanges. Some of the interesting features of Compound includes:

  • Algorithmic interest rate fluctuations
  • No limit on lending and borrowing
  • No counterparty risk except for possible smart contract failure

In a nutshell, Compound’s high-interest rates for lenders, near-instant interest payments, absence of loan terms or penalties, and accessibility by anyone anywhere make it beats any centralized platform offerings. Subsequently, due to the varying interest rate, Compound makes a good case for financing short term loans.

However, to forestall any excess borrowing from the protocol, Compound algorithmically adjust interest rates. This happens in such a way that the higher the interest rate, the lesser the borrowing and vice versa.

How will DeFi Protocols like Compound drive the Future of Finance?

DeFi by design, promotes transparency. This is why it is also called Open Finance. It’s already one of the strongest use cases of blockchain technology. Evidently, DeFi’s explosion in 2020 is a clear testament that people and institutions see opportunities in it. From the high-interest rates, they get from lending to protocols and other opportunities. The curve is pointing upward and looking promising.

Compound DeFi Money Protocol users
Compound Users, Source: Dune Analytics

In fact, Compound recently introduced wrapped bitcoins opening more opportunities for lenders to unlock liquidity in crypto’s most establish coin.

Compound and a few other money market protocols are already bringing about a more transparent financial market. Unlike centralized financial institutions and systems, the governance of Compound protocol and many others are done by token holders. Governance token holders vote on proposals which may then be implemented if it gathers enough votes. Hence, if you must participate in the system, then you must have skin in the game.

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