Imagine you're at a party and you have a delicious tray of hors d'oeuvres that you'd like to share with your friends. You could go around the room and offer each person a bite, but that would be time-consuming and inefficient. Instead, you decide to set the tray down on a table in the middle of the room and let everyone help themselves.
This is a bit like how Compound works. Instead of each individual lender and borrower negotiating terms with each other, they can all deposit and withdraw funds from a communal pool. The pool automatically matches lenders and borrowers based on supply and demand, and interest rates are determined by the market.
In this article, we'll take a closer look at how Compound works, its advantages and risks, and how you can get started using this platform to lend and borrow your cryptocurrency holdings.
Review: What is Compound Finance?
Compound is a decentralized lending and borrowing platform built on the Ethereum blockchain. It allows you to earn interest on your cryptocurrency holdings by lending out to other people who need to borrow.
Unlike traditional lending and borrowing platforms, Compound is entirely decentralized, meaning there are no intermediaries involved in the lending process. This creates a trustless system where borrowers and lenders can transact directly with each other without the need for a centralized authority.
How Does Compound Work?
As we mentioned earlier, Compound works like a communal pool. When you deposits cryptocurrency into the pool, you receive cTokens in return. These cTokens represent the your share of the pool and accrue interest over time.
For instance, when you supply 100 USDC and the total USDC supply in the pool is 10,000 USDC, you would receive 100 cUSDC tokens, representing your 1% ownership of the USDC in the pool.
When people borrow from the pool and repay their loans with interest, the pool earns interest, which is distributed proportionally to cToken holders. This increases the value of cTokens, allowing you to earn passive income on your assets. When you're ready to withdraw, you can exchange your cTokens for the underlying asset plus any accrued interest, all while retaining full control and ownership of your assets.
Borrowers can borrow cryptocurrency from the pool by depositing collateral of their own. The interest rate on the loan is determined by the supply and demand for the borrowed cryptocurrency. If the value of the collateral drops below a certain threshold, the collateral can be liquidated to repay the loan.
Think of Compound like a giant potluck dinner. Everyone brings a dish to share, and everyone gets to sample a little bit of everything. Each dish represents a user's deposit into the pool, and each person's share of the potluck represents their cTokens. The more dishes there are, the more variety there is to sample. Similarly, the more deposits there are in the pool, the more assets there are to lend and borrow.
Advantages of Using Compound
- Wide range of cryptocurrency assets that can be lent and borrowed, including popular tokens like ETH, DAI, USDC, and more.
- Decentralized nature of Compound creates a more democratic and trustless system where you can transact directly with others.
- No minimum deposits: Unlike traditional lending platforms that require a minimum deposit, Compound allows you to start lending and borrowing with as little as they want.
- Transparency: Since Compound is built on the blockchain, all transactions are transparent and can be easily audited.
Risks of Using Compound
- Volatility of the cryptocurrency market: If the value of the collateral deposited by a borrower decreases significantly, it could trigger a liquidation event where the collateral is sold to repay the loan. This could result in the lender losing some or all of their funds.
- Smart contract exploit or hack: As with any DeFi platform, there is always the risk of smart contract exploits or hacks. While Compound has never been hacked, other DeFi platforms have experienced security breaches in the past.
- Overcollateralization: Borrowers need to deposit collateral that is more than the amount they are borrowing, which can limit the amount of funds they can access.
- Liquidation penalties: If a borrower's collateral drops below a certain threshold, the collateral can be liquidated to repay the loan. However, this can result in a penalty fee for the borrower.
As seen, the advantages of Compound Finance outweighs the risks of using it. However, It's important to note that the risks and advantages of using Compound can vary depending on individual circumstances and market conditions. As with any financial decision, it's important to do your own research and understand the risks involved before using any DeFi platform.
Getting Started with Compound Finance
Here is a step-by-step guide on how to get started with Compound:
- Choose a compatible wallet: Compound supports a variety of wallets, including MetaMask, Coinbase Wallet, and WalletConnect. Choose a wallet that supports the cryptocurrency you want to lend or borrow.
- Select the chain: You can select the chain amoung Polygon and Ethereum chain.
- Connect your wallet: Once you have chosen a wallet and chain, you will need to connect it to the Compound platform. This is done by clicking the connect wallet button on the Compound website and selecting your wallet from the list of available options. Follow the prompts to complete the connection.
- Deposit cryptocurrency: Once your wallet is connected, you can deposit cryptocurrency into the Compound Finance platform as collateral. Click on the supply button, select the cryptocurrency you want to deposit, and enter the amount. You will then be prompted to confirm the transaction in your wallet.
- Start earning interest: Once your cryptocurrency has been deposited as collateral, you can start earning interest on it. The interest rate will vary depending on the supply and demand for the cryptocurrency you have deposited.
- Borrow cryptocurrency: If you want to borrow cryptocurrency, you can do so by clicking on the borrow button, selecting the cryptocurrency you want to borrow, and entering the amount. You will need to deposit collateral that is worth more than the amount you are borrowing.
- Repay your loan: When you are ready to repay your loan, simply click on the repay button and enter the amount you want to repay. You can also choose to repay part of your loan if you don't want to repay the full amount at once.
- Withdraw your funds: If you want to withdraw your funds from the Compound platform, click on the withdraw button, select the cryptocurrency you want to withdraw, and enter the amount. You will need to wait for the transaction to be confirmed before the funds are available in your wallet.
It's important to note that the process of lending and borrowing on Compound can be complex, and there are risks involved. It's important to do your own research and understand the risks involved before using any DeFi platform.
Compound is indeed a game-changer for the world of cryptocurrency finance. By creating a trustless system that allows you to transact directly with each other, Compound is challenging the traditional financial system and paving the way for a more decentralized future. While there are risks involved in using any financial platform, the advantages of using Compound make it a compelling option for those looking to earn interest on their cryptocurrency holdings.
Frequently Asked Questions
1. What types of cryptocurrencies can be used on Compound?
Compound currently supports a variety of cryptocurrencies, including Ethereum (ETH), Wrapped Bitcoin (WBTC), and USDC. Here you can get complete market overview of Compound finance.
2. Is there any risk involved in using Compound?
Yes, there is risk involved in using any DeFi platform, including Compound. The value of cryptocurrencies can be volatile, and there is a risk of losing money if the value of the collateral falls below the amount of the loan. Additionally, there is a risk of smart contract bugs or exploits that could result in the loss of funds.
3. How can I get help with borrowing on Compound?
4. What is the Compound Finance Token and what is its use case?
Compound Finance has its own governance token, COMP, which can be used to vote on proposals within the community. You maybe interested in participating in Compound Finance governance, you can learn how to do so here.
5. What is team behind Compound Finance?
Compound Labs is company behind Compound finance platform. In 2017, Compound was founded in San Francisco by Robert Leshner and Geoffrey Hayes. Leshner serves as the CEO of Compound Labs, while Hayes is the CTO. Today, the company continues to call the City by the Bay home sweet home.