DeFi protocols are experimental works in progress. Funds deposited into DeFi protocols in general can be at risk of smart contract vulnerabilities, malicious developers and hacks. DeFi Protocols are generally governed by token holders through a DAO (decentralised autonomous organisation).
In the traditional world of finance, users can deposit cash savings in a bank account and earn interest on the savings. However, for many cryptocurrency investors, the option to generate interest on cryptocurrency holdings has not been an option. This has often meant that cryptocurrencies sit in a digital wallet or on an exchange without yielding interest.
Thanks to advancements in decentralized finance (DeFi), the process of borrowing and lending, and therefore the potential to earn interest on cryptocurrencies, is now prevalent in the crypto space. Compound Finance is one such protocol.
Borrowing and lending with Compound is accessible to anyone anywhere in the world and requires no special permissions.
What is Compound Finance?
Compound Finance is a decentralized lending and borrowing protocol built on the Ethereum blockchain. Lenders can deposit funds in exchange for a return on their investment and borrowers can gain access to credit in exchange for depositing collateral. With the application of smart contracts and algorithmically adjusted interest rates, the system is frictionless, highly accessible and removes the cumbersome processes of traditional financial banking.
Launched in September 2018, Compound Finance has been thoroughly field-tested in comparison to newer DeFi protocols and holds a relatively high platform reputation. At the time of writing, the platform currently holds $9.1 billion worth of cryptocurrency assets.
It bridges the gap between those that wish to lend Ethereum-based, ERC-20 assets with those that wish to borrow them. In comparison to traditional banks, Compound Finance offers users interest rates far above the current global average.
Smart contracts are utilised to automate the process of borrowing and lending. This includes the storage and management of funds that are added to the platform. Interest rates are adjusted by an algorithm that increases or lowers rates based upon supply and demand.
The platform is accessible for anyone that has a Web3 digital wallet, such as MetaMask. In comparison to conventional borrowing and lending services, Compound requires no permissions and allows anyone to use the platform.
The native token to the Compound Finance protocol is COMP and is used to incentivize lenders and provide governance to the platform.
As the protocol is decentralized, Know Your Customer (KYC) data is not required. There are no penalties for withdrawing funds and no minimum or maximum limit on the time funds can be deposited onto the platform.
How to supply assets on Compound
To interact with the Compound Finance protocol, a user needs to have a Web3 digital wallet like MetaMask. This Web3 digital wallet acts as a bridge between the decentralized Compound application and the cryptocurrency assets that you hold. Aside from the cryptocurrencies you want to interact with, a user will also require a small amount of Ether (ETH) so that transactions on the Ethereum blockchain can be completed.
How to supply assets on Compound:
- Compound Finance. Head over to the Compound Finance website and choose App at the top right of the screen. On the following page, you will be prompted to connect your Web3 digital wallet. Select your chosen wallet and connect.
- Select an asset. Choose a cryptocurrency asset that you would like to lend. Choose the digital asset.
- Enable. In the pop-up screen of your chosen cryptocurrency asset, select Enable. This will allow Compound Finance to access funds in your digital wallet. A small transaction (gas) fee will be required at this step. Confirm the transaction via your Web3 digital wallet.
- Supply. Once enabled, supply your chosen cryptocurrency asset. Choose your chosen asset again. This time you will have the option to enter the amount you wish to supply. Enter the amount and hit Supply.
- Confirm. Review the gas fees and confirm the transaction via your Web3 digital wallet.
After lending, you will be able to view your supply balance and net annual percentage yield (APY) on the Compound dashboard. The net APY will be an average figure if you supply more than one cryptocurrency asset.
For deposited cryptocurrency assets, users will earn the associated interest rate (APY), which is dynamic and changes based upon supply and demand. Alongside the interest rate, lenders will also earn the native COMP token, which is distributed proportionally based on what percentage of the market that user is supplying. The higher the interest rate, the more COMP tokens that individual market will receive.
The COMP tokens can be withdrawn at any time to be cashed out or exchanged for other cryptocurrency assets.
Deposited assets can be used as collateral for any loan a user wishes to take out in the future.
Interest on supplied tokens is accrued using liquidity provider tokens, known as cTokens.
When lending assets with Compound, supplied assets are represented and tracked by tokens called cTokens. cTokens are Ethereum-based, ERC20 tokens that are minted and provided to a user when that user lends funds to the Compound protocol.
For example, if you deposited the stablecoin DAI into Compound, you would receive cDAI tokens back in your digital wallet.
They are liquidity provider tokens that ensure a user remains in control of their digital assets at all times. The tokens can be used at any time to withdraw your cryptocurrency assets.
cTokens represent the user’s proportion of the supply pool they have lent cryptocurrency assets to. cTokens accrue interest from the associated market, which means over time, the cTokens will be able to redeem more of the underlying asset than what was deposited. This is how lenders earn interest through Compound.
Because cTokens are in ERC20 form, they can be easily transferred on the Ethereum blockchain to other DeFi protocols. Because cTokens correlate to an actual asset, they are valuable to other DeFi protocols, which means they can be used to earn additional interest through other lending protocols.
How to borrow on Compound
When borrowing from Compound, aside from a Web3 digital wallet, the only other thing a user requires is the cryptocurrency to be deposited as collateral. Compound, like many other DeFi protocols, works on an over-collateralization basis, which means that the amount deposited as collateral must be higher than the borrowed amount.
For example, at the time of writing, the limit for most assets on Compound is currently 80% — which means a user can borrow 80% of what was deposited as collateral. If you deposited $100, you would be able to borrow a maximum of $80.
The borrowing limit is calculated automatically for users based on their deposited funds. The protocol won’t allow a user to go over that borrowing limit.
Thanks to the over-collateralization and the decentralized system, there’s no need for credit checks or income statements.
To borrow, a user must first supply cryptocurrencies to the platform. Please review the section on supplying assets on Compound above. A unique feature of Compound is that regardless of the asset supplied to the protocol, the user can borrow any other cryptocurrency asset.
How to supply assets to Compound:
- Connect. Head over to the Compound dashboard and connect your Web 3.0 digital wallet.
- Collateral. Cryptocurrency assets lent to the Compound protocol can be viewed in the Supply column of the Compound dashboard. Select the Collateral slider next to each deposit you wish to use as collateral.
- Enable. Choose Use X as Collateral. This will require a transaction confirmation via your Web3 digital wallet. This step will enable deposited cryptocurrency assets to be used as collateral against future loans.
- Select an asset. In the Borrow column on the Compound dashboard, choose the asset that you would like to borrow.
- Enter the amount. Enter the amount that you would like to borrow. On this pop-up window, you will see Borrow Limit Used. This is the maximum amount of the chosen cryptocurrency you are entitled to borrow based on the collateral you have supplied. Once you’re happy with the amount, hit Borrow.
- Confirm. Confirm the transaction through your Web3 digital wallet.
Once the transaction is completed, you will be able to see your Borrow balance alongside your Supply balance on the Compound dashboard.
The associated interest will be accrued to the Borrow balance total.
Liquidations and the borrowing limit
The Compound Finance protocol uses over-collateralization to ensure no KYC or credit checks are required by borrowers before they take out a loan. Over-collateralization means that a user must deposit more than the loan required. If a user cannot repay a loan, then the protocol can use some of the collateral to pay it off instead.
When borrowing through Compound, it is always advisable to stay well beneath your borrowing limit. The price of cryptocurrency assets can change quickly so the collateral provided to Compound may decrease in value against the assets borrowed. If this occurs and the borrowing limit is reached, the account will move into negative account liquidity or liquidation.
At this stage, Compound will sell some of your collateral to move the account back into positive liquidity. To avoid this scenario, it is always worth having a comfortable buffer within your borrow limit.
How to Repay on Compound
Once you have used the borrowed funds for the intended purpose, you will want to repay the loan so that you can stop being charged interest on it.
- Select an asset. On the Compound dashboard, select the asset associated with the loan that you would like to repay.
- Repay. Choose the Repay tab, which is alongside the Borrow tab.
- Enter the amount. To repay the entire loan, select MAX or else enter the amount that you would like to repay. Choose the Repay button at the bottom of the screen.
- Confirm. Confirm the transaction through your Web3 digital wallet.
Once the transaction has completed, your previously borrowed funds will disappear from the borrow section on the Compound dashboard.
What does the COMP token do?
The COMP token is the native cryptocurrency to the Compound Finance protocol. The token was launched in 2020 to incentivize the use of the platform and to decentralize governance.
Compound Finance is a decentralized protocol and is governed by holders of the native COMP token. COMP token holders can vote on items such as the direction of the platform, interest rate decisions and the development of additional protocols. This ensures no one entity has control over its use or development.
Alongside the governance use case, the COMP token holds value in its own right and is therefore an incentive for lenders and borrowers of the platform. COMP can be exchanged for other cryptocurrency assets at any time.
COMP tokens can be purchased via an exchange, or they can be earned through lending or borrowing on the Compound Finance protocol. Users that lend and borrow digital assets are rewarded a proportion of the daily minted COMP token that is proportionally distributed to users based on the amount held in the platform and the interest rates at the time.
Holders of the COMP token can view their balance either through their digital wallet or on the Vote tab on the Compound Finance dashboard.
Where to buy COMP
Use the table below to compare exchanges that sell the COMP token, or read our full guide about how to buy COMP.
Our verdict: Should you use Compound?
Compound Finance is a very easy, and extremely user-friendly platform for cryptocurrency investors looking to earn interest on their cryptocurrency holdings. Not only does it offer the option to obtain a return on investments but in comparison to traditional financial models interest payments can be significantly higher.
The platform is one of the oldest among the DeFi protocols and has a high reputation among users. Although highly reputable, the protocol still utilizes smart contract technology and is still integrated within the larger DeFi ecosystem, so the risks of lending with Compound should still be assessed. Even if slightly limited in variety, there are still plenty of popular cryptocurrency tokens for the average investor looking to put their assets to work.
Pros and cons
- Return on investment. Returns on deposits can be much higher when compared with traditional financial entities such as banks.
- Tried and tested. The protocol is one of the older DeFi protocols, launching back in 2018.
- Noncustodial. Users remain in control of their digital assets at all times, even when lending.
- No restrictions. There is no minimum or maximum amount of time assets can be lent or borrowed for.
- No KYC data. The protocol is completely permissionless, meaning no KYC or income statements are required for either borrowing or lending.
- Limited cryptocurrencies. There are currently only nine cryptocurrency options for both borrowing and lending.
- Smart contract risk. The protocol is heavily reliant on smart contracts, which are always at risk from technical bugs.
- Liquidation. Due to the volatility of cryptocurrency markets, liquidation events can catch users by surprise.
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