From mortgages to personal loans and leveraged trading of assets, lending is an important function of the traditional financial system. Likewise, lending and borrowing are essential functions of decentralized finance (DeFi) meant to perform a similar function but without the reliance on centralized third-parties.
With its introduction in 2018, Compound Finance was one such lending and borrowing protocol. While banks and traditional capital markets allow governments, businesses, and individuals to borrow and lend fiat money, Compound connects those who want to lend their crypto assets with potential borrowers via its smart contracts.
Compound’s native token, COMP, is used to govern the platform and as a medium of rewards for using its lending and borrowing services.
How was Compound developed?
Compound was first launched in September 2018, founded by University of Pennsylvania graduates Robert Leshner and Geoffrey Hayes. Leshner has a degree in economics and now serves as the CEO of the San Francisco-based Compound Labs, while Hayes has a background in engineering and computer science and serves as CTO.
Compound has gone through significant changes with each of its updates since 2018, demonstrating an active community and developer culture. In May 2019, a second version of the protocol (Compound v2) was released, and this was followed three years later by Compound III (also called v3 or Comet) in August 2022.
Throughout its existence, Compound Labs has received nearly $71 million in funding from multiple venture capital sources, including Andreessen Horowitz.
How does Compound work?
As one of DeFi’s oldest lending and borrowing protocols, Compound began with a relatively straightforward model of lending pools. In this model, lenders supply assets into a pool, and borrowers can withdraw those assets as loans—as long as the loans are adequately collateralized by the borrower’s deposits into the platform. Each asset was contained in its own pool (i.e. one pool for ETH, one for UNI, one for COMP, etc.).
Because borrowers cannot withdraw more than their deposits, the loans they take are considered overcollateralized. This protects lenders from default (when borrowers can’t or don’t make their required payments on debt).
Overcollateralization is a key component of DeFi and is what allows decentralized lending/borrowing to be trustless.
Compound v2 and Compound v3
Compound v2 introduced two important new features to the platform:
- COMP – Compound’s token allowed for community governance of the platform and was also used to incentivize deposits, lending, and borrowing.
- cTokens – When users deposited assets (like LINK) into Compound v2, they received cTokens (like cLINK) in return. These allowed users to benefit from collecting interest at the specific market’s rates and turn and use cTokens as collateral in other DeFi protocols.
Compound v3 converted Compound from a market of many assets to a market of one base asset, setting it apart from other lending/borrowing protocols like Aave. This means that when users deposit crypto collateral (like ETH, LINK, UNI, or COMP), they can borrow up to a percentage of their deposit value only in the USDC stablecoin. Using one base asset makes the process of taking out loans more capital efficient and reduces risks of exposure to multiple potentially volatile assets.
Users who provide loans to borrowers in USDC can earn rewards on their holdings, and the reward rate is set by governance and is subject to change based on market conditions. The interest paid by borrowers of the base asset conforms to similar rules.
Additionally, extra rewards may be offered to lenders and/or borrowers (in the form of COMP tokens) depending on market conditions.
Borrowing and liquidation
Compound’s stability relies on loans being overcollateralized. When loans exceed their collateral backing, users can get liquidated. This means the network will “absorb” the borrower’s collateral and returning a percentage of that collateral back to them in the form of the base asset, minus a fee (the liquidation penalty). Through this process, a borrower loses some of the original value of their collateral but is not left entirely empty-handed. Lenders are thus protected from borrower defaults.
When borrowing crypto through Compound, the platform’s borrowing specifications for each type of collateral include:
- Oracle price – the quoted price of the collateral, according to Compound’s oracle.
- Collateral factor – the portion of the collateral that can be borrowed against. For instance, if the collateral factor for ETH is 83%, then if you deposit 100 ETH you can borrow USDC up to an equivalent value of 83 ETH.
- Liquidation factor – the level at which a borrower can have their collateral liquidated. For instance, if the value of the above example’s USDC loans exceeded 90 ETH (liquidation factor of 90%) due to fluctuations in price, the user could get liquidated.
- Liquidation penalty – the fee a user pays to the protocol for being liquidated.
How is the COMP token used?
Compound’s platform token, COMP, conforms to the ERC-20 standard used by all assets on the Ethereum blockchain.
COMP is primarily used to govern the protocol through proposing and voting on changes to the platform. The protocol also provides COMP as an incentive for using the system, such that users collect distributions of COMP tokens according to how much they are lending or borrowing.
There is a maximum supply of 10 million COMP tokens. Of these, 42% of tokens will ultimately be distributed to users of the platform over time, 26% were allocated to the founders/team, 24% were promised to investors/shareholders, and 8% were reserved for the community and governance incentives. The tokens allocated to the founders/team and investors/shareholders are subject to a release schedule over the course of four years, ending in June 2024.
- Compound was introduced in 2018 as a novel decentralized lending and borrowing platform which has since gone through two major updates
- The platform’s most recent version, Compound v3, allows borrowers to supply collateral in the form of multiple cryptocurrencies but borrow only one (for instance, USDC)
- The COMP token is used for governance and to incentivize use of the platform