Compound is a Defi protocol that has attracted a large number of new users since its launch in 2018. It is a decentralized application (DApp) that works on top of the Ethereum network. The platform works by letting users contribute or deposit crypto funds into a liquidity pool in order to earn interest on their assets. Users can currently use 14 different cryptocurrencies and the top three markets in Compound are USD Coin, Dai  and Ether. 

Compound allows users to seamlessly lend, borrow, and earn interest in cryptocurrency. If you lock in your crypto funds with the platform, you can pocket increasingly lucrative returns with compounding interest (hence the name). For example, if you lent ETH to Compound’s pool of funds, you would begin to see interest accrue in the form of ETH almost immediately. This idea is identical in nature to holding your funds in a high yield savings account at a bank. Yet instead of routing through banks, the system is entirely peer-to-peer (P2P). 

How Does Compound Work? 

Compound automates the process of matching lenders and borrowers by combining crypto funds into pools of liquidity. To offer a visual metaphor, Compound users each contribute their coins to a jar (the pool) and other users who require funds now can borrow coins from it. Eventually, the borrowers will need to put the coins back into the jar, with additional interest. Compound will reward those who placed their coins in the jar by transferring the earned interest into their wallets. 

This automated process is possible thanks to smart contracts that are built into Compound’s native cTokens. Each time users lock in funds with Compound, the platform will temporarily convert their holdings to cTokens that represent the value of the crypto they put in and therefore their stake in the pool. 

These cTokens act like a contract at a bank, through which borrowers and lenders agree to the terms of the transaction. However, the Compound protocol shortcuts many of the processes associated with taking out a traditional loan. Users don’t need to sign papers or to formally apply for the loan; the contract terms are coded into the protocol and cTokens. Decisions, e.g. how much interest is rewarded, are based on these predetermined smart contracts. 

Removing these barriers begs the question: what happens if I don’t repay my loan? There are no authorities involved and there would be no one coming to seize the crypto or penalize you. So why wouldn’t everyone borrow crypto from Compound and never pay it back? The answer is that to take out a loan on Compound, you must “overcollateralize” your loan. This means you need to have more funds locked in with Compound than your loan is worth. The only party that would take a loss from not paying back the loan would therefore be the borrower. That is why Compound doesn’t require any identity verification or other documentation from its users. If you decide not to repay your loan on Compound, the automated contract will simply subtract the value of the loan from the value you hold in Compound as collateral (which, as noted, can never be less). 

The idea behind this is similar to trading on margin. You wouldn’t be able to borrow money to trade on an investment platform if you had an account balance of zero. In this case, if the value of the trade dips below a certain amount, your position is closed and your collateralized funds liquidated (as in a margin call). As anyone who has spent time investing in cryptocurrency may know, the value of your crypto loan may at some point drastically decrease, due to price volatility. This can drastically and suddenly affect the value of your loan.   

What Makes Compound Unique? 

It may be clear to you by now how Compound can help you to benefit from earning interest or borrowing without using a bank but how is it different from other DeFi protocols? By now there are hundreds of liquidity protocols and DeFi apps out there, including Uniswap, Aave, Maker, Curve, Bancor and SushiSwap. They each offer unique solutions to users, so what sets Compound apart? 

Definitive Yields. The make or break moment for many cryptocurrencies seems to rely on how well they can simplify and maximize what they offer. Compound has made what it offers as simple as possible and has advertised it effectively. It was helped in thisby a new major investor: Coinbase. Compound was able to make users aware that they could earn attractive interest on the crypto holdings they had laying dormant, just like with a traditional savings account. 

But What Role Does the COMP Token Play? 

Like with other DeFi protocols, COMP acts as the native crypto and governance token for the Compound platform. COMP tokens enable their holders to vote on the platform to determine the future direction of Compound. All COMP holders can also get an inside look at the platform’s protocol, treasury and other inner workings of the ecosystem. 

Conclusion

Compound is a solid DeFi protocol and is competitive in the emerging field of decentralized liquidity yield farming. Over the next few years, we’ll see where Compound ends up by coin market cap. On the basis of its concept, design and backers, it should be well poised to remain a strong player.

DISCLAIMER

The contents of this article are for information purposes only and do not constitute an advice or a legal opinion and are personal views of the author. It is based upon relevant law and/or facts available at that point of time and prepared with due accuracy & reliability. Readers are requested to check and refer relevant provisions of statute, latest judicial pronouncements, circulars, clarifications etc before acting on the basis of the above write up.  The possibility of other views on the subject matter cannot be ruled out. By the use of the said information, you agree that we are not responsible or liable in any manner for the authenticity, accuracy, completeness, errors or any kind of omissions in this piece of information for any action taken thereof. CA Mitesh and Associates is Mumbai's leading Cryptocurrency Taxation Firm which is committed to helping people navigate complex tax laws and banking regulations. Our main aim is to assist the individuals with applicable laws & regulations compliance and providing support at each & every level to make sure that they stay compliant and grow continuously. For any query, help or feedback you may get in touch here - Appointment with CA. Please note the all consultations with the CA are Paid consultations.

CMS meta: