What is Compound (COMP)? — All about the DeFi Lending provider
By: Lukas Wiesflecker
Tags: Compound, Investing, Defi, Technology, Lending

Decentralized Finance (DeFi) has become a household name for everyone this year at the latest, thanks to Compound. The lending protocol got off to a flying start with the launch of its own governance token COMP, rising several 100% in a concise period of time to rank #1 among all DeFi tokens.

The dominance of MakerDAO seems to be over for now, but what is actually behind the project? How can you earn money with Compound? How do users achieve returns of 100% and more? What is behind the DeFi app, the COMP token, and the dangers of being aware?

We provide you with answers to the most important questions about the DeFi and Lending Highflyer in our “What is Compound” knowledge article.

What is Compound — explained

The compound is a DeFi protocol that runs on the Ethereum Blockchain using smart contracts. The principle is explained, as the focus of the project is on lending and borrowing cryptocurrencies. Behind it is nothing more than lending and borrowing Ethereum-based tokens (ERC20).

To lend his tokens (Lending / giving loans), the user receives interest and can also earn COMP tokens. Lending (borrowing) cryptos are also rewarded with COMP tokens, but more on that later. The interest rates are variable for both sides and are based on the supply and demand of the deposited cryptocurrency.

The advantage: Compound runs 24/7 and is therefore always available, unlike a bank. Besides, the deposited cryptocurrencies can be paid out at any time, just as a loan can be repaid.

So, in summary, Compound is a liquidity pool for loans on the Ethereum Blockchain, where users are motivated to use the protocol through interest and issuance of the COMP token.

The history and brains behind the project

Compound Finance is a startup based in San Francisco. The project triggered a lot of hype on DeFi this year. However, the fact that the COMP launch was probably such a success is no mere coincidence. After all, in 2018 and 2019, the project raised a total of USD 33.2 million through funding rounds, so that the founders and developers were already provided with sufficient liquidity for the actual development work. However, the investors themselves are also exciting:

Andressen Horowitz, Polychain Capital, Coinbase Ventures, and Bain Capital Ventures invested in the young startup. Coinbase, in particular, triggered the run on the tokens with its subsequent COMP listing.

The brains behind the company are CEO Robert Leshner and CTO Geoffrey Hayes, who have already jointly and successfully built companies and bring experience from the financial industry.

How does Compound work?

As explained in part above, Compound works on a simple principle that we know from banking: Because similar to a bank, I can deposit my money (= cryptocurrencies) in my account and receive an annual interest rate for it. The principle can thus be compared to a checking or call money account, although the interest rates are significantly more attractive in the case of Compound.

However, the big difference to a bank is the custody because the company Compound Finance does not manage any cryptocurrencies. Everything takes place via smart contracts on the Ethereum blockchain. This eliminates the middleman, and the control and responsibility (!) over the assets remains with the user.

This is where the term “Decentralized Finance” (DeFi) comes from. Because DeFi protocols often map applications from the “real” or centralized financial world onto the blockchain, making them accessible to everyone. Compound focuses on lending, which we refer to in English as lending and borrowing.

But before we look at how you can make money with Compound, we need to understand how the protocol works and what role the COMP token plays in it.

The COMP Token and Governance

The COMP Token plays a central role in the Compound ecosystem and forms the core of the decentralized autonomous organization (DAO) that governs the protocol. Each COMP Token reflects voting right in the organization, which decides the future of Compound in proposals. The principle of 1 COMP = 1 vote applies.

Whoever therefore combines many COMP and thus many voting rights, decides, for example, on:

Interest rates

Collaterals (security, the minimum amount of the deposited credit sum)

Admins

COMP distribution

and many other parameters and variables of the protocol

Thus, it follows directly that all the above parameters are flexible and can be adjusted at any time by DAO’s change proposals.

Proposals — decisions in the protocol

To propose, i.e., a change proposal for Compound, one must hold at least 1% of the COMP tokens in circulation. The proposal must then be voted on within 3 days. In doing so, each person with a vote (i.e., at least 1 COMP Token) can decide for or against the proposal. If at least 400,000 votes are cast for the proposal, the change will be implemented after another 2 days.

IMPORTANT: A proposal is a direct change to the code and not a vote for an idea implemented by the Compound Team.

Polychain Capital currently holds most COMP (voting rights). For an overview of all proposals and voting distribution, we recommend the Compound’s governance page.

The COMP distribution

In total, there will be 10 million COMP tokens, of which 4,229,949 COMP will be distributed to users over 4 years. It kicked off on June 15, 2020, with 0.5 COMP per Ethereum block (2,880 per day) flowing into the hands of users of the protocol since then. All active markets, weighted by their interest rate, receive a portion of this payout in the process. As mentioned above, both lenders and borrowers get shares of this distribution. Thereby there is an equal weighting (50:50). The principle of receiving not only the interest rate but also the tokens of a certain project is to yield farming.

Graphically, this looks as follows:

IMPORTANT: The other part of the 10 million COMP tokens belongs to investors and the team. These tokens are partially protected by lock-ups but could certainly put selling pressure on the price.

This happened, for example, after the COMP listing on Coinbase. The team sold part of its own tokens.

cTokens and interest on Compound

We now know that you can earn interest for lending cryptocurrencies on Compound and even get COMP Tokens as a bonus. This certainly raises the question of how this process works in detail. We would now like to explain this question in the following. An important component for this are the so-called cTokens.

cTokens are nothing more than a computing unit for the compound protocol. When a user provides cryptocurrency to the protocol, cTokens are used to keep track of the funds they lend and any interest earned. Each time a user provides funds to the lending pool, they receive a corresponding balance in cTokens.

Each asset has its own cToken. For example, when a user lends DAI for the protocol, they receive a corresponding balance in cDAI.

cTokens are ERC20 tokens, which means they can be viewed on Etherscan at any time and can also be stored in Ethereum wallets such as Metamask. It also makes them easy to use on various other platforms.

In summary, cTokens securitize your share in the corresponding lending pool of a particular cryptocurrency and thus your right to interest. Since they represent the value of an underlying cryptocurrency, they belong to the category of derivatives.

After all the theory, let’s illustrate this with a practical example.

Here’s how cTokens work — An example

Let’s say you send 1,000 DAI to the compound protocol when the exchange rate is 0.020070. You would then receive 49,825.61 cDAI (1,000/0.020070).

A few months later, you decide it is time to withdraw the DAI from the protocol. The exchange rate is now 0.021591: your 49,825.61 cDAI is now equal to 1,075.78 DAI (49,825.61 * 0.021591). Thus, you have earned 75.78 DAI in interest.

So, if you want to withdraw your DAI again, you redeem the amount of cDAI you want into DAI and transfer the DAI back to your Ethereum Wallet.

How do I set up Compound? — The quick guide

Let’s get to the exciting part that we know how Compound works and what role tokens play. So, let’s take a look at how you can earn money with Compound now in specific. Setting up Compound is actually very easy because that’s what makes the new DeFi protocols stand out.

Connect Ethereum Wallet to Compound

As mentioned earlier, the Compound protocol works on the Ethereum network. So, to get access to the dApp and its features, you need an Ethereum wallet that can communicate with Compound. For this, we recommend Ledger hardware wallet, Metamask (browser extension), or Argent (smartphone app), for example.

Once you have the services set up and Ethereum or other ERC20 tokens on the wallet, you can get started right away. If you use Argent, everything runs through the app on your phone. With Metamask, you can use the browser extension and connect your wallet to the Compound page protocol.

Lend or borrow cryptocurrencies

In the next step, you can start earning interest or borrow cryptocurrencies. To do this, you have to decide whether you want to lend tokens (Supply Market) or borrow them (Borrow Market). Then select the cryptocurrency you want and follow the instructions in the browser or on the app.

For our example, let’s assume that you want to lend DAI. Next, select the amount you want to deposit. Before you approve the loan, you will also see the expected interest per year. Keep in mind that this is only a snapshot. The interest rates vary and can be adjusted.

You will then be redirected to your connected wallet, where you sign your transaction and transfer your tokens to the compound protocol. As described in the “cTokens” section, you will then receive your cDAI using DAI as an example.

You can either claim the COMP tokens earned in addition to the interest yourself in the voting area or have them automatically paid out to your Ethereum wallet later with your withdrawal.

What cryptocurrencies does Compound support?

The compound, meanwhile, supports 8 cryptocurrencies that you can lend or borrow. Among them are Ethereum (ETH), of course, the stablecoins DAI (DAI), Tether (USDT), and USDC, as well as Augur (REP), 0x Token (ZRX), Basic Attention Token (BAT), and Bitcoin in the form of Wrapped Bitcoins (WBTC).

Bonus: 100%+ Annual Interest through COMP Yield Farming

For most of you, the focus is certainly on the yield that can be earned on Compound. DeFi protocols make it possible to earn a passive income on the cryptocurrencies held. These returns are often significantly higher than those from the traditional financial market. The background is not only the elimination of middlemen but, of course. Also, the enormous risks behind it, whether DeFi or classic financial market: An increased risk always accompanies an increased return. In the next section, we will go into more detail on this point. But first, let’s turn our attention to maximizing returns:

The best way to achieve the maximum return with compound is to take advantage of the protocol. This is what we call yield farming. Because with Compound, in addition to the interest for lending cryptocurrency, you can also earn the COMP token. This increases the yield even more, especially when the token performs as outstandingly as it did at the start in June.

However, it can get quite complicated because tricks can quickly increase the return from COMP and interest to 4–5 times. For example, one could deposit USDC and then borrow USDT. You then convert that to USDC and deposit it at Compound, use it there, and withdraw the USDT again.

What are the risks of Compound and DeFi?

The strength of DeFi protocols is their decentralized nature. At the same time, this is also one of their biggest weaknesses because if there is a bug in the smart contract, your funds are at risk. This has already happened with many DeFi protocols in the past and proves how much the sector is still in its infancy.

The dangers are hard to assess or evaluate for the ordinary user, making the DeFi platforms with their attractive interest rates a big challenge, especially for beginners. Therefore, you should always invest only what you are willing to lose. There are insurances for losses caused by possible hacks, but the complexity for the ‘simple’ user is still high even here.

Other threats include:

Base layer risk (Ethereum 2.0)

Errors in the economic design of a protocol (keyword governance)

User error

Bubble formation

High transaction fees

On top of that, Compound also offers its own risk: the liquidation clause. If you borrow money on the platform, you must post collateral. If the value of your borrowed cryptocurrencies exceeds your collateral due to price increases, liquidation may occur. Here, other users can step in to increase your collateral, but they also receive a discount and thus a real incentive to want to liquidate you.

This is a dangerous game, which can quickly lead to mass liquidations in volatile markets, as in the Corona crisis. Now it should be clear to you that the topic of DeFi has many opportunities and risks that should not be underestimated.

Conclusion and outlook

Compound has managed to get the buzzword “Decentralized Finance” (DeFi) into people’s heads. It is fair to say that 2020 represents the breakthrough of the trend. Where the end of the development will be is hardly foreseeable at the moment. The value of curled values in DeFi applications is skyrocketing from one record high to the next day.

The speed and rapid development offer opportunities and risks in equal measure. While some demonize DeFi, others see it as the foundation for the next big bull run in the crypto market. The future will show how sustainable this development is. However, we already see that Staking and DeFi are enjoying great demand and offer attractive interest rates to the cryptocurrencies.

However, the development probably stands and falls with the further development of the blockchain protocols, which still lack a performant scaling and currently make the DeFi venture very expensive. Ethereum 2.0 will undoubtedly be one of the most important steps for DeFi.

For Compound itself, the next steps will be to introduce new values in the Lending Protocol. Tokenized real assets are also to be listed on Compound in the future. Among others, the Japanese YEN, the US dollar, or even stocks like Amazon or Google. The possibilities through DeFi are limitless. The only question is how it will actually be accepted. We will, of course, keep you up to date here!

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