What is Compound Finance and How does it work?

Decentralized Finance (DeFi) experienced explosive growth in 2020 and 2021. A host of new and innovative financial products have emerged from the crypto space, which allow users to operate outside of the traditional financial system, without the need for centralized intermediation. Instead of relying on a middleman, DeFi uses smart contracts (computer code that is executed when certain pre-defined conditions are met).

What is Compound?

Compound is one of the most popular DeFi lending protocols, which allows investors to lend, borrow and earn interest on their cryptocurrency. Compound is a dApp (decentralized application) built on the Ethereum blockchain.

As mentioned previously, there is no need for an intermediary, such as a lending institution or bank. Conditions such as interest rates are programmed into the smart contracts on the protocol.

Compound uses the concept of “liquidity pools” to match lenders to borrowers. Users can deposit their cryptocurrency to a liquidity pool and earn interest on their deposits. On the other side of the equation, these deposits provide liquidity for those who wish to borrow.

cTokens

When users deposit their cryptocurrency to Compound, their crypto is automatically converted to an equivalent amount of cTokens. For example, if you deposit Ethereum to a liquidity pool, you will receive an equivalent amount of cEth. Users can redeem their cEth for Eth at any time they wish.

Users can connect the Compound app directly to a number of popular and widely used crypto wallets, including MetaMask, Coinbase and Ledger Hardware Wallets.

Overcollateralization

Unlike more traditional lenders, DeFi protocols such as Compound do not require users to fill out KYC documentation or identity verification to qualify for a loan.

So how does Compound deal with the risk of default? In order to offset this risk, borrowers are required to “overcollateralize” their loans. This simply means that a borrower must deposit more crypto than they want to borrow. Obviously, the crypto used for collateral must be different from the one the user wishes to borrow.

See Also

What is Internet Computer (ICP) and How is it Creating a Decentralized Web?

In the event that a user defaults on their loan, an amount of their collateral commensurate to the outstanding amount will be liquidated to cover the default. Again, this is all pre-defined and coded into the smart contracts running on the protocol.

The COMP Token

COMP is the native token of Compound. Like with many other DeFi protocols, the COMP token has value due to the fact that it is an integral part of the protocol’s governance. Users holding COMP can vote on decisions impacting the future of Compound. Issues holders may get to vote on include interest rates and the types of cTokens available on the protocol.

Where to buy the COMP token

COMP is available to buy on a wide range of crypto exchanges, including Binance.

Learn About Cryptocurrency Loans and Lending

Compound is just one of many crypto lending platforms. You can learn more about the different types of cryptocurrency loans and lending here.