What is compound finance? DeFi Borrowing & Lending

What is Compound Finance & how can you benefit from it? 

Compound Finance is a lending protocol which runs on the Ethereum blockchain and allows people to lend and borrow popular cryptocurrencies like Ether. 

People that want to borrow digital assets can do that directly with the protocol. They don’t need to negotiate anything with a counterparty.

However, they do need to add cryptocurrency as collateral before they are allowed to borrow. 

The beauty of this platform is that all you need to partcipate is a cryptocurrency wallet like the Trust Wallet or a hardware wallet like the ledger 

this allows you to log on to the compound finance dapp without having to create an extra account.  Your cryptocurrency wallet is automatically your account and password. 

 

Supplying Tokens

When a user supplies a token, it isn’t directly lent to someone else. The token is lent to the compound protocol where all the lent funds get added to the supply pool. This results in a higher level of liquidity. 

This lending mechanism allows users to withdraw their tokens at any time as long as there’s enough liquidity in the pool.

They do not need to wait for a loan to mature or negotiate any terms in order to get back the lent funds. Funds that are supplied to the compound finance protocol will accrue interest based on the supply interest rate of that digital asset. 

I will talk about how much interest you can earn later in the video. 

Borrowing Tokens

The way that borrowing works on compound is a lot different to other p2p platforms. On other platforms the borrower first needs to negotiate with the counterparty borrowing terms such as maturity date or funding period. 

On compound finance users can borrow directly through the compound finance protocol by specifying which asset they would like to borrow. This asset comes directly from that assets liquidity pool. This liquidity pool has a floating interest rate which changes based on the amount of liquidity available in this asset pool. If the liquidity is high the the interest charged to borrowers is low and vice versa. 

When a user wants to borrow funds from compound finance, the compound finance protocol enforces the rule that a user’s account needs to have a balance that covers the amount of borrowed funds. 

This is called collateral ratio. It means that a user can not borrow or withdraw any assets if the collateral ratio is not met. 

This rule is known as the collateral ratio, and a user cannot initiate action, for example borrowing or withdrawing assets, that would bring a user’s account value below the collateral ratio.

The Compound Finance protocol also utilizes a ‘Price Oracle’, which keeps track of the current exchange rate of each supported digital asset on the protocol. The responsibility of setting the value of assets on the protocol is delegated to a committee, which pools the prices of supported assets from the top 10 exchanges in the cryptocurrency space. These exchange rates are used by the protocol to determine the borrowing capacity and collateral requirements for an account, and any other function that requires calculating the value equivalent of an account on the protocol.

Interest Rates

The current lending and borrowing rates can be found on the compound finance platform. You need to be aware that these rates are not fixed. They have a floating interest rate and change based on the liquidity available to borrow.

Why is the supply rate lower than the borrow rate?

 

In each liquidity pool there needs to be an excess of funds. Assets supplied needs to be higher than the assets borrowed. 

This allows users to quickly withdraw or borrow funds from the protocol without having to wait. 

The interest rate that is paid by borrowers is earned by the suppliers of assets. Since there is a higher amount of supplied funds, the interest rate is proportionally lower. 

That is why you don’t earn the same interest on your funds that borrowers pay. 

Liquidation

If the aggregate value of your outstanding borrowing is greater than your Borrow Limit, your account will be liquidated.

 

https://chiragkhatri.me/compound-liquidator/

On this dashboard you can see the address, the amount of assets supplied and the amount borrowed. The Health column shows the status of this account. An account that has a Health below 1 can be liquidated. 

Supported Assets on Compound Finance

What are cTokens?

When you supply digital currencies to the compound finance protocol you get cTokens back. All assets supplied to compound finance markets are represented by an ERC20 token called cToken. 

The longer you hold cDai the more interest accrues over time. This makes earning interest as simple as holding an ERC20 cToken. 

Each market has it’s own cToken cETH, cUSDC, cDai. 

Use-Cases 

cTokens are being used in a bunch of popular DeFi projects such as:
Set Protocol
Dharma
DeFi Zap
Pooltogether – A no loss lottery system.

I will be making a video about this soon so make sure to hit that subscribe button. 

In a nutshell cTokens allows for passive income to be earned when holding a stablecoin asset like Dai or USDC. 

My favourite example for this is the ETH20MACO tokenset strategy . When the price of ETH goes below the 20 day moving average, eth gets sold for cUSDC. 

During the period of time when my ETH20MACO tokenset is in cUSDC I am earning interest on it. When the price goes back above the 20 day moving average the tokenset will have a little bit more funds available, thanks to interest, to buy back wETH. 

Is Compound Finance Safe?

Compound has undergone a number of security audits by reputable agencies like Open Zeppelin and Trail of Bits, all of which have been publicly disclosed.

 

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