By virtue of its user base and locked-in value, Compound is currently the most successful DeFi project. It is a decentralized lending system and platform, similar to MakerDAO, which came before it. As such, anyone can use it anywhere in the globe to lend to or borrow from anyone else using smart contracts.
Compound is an autonomous protocol that uses algorithms to determine interest rates at the most fundamental level. It is permissionless, thus anyone can use the resources whenever they want.
Both a verification procedure and a user identity system are absent. Numerous financial applications can make advantage of this real-time interest rate calculation.
Compound is stirring up the cryptocurrency industry for the right reasons. We shall explain why Compound is receiving so much attention in this article. Keep reading.
What is Compound?; A Quick Overview
Compound is a DeFi lending and borrowing protocol that runs on Ethereum and serves as the blockchain equivalent of a money market.
Compound is mostly used by individuals as a cryptocurrency borrowing and lending system. Users can at any moment invest one of the supported coins into a common pool and earn interest.
Or they can deposit their tokens and then borrow a smaller number of tokens for a fee. The quantity of tokens deposited and borrowed in the pool, as well as their supply and demand, determine the rate of interest.
You might comprehend things better if you use an example with established financial organizations. To earn interest, you must deposit money into a savings account at your bank.
Similar to this, DeFi protocols like Compound enable you to invest your cryptocurrency savings because the interest you get increases the value of your funds. Compound offers the same ability to borrow money against collateral that a bank does.
Compound is a decentralized lending platform. That basically means that direct lending is made possible by both a computer network and a mobile application (DApp).
It created its own app that focuses on lending via smart contracts. Compound operates on its own protocol, like all other DApps, which directs how users and smart contracts interact to produce a fully functional decentralized lending platform.
Why Are DeFi Protocols Needed?
Before delving further, let’s take a step back and consider the need for decentralized lending systems. Traditional lending is inherently flawed.
Who is eligible for loans and who is not is decided by banks and other lenders, and typically, their system is based on both your credit and your history with them. In other words, you will be able to obtain more loans the more business you conduct with them and the more successfully that business is conducted.
This normally means that those who are wealthy in money and financial ties prevail in the end, while those who are not usually do not. Big corporations triumph over tiny ones. The wealthy dominate the average.
How Compound Protocol Works
When you begin investing your savings in Compound, you can diversify your financial portfolio. In exchange, the protocol will continue to pay you interest for the full time that you hold onto your money.
However, you can also borrow money from the protocol if you want to make investments somewhere else. Naturally, you will be the one to pay Compound interest for the money you borrow from the protocol’s liquidity pool.
Lenders and borrowers make up Compound, as is clearly clear from the foregoing. Let’s explain their function and operation within the compound ecology.
How Lending Works With Compound
Simply give the cryptocurrency you want to provide liquidity for in order to lend using this protocol. Tokens are put into a liquid fund by lenders. As soon as you accomplish that, you will begin receiving interest, which is determined by the currency’s supply and demand.
Lenders lock or deposit their cryptocurrency into Compound in order to receive a variable annual interest rate. The advanced smart contracts of Compound are used to hold each specific token in a liquidity pool of other tokens of the same type.
The same token that lenders put in the pool is used to pay compound interest to lenders. As a result, your interest in ETH compounds if you lend it to Compound. In the same vein, you will receive your compound interest in USDT if you deposit USDT.
Lenders obtain the “cToken,” a native token of Compound, when they sell their cryptocurrency on the market. The cToken’s token value is the same as the token that was traded on a liquid market.
As the interest rate on that cryptocurrency rises, so will its value. Naturally, the value of the cToken will change along with the token’s market value.
You only need to return your cTokens when you need to spend your cryptocurrencies in order to get your original tokens back.
How Borrowing Works With Compound
It takes a little more work to borrow. Borrowers must first deposit collateral in order to have “borrowing authority.” Once they have that ability, they will be able to borrow tokens with a value equal to their current borrowing power.
Then, at a rate set by an algorithm that keeps track of the supply and demand of the borrowed tokens, borrowers can borrow anytime they want for as long as they want from that fund.
Compound follows the over-collateralization rule just like many DeFi projects. In order to eliminate risk for the lender and the system, users who want to borrow must have collateral that is greater than the amount they wish to borrow.
You must pay compound interest as you are taking money from the protocol. Let’s use an example to demonstrate how a system works so that we may better understand it. Suppose Bob deposits ETH worth $10K into Compound.
He can borrow any cryptocurrency valued at $6K from Compound if the borrowing cap is set at 60%. On the borrowed sum, he must pay compound interest, nevertheless.
How Does Compound Interest Work?
Compound interest operates in a dynamic manner, in contrast to banks where interest rates are fixed. The compound interest fluctuates based on the state of a certain liquidity pool.
The annual interest rate for lendings is low when the complete amount of cryptocurrency in a liquidity pool is widely available.
However, the Compound Annual Growth Rate is high for a smaller pool with a lower balance. This indicates that lending cryptocurrency to smaller liquidity pools will result in higher annual returns.
This style of floating interest is effective at preserving some parity in the cryptocurrency market. As a result of the larger compounding interest, users are motivated to provide liquidity to smaller pools.
Similar to this, since there is enough money to borrow, the interest rate for borrowing from a larger pool is lower. On the contrary, the interest rate is higher when someone borrows from a tiny liquidity pool.
Compound’s Unique Qualities
- No Need For Negotiations
Compound is fantastic since it does away with the need for haggling. There is no need for lenders to the market to haggle over terms like they would in a traditional bank or even in other DeFi apps.
To deposit or borrow cryptocurrency, Lenders and Borrowers just need to engage with the protocol. Algorithms control the operation in its entirety.
- It Makes Investing Easier
The benefits of this arrangement extend beyond lenders. Compound can be used by borrowers who wish to go long on a certain asset.
For instance, a trader can use his current ETH as collateral to borrow USDT, which can subsequently be utilized to purchase even more ETH, if he believes that the price of ETH would climb exponentially in the long to medium term.
Conclusion
For individuals who wish to leverage their digital assets and earn income on their holdings, compound is an intriguing option.
It’s a terrific way to maximize your long-term investments if you plan to hold a cryptocurrency asset for a long time and don’t want to take the danger of day trading, though it also works for short-term investments. By borrowing money at an interest rate determined by the system, it also enables you to leverage cryptocurrency.
Currently, crypto lending mostly advantages individuals who already utilize cryptocurrencies because it attracts interest from lenders and gives borrowers, who are frequently active traders, a variety of loan possibilities.
Many protocols are now being developed to make it simpler for users to lend and borrow assets. Nevertheless, Compound’s strategy is unquestionably intriguing, and it is frequently contrasted with Aave as one of the most extensive loan protocols known.
