Compound

Compound Finance is an Ethereum-based open-source money market protocol where anyone can supply or borrow cryptocurrencies frictionlessly. As of Feb 2020, 7 different tokens—Basic Attention Token (BAT), Dai (DAI), Ether (ETH), Augur (REP), USD Coin (USDC), Wrapped Bitcoin (WBTC) and 0x (ZRX)—can be supplied or used as collateral on the Compound Platform.

Compound operates as a liquidity pool that is built on the Ethereum blockchain. Suppliers supply assets to the pool and earn interest, while borrowers take a loan from the pool and pay interest on their debt. In essence, Compound bridges the gaps between lenders who wish to accrue interest from idle funds and borrowers who wish to borrow funds for productive or investment use.

In Compound, interest rates are denoted in Annual Percentage Yield (APY) and differ between assets. Compound derives the interest rates for different assets through algorithms which account for supply and demand of the asset.

Essentially, Compound lowers the friction for lending/borrowing by allowing suppliers/borrowers to interact directly with the protocol for interest rates without needing to negotiate loan terms (eg. maturity, interest rate, counterparty, collaterals), thereby creating a more efficient money market.

How much interest will you receive, or pay?

The Annual Percentage Yield (APY) differs between assets as it is algorithmically set based on the supply and demand of the asset. Generally, the higher the borrowing demand, the higher the interest rate (APY) and vice versa.

Using the DAI stablecoin as an example, a lender would earn 7.58% (as of Feb 2020) in a year while a borrower would be paying 8.00% interest after a year.

Do I need to register for an account to start using Compound?

No, you do not need to register for an account and that’s the beauty of Decentralized Finance applications! Unlike traditional financial applications where users are required to go through lengthy processes to get started, Compound users do not need to register for anything.

Anyone with a supported cryptocurrency wallet such as Argent and Metamask can start using Compound immediately.

Start earning interest on Compound To earn interest, you will have to supply assets to the protocol. As of February 2020, Compound accepts 7 types of tokens.

Once you have deposited your asset into Compound, you will immediately begin to earn interest on the assets you have put in! Interest accrued on the amount that you have supplied and is calculated after each Ethereum block (average ~13 seconds).

Upon deposit, you will receive corresponding amounts of cTokens. If you supply DAI, you will receive cDAI, if you supply Ether, you will receive cETH, and so on). Interest is not immediately distributed to you, but rather accrues on the cTokens which you now hold and are redeemable for the underlying asset and interest it represents.

cTokens?

cTokens represent your balance in the protocol and accrue interest over time. In Compound, interest earned is not distributed immediately but is instead accrued in cTokens.

Let’s go through this with an example. Assume that you have supplied 1,000 DAI on 1 January 2019 and APY has been constant at 10.00% throughout 2019.

On 1 January 2019, after you have deposited 1,000 DAI, you will be given 1,000 cDAI. In this case, the exchange rate between DAI and cDAI is 1:1.

On 1 January 2020, after 1 year, your 1,000 cDAI will now increase in value by 10%. The new exchange rate between DAI and cDAI is 1:1.1. Your 1,000 cDAI is now redeemable for 1,100 DAI.

1 Jan 2019: Deposit 1,000 DAI. Receive 1,000 cDAI. Exchange Rate:
1 cDAI = 1 DAI

1 Jan 2020: Redeem 1,000 cDAI. Receive 1,100 DAI. Exchange Rate:
1 cDAI = 1.1 DAI (cDAI value increased by 10%)

To account for the interest accrued, cTokens become convertible into an increasing amount of the underlying asset it represents over time. cTokens are also ERC-20 tokens, meaning you can easily transfer the “ownership” of supplied assets if someone wants to take over your position as a supplier.

Start borrowing on Compound

Before borrowing, you have to supply assets into the system as collateral for your loan. Each asset has a different collateral factor. The more assets you supply, the greater is your borrowing power.

Borrowed assets are sent directly to your Ethereum wallet and from there, you can use them as you would any cryptoasset—anything you want to! Do note that that borrowing incurs a small fee of 0.025% to avoid spams and misuse of the Compound protocol.

Price movement of collateral asset

If you’re thinking about putting in collateral to take a loan, you may be wondering - what happens if the value of the collateral changes? Let’s see:

1. Collateral value moves up

If the value of the asset you used as collateral goes up, your collateral ratio also goes up, which is fine - nothing will happen and you can draw a bigger loan if you’d like to.

2. Collateral value moves down

On the other hand, if the collateral goes down such that your collateral ratio is now below the required collateral ratio, your collateral will be partially sold off along with a 5% liquidation fee. The process of selling off your collateral so that you achieve the minimum collateral ratio is known as liquidation.

Liquidation

Liquidation occurs when the value of the collateral provided is less than the borrowed funds. This is to ensure that there is always excess liquidity for withdrawal and borrowing of funds, meanwhile protect lenders against default risk. The current liquidation fee is 5%.

And that’s it for Compound - if you’re keen to get started or test it out, we’ve included step-by-step guides on how to (i) supply funds to the pool and (ii) borrow from the pool. Otherwise, head on to the next section to read more on the next DeFi app!

Original article is taken from Coingecko's book "How to DeFi"

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