In terms of locked funds, Compound is the second DeFi platform in the world after MakerDAO. This is a protocol that allows the issuance of decentralized anonymous loans and operates thanks to special smart contracts and the so-called cTokens on the Ethereum blockchain.
This protocol allows lending and borrowing without intermediaries, earning interest on the amounts lent, or borrowing tokens which have to be collateralized. This effectively creates a decentralized liquidity pool open to all, whether someone wants to obtain a loan or is willing to grant one.
In fact, instead of lending assets directly to another user, liquidity is provided to an entire market managed by the same decentralized protocol, so that it is possible to borrow assets from the same protocol, which does not act as an intermediary but as a simple trading platform.
Loans are granted or obtained thanks to cTokens, i.e. ERC-20 tokens that represent digital assets that act as the collateral for loans.
To date, eight types of cTokens have been created, representing different cryptocurrencies or tokens:
- cETH, which represents Ether (ETH)
- cDAI, which represents the new multicollateralized DAI
- cSAI, which represents the old DAI collateralized only in ETH
- cWBTC, representing Wrapped Bitcoin (WBTC), an ERC-20 token which in turn represents Bitcoin (BTC)
- cUSDC, representing the stablecoin USD Coin (USDC)
- cBAT, representing the Basic Attention Token (BAT)
- cREP, representing the token of Augur (REP)
- cZRX, which represents the token of 0x (ZRX)
When lending, obtaining in exchange the payment of interest on the amount lent, it is sufficient to lock one of these underlying assets by swapping it with the corresponding cToken, for example on Eidoo.
Consequently, those who want to lend their ETH tokens must swap ETH for cETH, so as to lock in their ETH tokens and obtain in exchange an equal amount of cETH tokens that allow to immediately start earning interest, which accrues with each new block on the Ethereum blockchain.
Since the platform is based on an Ethereum-based decentralized smart contract there are no limits or obstacles, and everyone can use the procedure just described to lend funds and earn interest.
In addition, for the same reason, those who lock their assets by swapping them for cTokens can at any time perform the opposite procedure, in order to regain full ownership of the locked tokens and collect the interest by closing the open position. Thereafter, obviously, the interest payment ceases.
Interest rates vary continuously depending on the market supply/demand ratio, as well as on the assets. For example, when liquidity is abundant, interest rates are low, but if liquidity is scarce, interest rates increase, so as to encourage new supply.
Consequently, the granting of a loan in ETH can not only result in a different return compared to a loan in DAI but can also vary over time. In any case, the interest paid out can never be negative, of which the protocol sets aside 10% as a reserve.
Furthermore, anyone who decides to borrow from the Compound’s liquidity pool must lock funds as collateral in the form of cTokens, and can immediately obtain a loan of only between 50% and 75% of the value of the locked funds, depending on the asset borrowed.
The over-collateralization of loans serves to ensure sufficient coverage for the lender and reduces the risk of automatic liquidation of the loan in the event of a decline in the value of the collateral.
In fact, although these loans can be taken out and repaid at any time, if the value of the fixed assets as collateral falls below the minimum threshold required, the debt position is closed by the protocol by liquidating the collateral in order to pay off the loan and return the funds as a whole. In addition, a 5% discount is applied to the liquidated assets as a purchase incentive for the liquidators themselves.
No fees are applied to transactions within the protocol, although it is always necessary to pay ETH gas for transactions that require recording on the Ethereum blockchain. Moreover, Compound doesn’t even have its own native token, since cTokens are for all intents and purposes only representations of other tokens within the platform’s smart contract. There are several interfaces that allow accessing the platform’s services, some of which have been gathered on the home page of the official compound.finance website.
The values of the assets are determined using an average price extracted from an oracle connected to Coinbase Pro, Bittrex, Poloniex and Binance, expressed in Ether and published on-chain after a 1% deviation in the median price. For security reasons, these price changes are limited to 10% per hour unless manual approval is provided from a second offline address.
In this regard, however, Compound is developing an advanced oracle, Open Oracle System, to create transparent, decentralized, resilient and tamper-proof price feeds.
As far as governance is concerned, the Compound protocol allows a single address, the Timelock, to modify system parameters, logic and smart contracts with a time-delayed, opt-out update model. The Timelock itself is a smart contract that imposes a waiting period of 2 days before governance actions can be performed. These can be monitored via the Timelock Dashboard.
Currently, the Timelock is still administered by the Compound team, but a fully community-governed DAO is planned in the future to replace the current administration of the protocol. The objective of this initiative is precisely to make token loans on the Ethereum network completely decentralized.
The protocol was released at the end of 2018, which means it is still at an early stage. The path towards full decentralization is already underway, but not yet completed, meaning that it will be necessary to wait for a few more developments before it can be considered fully decentralized.
Meanwhile, it is working as planned, to the extent that it is now the second DeFi protocol in terms of locked assets, after MakerDAO, which still dominates the decentralized finance sector thanks to its DAI decentralized algorithmic stablecoin.