Compound DeFi Loans: How Do They Work?
January 08, 2024
January 08, 2024
Compound.finance is one of the most popular DeFi lending platforms. Read on to find out how Compound works, learn more about DeFi loans as a whole, and understand if Compound is right for you.
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Built on the top of decentralized blockchain networks such as Ethereum, decentralized finance, or DeFi, aims to provide users with more control, transparency, and access to their money without relying on intermediaries or centralized authorities. One of the most popular and innovative applications of DeFi is the lending and borrowing of crypto assets.
DeFi lending platforms allow users to borrow cryptocurrencies and stablecoins using their crypto assets as collateral. They differ from centralized finance, or CeFi lending platforms, in that they are not controlled or managed by a single entity and instead operate based on logic established through code. DeFi lending platforms allow users to borrow without creating an account or providing personal information or credit scores — leading to a much quicker process. DeFi lending also differs from traditional lending since it relies on crypto assets for transactions.
Across decentralized finance, lending platforms differ in the types of assets they support, the interest rates they offer, and the features they provide. In this article, we will take a deep dive into one popular DeFi lending platform: Compound.
Compound is a decentralized protocol that allows users to borrow and lend various crypto assets on Ethereum. It was founded in 2017 by Robert Leshner and Geoffrey Hayes and it launched on the Ethereum mainnet in 2018. It has since grown into one of the largest DeFi borrowing protocols, with billions of dollars in crypto collateral deposits.
Like other DeFi lending protocols, Compound relies on smart contracts to function. Smart contracts are programs that represent self-executing agreements which enforce the terms and conditions of financial transactions (such as loans). All of the lending and borrowing services offered by Compound, as well as the digital assets the platform accepts, are managed through its smart contracts.
The latest version of Compound, version 3, allows users to supply and borrow various crypto assets including:
The Compound also has its own governance token, COMP, which grants holders voting rights on protocol parameters and upgrades.
COMP is an ERC-20 token that runs on the Ethereum blockchain. It has a fixed supply of 10 million tokens, with some part allocated to the Compound team and investors, and some reserved for the community.
COMP is one of the most influential tokens in the DeFi ecosystem, as it grants voting rights for one of the largest and most established DeFi lending platforms. COMP also has a significant market value and liquidity, as it is traded on various exchanges and platforms. In addition to participating in governance, COMP holders may benefit from the growth and innovation of Compound protocol.
To borrow funds from Compound, you first need to fund your collateral with a supported asset. Compound provides “overcollateralized” loans, which means the platform doesn’t check your credit score, but it requires you to borrow less than your collateral value. This is to insure against the risk of default.
Let's have a detailed look at how to borrow on Compound:
Since Compound relies on the mechanism of overcollateralized lending, you’ll first need to add collateral assets in order to take out a loan. This serves as a guarantee that you will repay your loan, plus interest. If you fail to do so, the platform may sell some or all of your collateral to recover the loan amount. This is called liquidation, and it results in the borrower losing their collateral assets.
Compound supports a variety of crypto assets as collateral, including popular coins like ETH, WBTC, COMP, and others. You can check the complete list of supported assets on the Compound website. However, not all assets have the same collateral factor. The collateral factor is the percentage of your collateral value that you can borrow. For example, ETH has a collateral factor of 83%, which means that you can borrow up to 83% of the value of the ETH you put up as collateral.
For example, if you deposit 2 ETH worth $4,000 and the collateral factor is 83%, you can only borrow up to $3,320 worth of assets.
To fund your collateral, you need to connect your wallet to the Compound app and select the asset that you want to supply.
Once the transaction is confirmed, you will receive cTokens in exchange for your supplied asset.
cTokens are ERC-20 tokens that represent your loan balance on Compound.
After you have funded your collateral, you can take out a loan against it. Your loan funds can be in the form of any asset available for borrowing on Compound, though many borrowers choose to borrow funds in stablecoins like USDC.
In addition to the basic factors, you will also see your loan's LTV (loan-to-value) ratio and liquidation price. The LTV is the value of your loan divided by the value of your collateral. Since crypto assets fluctuate in price, your collateral may be liquidated if your loan exceeds the allotted LTV. The liquidation price is the price at which your collateral will be sold if it drops far enough in value. You need to pay attention to these two metrics as they determine your loan health. An example: Say you deposit 2 ETH worth $4,000 to borrow $3,000 of USDC (75% of your collateral amount), and your liquidiation threshold is at 80% LTV. In this scenario, your collateral will be liquidated if ETH drops in price enough for your collateral to become worth less than $3,750. Therefore, $3,750 is the “liquidation price" for this particular loan.
To familiarize yourself with more of the DeFi loan terms you'll encounter, see "DeFi Loans: The Terms You Should Know".
To take out a loan on Compound, you need to balance your individual needs and preferences:
Now that you understand the basics of how Compound works, let's take a look at the advantages it offers over traditional loans.
One of the primary benefits of using Compound is the potential for low Annual Percentage Rates (APRs) on borrowed assets.
Unlike traditional financial institutions that often impose high-interest rates on loans, Compound operates in a highly competitive environment where users can access loans at relatively low interest rates. This can make borrowing more cost-effective, especially for those looking to leverage their existing crypto holdings.
Compound is an open-source platform that operates under a decentralized governance system.
Users can participate in the governance process by holding COMP tokens, which grant them the power to vote on changes to protocol parameters and upgrades. This enables transparency and encourages user trust in the platform, as everything is out in the open.
Compound supports a wide range of assets, allowing users to choose from various cryptocurrencies as collateral for their loans. This flexibility provides users with options, enabling them to borrow against the assets they already hold.
Popular assets like Ethereum (ETH), Compound (COMP), and Chainlink (LINK) are among the collateral options available on Compound.
While Compound is a popular and reputable DeFi lending platform, it's not the only one in the market. There are other DeFi lending platforms that offer similar features and a host of benefits for users who want to borrow money using crypto assets as collateral.
Two notable Compound alternatives are Aave and Maker.
Aave: Aave is a prominent DeFi lending platform that supports many assets including ETH, USDC, LINK, and others. Aave also offers a variety of loans, including flash loans. Flash loans are a type of advanced loan that must be repaid within a single blockchain transaction block. Aave is fully decentralized and governed by its native token, AAVE, which grants holders voting rights.
MakerDAO: MakerDAO is one of the oldest and most influential DeFi lending platforms to come to market. Maker enables users to create DAI, a stablecoin pegged to the US dollar. MakerDAO uses a two-token system: MKR and DAI. MKR is the governance token that allows holders to vote on protocol parameters and upgrades and DAI is the stablecoin that is created by locking up collateral assets.
Each of these platforms has its own advantages and disadvantages. Check out "The Top DeFi Lending Protocols: Compound, Aave, & MakerDAO" for a more in-depth comparison between the three platforms.
Borrowing from DeFi protocols like Compound can be a great way to leverage your crypto assets, access liquidity, hedge against volatility, and seize arbitrage opportunities. However, these platforms also have some common drawbacks, with the most common one being complexity of use.
Thankfully, there’s a solution that allows you to easily borrow from Compound called Rocko.
Rocko is a soon-to-launch platform that enables crypto owners to easily and securely borrow from popular DeFi protocols like Compound and get funds in minutes — no experience needed! Use the loan to purchase real estate, pay down higher-rate debt, make everyday purchases, and much more.
Rocko also provides a loan management dashboard and tools like text and email alerts to help manage your loan and collateral. The Rocko team consists of crypto enthusiasts who are ready to help you with any questions you may have. You can join the Rocko Discord server, follow our Twitter account, or visit our resource center to learn more about DeFi borrowing.
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