Compound, found online at Compound.finance, is an open-source lending protocol built on the Ethereum blockchain. Find out how it works today in our review.
What is Compound?
Compound is an Ethereum-based platform that lets you earn interest or borrow ERC20 tokens without managing an order book. As described by the official website, the platform is “an open-source protocol for algorithmic, efficient money markets on the Ethereum blockchain.”
The unique feature behind Compound’s money market protocol (aside from getting an $8.2 million seed round investment from Coinbase) is its ability to algorithmically adjust money market interest rates based on asset-specific supply and demand. That means users and applications can frictionlessly exchange the time value of Ethereum assets without needing to negotiate terms, rates, or complex flows.
Each money market is transparent, auditable, and predictable, making Compound “perfect for profit-seeking humans and machines alike,” as the official website explains.
In more basic terms, Compound is a lending system that creates a fair market for borrowing and lending different Ethereum-based assets – like ERC20 tokens. Each money market for each ERC20 token will have a pre-defined rate – set by the Compound protocol and algorithm. That means users can borrow money through the Compound protocol without negotiating terms, while other users can lend money through the Compound protocol to securely earn interest on their ERC20 and Ethereum token holdings.
Compound’s whitepaper just appeared online in May 2018. The web app is scheduled to launch before the end of Q2 2018, while the Compound iOS app is scheduled for Q3 2018. An alpha version of the platform, however, can be viewed online here: https://compound.finance/alpha
What Problems Does Compound Seek to Solve?
Compound’s whitepaper mentions how the platform seeks to solve two major problems, including:
Borrowing mechanisms are extremely limited, which leads to mispriced assets; the whitepaper mentions “scamcoins with unfathomable valuations, because there’s no way to short them”
Blockchain assets have a negative yield due to significant storage costs and risks (both on-exchange and off-exchange), and there are no natural interest rates to offset those costs; this contributes to volatility because holding is disincentivized
Compound aims to solve both of these problems in a better way than the current solutions on the market.
Today’s solutions include centralized exchanges like Bitfinex and Poloniex. These solutions allow customers to trade blockchain assets on margin, with “borrowing markets” built into the exchange. These are trust-based systems because you have to trust that the exchange won’t get hacked, steal your assets, or incorrectly close your position. They’re also restricted to certain customer groups and a small number of assets.
Other solutions include peer-to-peer protocols that facilitate collateralized and uncollateralized loans directly between market participants. With these platforms, “decentralization forces significant costs and frictions onto users.” Lenders need to post, manage, and supervise loan offers and active loans. It’s an inefficient process.
How Does Compound Work?
Compound is a protocol on the Ethereum blockchain that establishes money markets. Money markets are essentially pools of tokens with algorithmically-derived interest rates. These algorithms derive interest rates based on supply and demand for the token. Suppliers and borrowers of an asset interact directly with the protocol, earning (and paying) a floating interest rate without having to negotiate terms such as maturity, interest rate, or collateral with a peer or counterparty.
With Compound, users or algorithms can easily monetize or borrow ERC20 tokens. Compound will algorithmically adjust money market interest rates. That means users don’t need to customize rates before agreeing to lend or borrow. Instead, borrowing takes place at whatever rate decided by Compound.
There are two core functions with Compound, including supply tokens (lending them) or borrowing tokens.
Unlike peer-to-peer platforms, where a user’s tokens are matched and lent to another user, Compound will aggregate the supply of each user. When a user supplies a token, that token becomes a fungible resource. This approach offers complete liquidity because users can withdraw their tokens at any time without waiting for a specific loan to mature.
If you supply tokens via Compound, then your tokens will accrue interest based on the supply interest rate unique to that asset. The Compound algorithm will decide an interest rate for a particular ERC20 token, and you’ll earn that interest rate.
Users can borrow tokens over the Compound protocol in a frictionless way, using collateralized lines of credit, for use anywhere within the Ethereum ecosystem. Users can specify their desired asset – like an ERC20 token – then borrow that asset at a market rate. There are no terms to negotiate. Each money market – the market for each ERC20 token – has a floating interest rate set by market forces that determines the borrowing cost for each user.
One major restriction with borrowing tokens through Compound is that there’s a rule that each account must have a balance that more than covers the outstanding borrowed amount. This is called the collateral ratio. An account can take no action (like borrowing or withdrawing) that would bring the value below Compound’s desired ratio. Users are free to increase or reset their collateral ratio at any time by repaying a borrowed asset.
Who’s Behind Compound?
Compound was created by a San Francisco-based development team. That team includes CEO Robert Leshner and CTO Geoffrey Hayes.
Leshner is a Chartered Financial Analyst, a former economist, and the founder of two software startups. He also led Merchant Product at Postmates and managed Discover Bank’s liquidity and rate risk.
Hayes, meanwhile, is a maintainer of Exthereum, a founder of two tech startups, and led Core Services at Postmates.
The company is organized under the name Compound Labs, Inc.
Ultimately, Compound aims to create properly functioning money markets for Ethereum assets – something that doesn’t really exist in today’s crypto ecosystem. These money markets will allow users to lend or borrow Ethereum and ERC20 tokens at market rates.
These rates are defined by the Compound protocol’s algorithm, which analyzes supply and demand to create the market rate. The rate for one ERC20 token might differ from another, creating hundreds of different money markets within the Ethereum ecosystem.
Users can supply tokens to a money market to earn interest without trusting a central party. Other users, meanwhile, can borrow a token (to use, sell, or relend) using their balances in the protocol as collateral.
Compound’s MVP has already been posted online at Compound.finance. A web platform is scheduled to launch by the end of June 2018, with an iOS app scheduled to be released in Q3 2018.