Compound is one of the leading DeFi applications on Ethereum. We explain how Compound operates and governs and how to go about obtaining your first yield from it.
Compound is a system of smart contracts (aka DApps) on the Ethereum blockchain. The Compound DApp allows you to earn interest by supplying assets to a shared liquidity pool from anywhere in the world. Further, you can borrow digital assets from that liquidity pool by posting collateral. Borrowings are paid back with interest. All this is done without permission from any party – everyone follows transparent rules.
Compound offers an innovative way to earn a yield on assets
The idea behind Compound is that most digital assets, including digital dollars, are idle when not involved in transactions. They sit inertly in wallets and on exchanges. With Compound, you can put your idle digital assets to use by supplying it to the liquidity pool and earning interest. The interest you accrue depends on how much liquidity (supply and demand for digital assets) is present in the pool at any given time.
Your idle assets don’t necessarily have to be cryptocurrency. They are also the digital dollars like USDC that are pegged 1:1 to the U.S. dollar.
Compound will soon be community-governed
Compound was launched by a San Francisco-based team of technologists and visionaries and is backed by leading venture investors. There are no intermediaries involved who set the interest rate. It’s all automated and transparent, which is a foundational feature of DeFi. In the near future, the Compound community will collectively govern the smart contract system, also called the protocol. The operational parameters, such as the allowed assets, collateral ratios, and liquidation process, will be determined by the community. Linen App, along with many other ecosystem participants, is looking forward to becoming a community delegate, voting on important proposals, and contributing to governing of the protocol.
Why is it called the Compound Liquidity Pool?
The Compound Liquidity Pool is a system of smart contracts. For anyone to borrow from it, this system has to have funds (liquidity) at all times regardless of the borrowed amount. Pooled liquidity, where multiple parties form a greater pool, is the optimal structure to achieve such a goal. Participants of Compound supply digital assets to create a shared, open, and autonomous market. Borrowers can post collateral and borrow digital assets from the common market and pay it back with interest. In other words, Compound’s open market is a shared pool of liquidity.
Multiple liquidity pools tied to Compound
Compound works with several digital assets, and each asset has its own market or liquidity pool. There are eight assets – and by extension markets – currently. They are Ether, USDC, Dai, Augur, Wrapped BTC, Basic Attention Token, 0x, and Sai. More assets may be added in the future based on community voting. Every asset on Compound has a distinct interest rate that is calculated separately based on supply and demand for a particular asset. Linen App provides tools to its members to access the deposit side (supply) of the USD Coin (digital dollar USDC) pool.
Who can supply to liquidity pools?
Anyone with an internet connection can supply supported digital assets to a pool, provided they have digital assets. All you need is an interfaсe or an app that is connected to Compound. Linen App is one such interface. You are free to supply and withdraw your digital assets (digital dollars) at any time provided there is enough liquidity in a particular asset pool when you need to withdraw. When you supply digital assets to Compound, a record of your deposit is produced and recorded on the Ethereum blockchain. These records are cTokens that are stored in your wallet. More on cTokens in later posts. There are no binding durations, meaning you don’t need to commit to a predefined term length to start accruing interest.
Who can borrow from liquidity pools?
To borrow from a Compound Liquidity Pool, you need to have supported collateral before you’re allowed to borrow. Compound smart contracts encode all these terms. Each collateral asset has its own collateral factor, such as how much can be borrowed against that asset. Presently, borrowers have to post 30-150% more collateral than the borrowed asset. Simply put, you also have to be a supplier to borrow. The more you supply, the more you can potentially borrow.
When is collateral liquidated?
Collateral liquidations happen when the value of the collateral drops or the borrowed assets appreciate in value. When the collateral ratio – as determined by the amount of collateral posted divided by the amount of borrowed assets – is lower than the predetermined threshold, a liquidation occurs. The collateral ratio is different for each collateral type (digital asset) and is about 130-250% currently. Anyone in the world, no permission necessary, can monitor the collateral ratios of borrowings and liquidate underwater collateral. Liquidators are incentivized with a 5% discount of the liquidated collateral value.
How are interest rates calculated in Compound Liquidity Pools?
Compound calculates interest rates algorithmically, depending on the supply and demand of digital assets. Supply and demand fluctuate in real-time, so the interest rate may change rapidly. When there’s a lot of liquidity in a particular pool – because suppliers (depositors) are plentiful or the borrow demand is down, or both – then interest rates will be lower. If there’s less liquidity, interest rates are higher. It may happen that for a period of time, there is not enough liquidity to borrow and withdraw digital assets. In this case, interest rates become high to incentivize suppliers to add more funds to the pool and borrowers to repay.
How much interest can you earn?
It depends on market conditions. The interest rates shown are annual rates, but they are actually calculated every block, which is about every 15 seconds on the Ethereum blockchain. That means that interest on your supplied assets to Compound accrues every 15 seconds.
Historically, interest rates have been 0.3-6% APY for the Compound USDC pool. The DAI pool has seen 0.3-12% APY. Compound, and DeFi as a whole, is new and experimental, so these numbers may change drastically.
Linen App provides access to Compound
Linen App acts as an interface for Compound. Its members connect their bank accounts to exchange U.S. dollars for digital dollars USDC and supply them to the Compound USDC Liquidity Pool to discover new interest-earning opportunities.
Linen App works with stablecoins that are pegged 1:1 to the U.S. dollar. Currently, Linen App provides tools to access Compound exclusively, but it will offer access to other DeFi liquidity pools in the future.
Conclusion
Ethereum is going places – there’s no doubt about it. According to Etherscan, the Ethereum network has over 95 million unique addresses (wallets) as of April 23, 2020 and is growing rapidly. Compound is well-positioned to become a major addition to the global interest rates markets. It offers a way to earn interest on digital assets.