1. Introduction to Compound
1.1 What is Compound?
Compound is a decentralized finance (DeFi) lending protocol that functions as an algorithmic money market on Ethereum. It allows users to:
- Deposit cryptocurrencies to earn interest (supply assets)
- Borrow assets against collateral (borrow assets)
Unlike peer-to-peer lending platforms, Compound operates via liquidity pools where rates are algorithmically determined based on supply and demand.
1.2 Key Characteristics
- Pool-Based Model: Funds are aggregated into shared liquidity pools rather than matched individually
- Real-Time Rates: Interest rates update per Ethereum block (~15 seconds)
- Transparent Accounting: Follows international accounting standards with on-chain verifiability
- Overcollateralization: Requires collateral exceeding loan value (typically 150% ratio)
2. Core Protocol Mechanics
2.1 Smart Contract Architecture
| Contract | Purpose |
|---|---|
MoneyMarket | Handles deposit/withdrawal/borrow/repay functions |
InterestRateModel | Calculates floating interest rates |
PriceOracle | Provides real-time asset pricing |
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2.2 cTokens Explained
When users deposit assets, they receive cTokens (e.g., cDAI for DAI deposits) that:
- Represent deposit balance + accrued interest
- Serve as collateral for borrowing
- Appreciate in value relative to the underlying asset
2.3 Borrowing Process
- Collateralization: Deposit supported assets (e.g., ETH) to receive cTokens
- Borrowing Power: Calculated as
Collateral Value × Collateral Factor(0-1) - Liquidation Risk: Occurs when borrowed value exceeds collateral threshold
3. Interest Rate Dynamics
3.1 Algorithmic Rate Model
Rates adjust based on pool utilization:
Borrow Rate = Base Rate + (Utilization × Multiplier)
Supply Rate = Borrow Rate × Utilization × (1 - Reserve Factor)Example: If DAI pool is 60% utilized with 10% base rate and 25% multiplier:
- Borrow Rate = 10% + (0.6 × 25%) = 25%
- Supply Rate = 25% × 0.6 × 0.9 ≈ 13.5%
3.2 Key Variables
| Parameter | Typical Value | Purpose |
|---|---|---|
| Base Rate | 0%-5% | Minimum borrow rate |
| Multiplier | 20%-50% | Sensitivity to utilization |
| Reserve Factor | 10%-20% | Protocol reserve percentage |
4. Risk Management
4.1 Liquidation Process
When collateral value drops below maintenance threshold:
- Liquidators repay portion of debt
- Receive discounted collateral (e.g., 5-10% bonus)
- Protocol maintains solvency
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4.2 Collateral Factors
| Asset | Typical Factor |
|---|---|
| ETH | 75%-85% |
| Stablecoins | 80%-90% |
| Altcoins | 50%-65% |
5. Governance (COMP Token)
5.1 Voting Mechanism
- 1 COMP = 1 Vote
- Minimum 1% delegation (10K COMP) to propose changes
- 3-day voting period + 2-day timelock delay
5.2 Governance Parameters
| Parameter | Value |
|---|---|
| Proposal Threshold | 10K COMP |
| Quorum | 40K COMP (4%) |
| Voting Period | 3 days |
| Timelock | 2 days |
FAQ Section
How does Compound differ from traditional banking?
Compound eliminates intermediaries through smart contracts, offers programmatic interest rates, and provides 24/7 global access without credit checks.
What happens if my collateral value drops suddenly?
The protocol will liquidate positions automatically when collateral falls below required thresholds to maintain system solvency.
Can I lose money by supplying assets?
While supplying is generally low-risk, potential losses could occur from smart contract vulnerabilities or extreme market conditions causing protocol insolvency.
How frequently do interest rates update?
Rates recalculate every Ethereum block (~15 seconds) when user transactions occur.
What's the advantage of cTokens?
cTokens simplify accounting by automatically accruing interest and can be transferred/traded while maintaining underlying asset exposure.
How is Compound more efficient than P2P lending?
Pool-based models provide instant liquidity without waiting for counterparty matching, with standardized terms for all users.