As a decentralized money-market protocol, Compound enables users to participate as depositors or borrowers by interacting with smart contracts. In other words, Compound is a peer-to-smart-contract ecosystem, removing some of the pitfalls of centralized exchange and peer-to-peer lending.
As depositors, users place their assets (Ethereum tokens) into asset-specific money-markets. And borrowers can borrow assets from these money-markets as long as they are over-collateralized on their loan. Each asset-specific money-market is a smart contract within the protocol.
Key features of Compound include
- Over-collateralized borrowing of assets
- Deposits represented by Compound-specific versions of assets i.e. "cTokens"
- An algorithmically set interest rate
What is over-collateralized borrowing?
In Compound, users are expected to deposit assets into the protocol to use as collateral when they plan on borrowing assets. Every user has a maximum borrowing capacity which is measured as the sum of each deposited asset multiplied by the asset’s collateral factor. Each asset will have its own collateral factor - the maximum percentage of the asset’s deposited value that can be borrowed - as determined by the protocol’s governance. A user risks being liquidated if they exceed their borrowing capacity.
What are cTokens?
Compound represents deposited assets as ERC-20 cTokens e.g. USDC will be cUSDC. There is an exchange rate between a cToken and its underlying asset. The exchange rate will increase over time as borrower interest - and hence the total borrowed balance - accumulates in the protocol. As a result, when a user wants to redeem their cTokens and withdraw their deposits, they should receive a larger amount of their asset during withdrawal compared to the initial deposit.
The interest rate for each market updates on any block where the ratio of borrowed assets to supplied assets in the market has changed. The amount of change in the rate is dependent on the interest rate smart contract implemented for the market and the amount of change in the ratio of borrowed and supplied assets.
COMP token and governance
Holders of the COMP token can participate in the governance of the protocol by voting on new proposals, new assets and upgrades to the protocol. Every Compound user accrues COMP for each block in which they are supplying to or borrowing from the protocol.