The Decentralized Finance Revolution: Part I Understanding Compound

Written by Malik Corbett

One of the most promising areas of the blockchain space today, is the decentralized finance sector or DeFi. The DeFi movement was born out of the idea that individuals should be able to obtain credit on a peer-to-peer basis without relying on banks or other centralized financial intermediaries. The DeFi movement also promises to be more inclusive to people who don’t have access to the legacy financial system around the world. Furthermore, decentralized finance is orders of magnitude more cost effective than centralized fintech systems. However, there are some challenges that must be answered before DeFi becomes mainstream. Before we discuss the challenges and potential solutions, in the first 3 parts of this 4 part series, I will provide an overview of the Ethereum DeFi ecosystem which is the most mature and most liquid DeFi platform, so that the reader can get a grasp for what’s possible today.

Crypto Money Markets 

Compound is a decentralized money market protocol built on top of the Ethereum blockchain. The importance of Compound to the Ethereum ecosystem can not be understated. The value proposition of Compound  is that it allows Ethereum account holders to lend or

borrow native network assets, while computing interest in an autonomous manner using an algorithmic interest rate.

How does Compound work?  

To best understand the complex architecture of the Compound protocol, I will break up the decentralized money market protocol into 4 main components which are: 

  1. The Compound Smart Contracts   
  2. The Compound Utility token: cToken 
  3. Algorithmic Interest Rate 
  4. Price Feed

1. Compound Smart Contract

A smart contract is a set of computer code that sits on top of the blockchain network. The smart contract maintains the business logic and rules which are agreed upon between two or more parties. Blockchain smart contract is analogous to a web server which is software or hardware that manages an internet user requests for web applications. 

To that end, in the Compound platform, Ethereum account holders who either want to borrow or lend Ethereum based assets (e.g. Ether, Augur, 0x, DIA, Wrapped BTC, USDC and BAT) can interact with the Compound smart contracts. In fact, each smart contract is a separate money market designated for a specific Ethereum asset. For example, there is a money market smart contract for Augur token and a different money market smart contract for 0x. 

When Compound users want to lend an Ethereum asset such as Ether, the user stake their tokens in in the smart contract in return for the utility token(s) called cToken. The Compound protocol aggregates the supply of each user, when a user supplies an asset, it becomes a fungible resource ready to be lent. Unlike other forms of decentralized lending platforms where a user’s assets are matched and lent to another user, Compound’s model allows users to lend their assets to earn interest but do not have to wait for a maturity date to receive their assets back.   

2. cToken 

In the Compound protocol, user’s account balances are represented with the utility token named cToken. As mentioned above, each money market is implemented as a smart contract. Each user can perform five (5) basic functions on the smart contract which are: 

3. Algorithmic Interest Rate 

DeFi will revolutionize finance because it provides a more seamless and cost effective way for people to lend and borrow money and other assets. In systems such as Compound 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. The business logic, terms and interest rate are built right into the smart contract. In fact, the interest rate is set algorithmically based on supply and demand of the underlying asset in that specific smart contract.  As with the legacy markets, the Compound algorithm sets interest rates based on demand. When demand is low, interest rates will be low, and when demand is high, interest rates will be set high.

4. Price Feed

The final component that brings the Compound protocol together is the Oracle network. Blockchains and smart contracts are not able to communicate with the outside world. Hence, oracles gather information from third-party sources; oracles have the sole function of supplying data to trigger smart contracts to execute when the original terms of the contract are met.

In Compound the Oracle network gathers prices from the top crypto exchanges and reports back to the smart contract. The exchange rates are then pooled together to calculate the borrowing capacity and collateral requirements for each user. 

In closing, above I provided an overview of the 4 major components of Compound which should give the reader a better understanding of how a decentralized money market works on Ethereum. In Part II, I will describe DAI which is a decentralized Ethereum stable coin.    

Disclaimer: This post is for educational purposes only. This is not an endorsement to buy or sell any utility tokens or cryptocurrencies. Please consult your financial advisor before purchasing any digital assets.

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