Curious to learn about Compound Protocol? This article provides an in-depth understanding of Compound protocol, problems with centralized systems, and explains the concept of cTokens and how they can be created.
So, let’s get started.
Learning of the Blog
- Understanding COMPOUND
- Flaws with the Centralized Exchanges
- How does Compound work?
- What are cTokens and How They are Produced?
- Risks to Consider
- Concluding Lines
Robert Leshner is the founder and CEO of Compound protocol. According to the Compound’s official website, “It is an algorithmic, autonomous interest rate protocol built for developers, to unlock a universe of open financial applications.”
In simpler words, we can define ‘COMPOUND’ as a decentralized protocol for the frictionless borrowing of Ethereum tokens. It enables suitable money markets to function and offers a safe and positive approach to store digital assets, without the flaws of existing approaches.
This Ethereum- based blockchain protocol establishes money markets for the borrowing and lending of assets. Without negotiating in terms of the interest rate or collateral, suppliers, and borrowers of an asset can interact directly with the protocol and can earn and pay a floating interest rate.
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Flaws with the Centralized Exchanges
Centralized exchanges are in general owned and administered by an individual or a company that maintains complete control over all trader’s transactions.
Centralized exchanges place all traders’ trust in the hands of the exchange operators, as transactions can only be operated and approved by a central authority. These exchanges not only deal with privacy issues but are also prone to hacking; thus, users could end up losing their funds. Such exchanges do not provide users full control of their cryptocurrencies. This is due to the reason because the private keys of their wallets are held with the central exchanges, and if in case they got hacked, users will lose their funds.
How Does Compound Work?
As most of the cryptocurrencies sit idle on exchanges and in wallets, without yielding interest, the compound protocol aims at changing this methodology. Compound with its decentralized system aims to offer users a positive yield while storing assets. Now, let’s delve deeper to know how exactly it works.
Compound enables lenders and borrowers to provide and take out loans, respectively, by locking their assets into the protocol. The interest rates paid and received are determined on the basis of the supply and demand of each crypto asset, and the rates of interest are generated with every block mined. A user defines the asset they desire, and the transaction takes place instantly. The assets supplied are always higher than the assets borrowed, and it’s this excess liquidity that allows users to quickly withdraw or borrow their funds. Moreover, with Compound, loans can be paid back, and locked assets can be withdrawn almost instantly. Also, the protocol eradicates the long procedure involved where users have to wait for several days and even months to get their loans matured.
What are cTokens and How They are Produced?
cTokens are Compound’s native tokens. These are similar to other Ethereum ERC 20 tokens and can be transferred, traded, programmed, or redeemed at any given time. In simpler words, we can say that they represent a user’s funds deposited in Compound. By putting ETH or another ERC20 in the protocol, users get an equivalent amount of cTokens.
You might be wondering how much money your cTokens will accumulate over time? Here, it is important to understand that each asset has its own market, and the demand for lending or borrowing in that market determines the rate of interest.
Now comes the question- how can they be created?
When a user deposits crypto-assets into the Compound, then new cTokens are created. Like for example, if a user wishes a loan using ETH as a deposit, then, automatically, a user receives cETH in return for their collateral.
With Compound protocol, supported assets include Ether, Wrapped Bitcoin, Dai, Coinbase’s US Dollar Coin, Augur Reputation, 0x Token, Tether, and Basic Attention Token.
Risks to Consider
Undoubtedly, the Compound protocol offers reliable, trusted lending and borrowing solutions and has even gone through several security audits by reputed agencies such as Open Zeppelin and Trail of Bits. Still, the risk associated cannot be overlooked.
It should be noted that, when storing any crypto on an exchange or a wallet, the place can be hacked. Also, one needs to be careful when transferring cTokens because when you are transferring, you are also transferring the balance of the underlying asset, which can decline rapidly. Moreover, to maximize yield by over-leveraging, your position can get liquidated as well.
Don’t let the last section of this blog scare you, though. Each and every investment in the world comes with its own varying degrees of risk. It’s up to you to exercise properly to take precautions and mitigate those risks.
Compound’s public launch is one of the most significant growth events in the cryptocurrency market. It aims to help people have more access and control over their money and creates properly functioning money markets for Ethereum assets where each money market has interest rates based on supply and demand of the underlying asset. With Compound, users can supply tokens to a money market to earn interest, without relying on any intermediary.
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