Compound Finance —Simplified

This article was featured on CoinMonks Blog.

[Edit : 07/21/2020] — This post is deprecated. Please refer new whitepapers released by Compound Labs

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This post is an attempt to explain the “Compound Protocol ” developed by Compound Labs, Inc. They released their White Paper (v1) on February 2019 and its v2 was officially rolled out in last May. Since the protocol is something new to the community, I will try to break down the concept in much simpler terms.

Money Market

Money market is the trade in short-term, highly-liquid debt securities. The role of individuals in any money market is to invest in short-term certificates of deposit (CDs) or Treasury bills and other such instruments, with an aim to gain a short-term return in the form of interest. This helps those who are in excess of liquid fund to earn a reasonable return within very short-span of time at a lower level of risk. At the same time, it also act as a major source for short-term cash flow needs of banks, companies and financial institutions of an economy. There also exist wholesale money market, which is actually limited to companies and financial institutions that lend or borrow in huge denominations.

Since the crypto-market has attracted many investors, speculators and traders during the past couple of years, need for trading time value of crypto-assets was also came in to picture. Unlike conventional financial markets, this new market was limited by two major limitations of blockchain technology:

Limited borrowing mechanism resulted in mispricing of assets in crypto-environment. Due to the decentralized nature of blockchain technology, it is kind of hard to value securities like “scamcoins”, which are bogus per se.
Also, the storage (hardware wallet) and maintenance (security assurance) cost incurred for the crypto-assets were so high that the asset itself become negative-yielding, if kept idle or HODL.

In order to ensure the creation of non-zero sum wealth, the community tried alternative solutions to create money markets that yield marginal income from liquid assets held by individual investors.

Centralized Exchanges like Poloniex introduced in-house “borrowing markets” enabling its customers to trade their crypto-assets on margin. As these exchanges were centralized by nature, it purely worked on trust and an assumption that the exchange won’t get hacked and lose your assets. In other words, you won’t get a chance there to move a position on-chain.
Peer to Peer decentralized protocols were introduced to facilitate collateralized and uncollateralized loans between market participants like lenders and borrowers. Since the protocol can be operated only by its participants, all those works like posting, managing and supervising of loan offers and active loans, along with confirming loan fulfillment also needed to be done by them which makes the process more hectic and slow.

These alternatives were not that effective when compared to the techniques we got there in conventional financial markets. Compound actually answered all these concerns.

Compound: The Money Market Protocol

Compound is a protocol built on ethereum ecosystem that gave birth to different ethereum-asset-based money markets on its decentralized nodes. These markets are actually a pool of assets that algorithmically derive interest-rates based on the supply and demand for that particular asset category. Lenders and Borrowers of these assets interact with the protocol directly in order to earn and pay (respectively) a floating interest rate, without having to negotiate any kind of terms such as maturity, interest rate, or collateral.

Supplying Assets

Since the conventional and decentralized peer-to-peer money markets need to match user’s asset-requirements with the available lenders in order to initiate a trade. Here in Compound, the protocol combines similar assets supplied by the lenders into a single fungible resource. This actually increases the liquidity of such pooled assets when compared to that of their status in direct-lending protocols. Also, it enables every lender to withdraw their assets anytime without waiting for the maturity of any loans issued against the pool.

When a lender supplies his assets to this protocol, he will be issued with an ERC-20 Token called ‘cToken’. Based on demand and supply of a particular asset type in the market, functions of the compound protocol will calculate the interest accrued for all those issued cTokens. The incentivization process is done by converting cTokens into an increasing amount of its holder’s underlying asset.

Borrowing Assets

In other peer-to-peer protocols, users need to negotiate with the lender for the loan’s maturity, interest rate, and other terms. But when we take Compound, the user only needs to select asset they want and nothing else. Borrowing cost of the same will be assigned by the protocol, calculated based on pure market forces.

Each market in the compound has a collateral factor that ranges from 0 to 1, which represents the portion of underlying assets value that can be borrowed from it. Like in any other markets, illiquid and small-cap assets will have the lowest collateral factor when compared to those liquid and high-cap assets.

Borrowing Capacity = Σ(Value of underlying Token Balance) x Collateral Factor

A user can only borrow up to their borrowing capacity and cannot transfer or redeem the collateral (after borrowing against it) in order to protect the protocol from default risks.

Interest Rate Model

The compound protocol follows an equilibrium interest rate model in each of its money markets, based on the demand and supply of that particular asset in the same market. Following the Price Theory, price here (interest rate) will act as a function of demand and supply, resulting in a decrease in interest rate when the demand is low and vice versa when the demand is high.

Utilization Ratio (U) is the single-unified variable of supply and demand in each markets(a). This can be expressed as:

Uₐ (utilization ratio of Market ‘a’)= Borrowingsₐ / (Cashₐ + Borrowingsₐ)

Now that we have utilization ratio, demand curve can be codified and expressed as a function of utilization. This helps in plotting the borrowing-interest-rates of each markets. For example, it can be calculated as a function:

Borrowing Interest Rateₐ = 2% + (Uₐ x 20%)

Same way, the interest rate earned by lenders can be calculated as the ratio of Borrowing Interest Rate’s to the utilization of funds in same money market. This can be illustrated as follows:

Lending Interest Rateₐ = Borrowing Interest Rateₐ x Uₐ

Compound Protocol doesn’t guarantee the liquidity of their tokens, rather it uses the interest rate model to incentivize its liquidity position. When demand for an asset is high, the liquidity of protocol / tokens will fall for sure. When that happens, interest rate will hike, thus incentivizing the supply and disincentivizing the borrowing.

What’s happening in Compound

Acknowledging the potential implications of this protocol, Dharma opened their platform for compound and they’ll be rolling it out in their V2, which is in beta version now.

Since the protocol has gained enough attention of the community, Ameen Soleimani wrote a medium post explaining the risks of lending on Compound. Considering his points, Robert Leshner replied to him as tweets about how Compound is going to address each of those risks.

Since the protocol is in its very growing stage, there are unexplored uses of the same for a better decentralized financial market environment. The community is so thrilled to explore the possibilities and utilize everything at its fullest.

Let’s wait and see how Compound itself become admin-less and decentralized as the team envisioned. Also, we wish the protocol remain unregulated for a better DeFi experience. Kudos!