What is Compound (COMP)? How does It Work? A Complete Beginner’s Guide[2024]

Compound Finance is a decentralized lending and borrowing platform based on the Ethereum blockchain.

From mortgages to personal loans and leveraged trading of assets, lending is an important function of the traditional financial system. Likewise, lending and borrowing are essential functions of decentralized finance (DeFi) meant to perform a similar function but without the reliance on centralized third-parties.

With its introduction in 2018, Compound Finance was one such lending and borrowing protocol. While banks and traditional capital markets allow governments, businesses, and individuals to borrow and lend fiat money, Compound connects those who want to lend their crypto assets with potential borrowers via its smart contracts.

Compound’s native token, COMP, is used to govern the platform and as a medium of rewards for using its lending and borrowing services.

What is the Compound protocol (COMP)?

Built on the Ethereum blockchain, the Compound protocol provides liquid money markets offering services such as lending and borrowing. Supporting a number of crypto assets, the Compound protocol allows users to deposit crypto into lending pools providing capital for borrowers on the network and allowing them to earn interest in return.

After depositing funds into the lending pool, lenders are issued “cTokens” (cETH, cDAI, cBAT) which represent the deposit made. These tokens can then be traded or transferred within the platform, or redeemed for the original cryptocurrency deposited. This process is conducted by smart contracts and operates entirely automatically with interest rates algorithmically assigned based on the activity in its liquidity pools. 

The Compound protocol also uses the ERC-20 native COMP token which is distributed to traders that utilize the Compound market, i.e. borrowing, withdrawing or repaying the asset. COMP tokens are distributed each time an Ethereum block is mined proportional to the interest collected from each asset. The COMP cryptocurrency grants COMP token holders governance and voting rights.

Following notable investments from the likes of consulting firm Bain Capital Ventures, Andreessen Horowitz, and Polychain, the platform has grown and established a strong reputation within the decentralized finance space and the greater crypto world.

The history of Compound and who created it

Compound was founded in 2017 by Robert Leshner and Geoffrey Hayes, who both previously held high-profile jobs at PostMates, an online food delivery service. Leshner holds the CEO position while Hayes remains the CTO at Compound Labs, Inc, the software development firm behind the COMP protocol. Compound Labs is an open-source software development firm creating cutting-edge tools, products, and services for the innovative DeFi ecosystem.

In 2018, the platform raised $8.2 million from notable venture capital firms Bain Capital Ventures and Andreessen Horowitz. A year later, Compound raised an additional $25 million from many of the same investors along with new ones including Paradigm Capital.

How was Compound developed?

COMP was first launched in September 2018, founded by University of Pennsylvania graduates Robert Leshner and Geoffrey Hayes. Leshner has a degree in economics and now serves as the CEO of the San Francisco-based Compound Labs, while Hayes has a background in engineering and computer science and serves as CTO.

Compound has gone through significant changes with each of its updates since 2018, demonstrating an active community and developer culture. In May 2019, a second version of the protocol (Compound v2) was released, and this was followed three years later by Compound III (also called v3 or Comet) in August 2022.

Throughout its existence, COMP Labs has received nearly $71 million in funding from multiple venture capital sources, including Andreessen Horowitz.

How does Compound work?

As one of DeFi’s oldest lending and borrowing protocols, Compound began with a relatively straightforward model of lending pools. In this model, lenders supply assets into a pool, and borrowers can withdraw those assets as loans—as long as the loans are adequately collateralized by the borrower’s deposits into the platform. Each asset was contained in its own pool (i.e. one pool for ETH, one for UNI, one for COMP, etc.).

Because borrowers cannot withdraw more than their deposits, the loans they take are considered overcollateralized. This protects lenders from default (when borrowers can’t or don’t make their required payments on debt).

Overcollateralization is a key component of DeFi and is what allows decentralized lending/borrowing to be trustless.

Lending/supplying

The process of lending on the Compound platform is called supplying. Lenders are able to earn interest on their cryptocurrency by depositing cryptocurrencies into the Compound platform. Borrowers are also required to deposit digital assets into the protocol, which can earn interest but cannot be withdrawn for the duration of the borrowing period.

The platform currently supports roughly 20 crypto assets, from Basic Attention Token (BAT) to Wrapped Bitcoin (WBTC), with Ethereum (ETH) and a number of stablecoins (DAI, USDC, and USDT) being the most actively used.

Once users lend assets to the platform, they are issued with ERC-20-based cTokens corresponding to the cryptocurrency deposited (i.e. cETH, cDAI, etc.). These tokens confirm the liquidity providers’ deposits and offer a number of other incentives.

Borrowing

After depositing a particular cryptocurrency into the decentralized finance protocol, users are assigned a “borrowing capacity”. This is a limit set in USD based on the rate of the crypto asset which is determined by the Open Price Feed. When depositing multiple cryptocurrencies, the borrowing capacity will factor this in.

Users can also borrow cryptocurrencies supported by the protocol based on a coin’s collateral ratio. For instance, if DAI has a collateral ratio of 70%, users can borrow DAI up to 70% of the total amount deposited. Typically, collateral ratios are between 60% and 85%.

Similar to the lending process, when borrowing cryptocurrency borrowers are issued cTokens. So when borrowing DAI for instance, borrowers will be issued cDAI tokens, with the interest payable based on these tokens as well.

Withdrawing

After paying back the borrowed debt, users can redeem their deposited funds. Without having to deal with other traders, the protocol seamlessly utilizes a dynamically maintained set of liquidity pools. The platform also does not charge any withdrawal penalties or hold users to minimum investment times.

When users redeem their funds, the cTokens issued are added to the accumulated interest and converted back to the originally deposited cryptocurrency. These funds can then be withdrawn into the connected wallet.

Account Health

The COMP platform uses a system called “account health” to establish whether accounts are in risk of liquidation. This system measures the sum of the deposited funds against the total amount borrowed. If a user’s account health falls dangerously low, the account could be liquidated, and some of the collateral forfeited.

This process is managed in a decentralized way where platform users act as liquidators and monitor for risky accounts. Should they liquidate an account they earn a portion of the liquidated funds.

What is the COMP token?

The COMP token is the Compound platform’s native token which mainly serves as a governance token, with a built-in incentive for users holding the token. Holders of COMP tokens are able to vote on all important decisions pertaining to the protocol, including interest rates. Much like the cTokens, COMP tokens are based on Ethereum’s ERC-20 token standard. 

Compound tokens have a total supply of 10,000,000 tokens, of which over 70% of Compound coins are in circulation (at the time of writing).

Who Are the Founders of COMP? (History of Compound)

Compound was founded by veteran entrepreneurs Geoffrey Hayes and Robert Leshner.

In 2018, Compound raised $8.2 million in funding from distinguished venture capital firms Andreessen Horowitz and Bain Capital Ventures.

The following year, it raised an additional $25 million from many of the same investors – along with new parties such as Paradigm Capital, a VC fund with ties to Coinbase.

A share of the total supply of COMP cryptocurrency was initially distributed to investors in the company as well as the team.

What Makes Compound Unique?

Compound is unique in its incentivized approach to decentralized finance (DeFi). Along with the usual benefits associated with DeFi, users are rewarded for their participation with COMP tokens.

COMP not only gives users additional value for their loyalty, it also acts as a governance token. This incentivizes users to not just participate in the protocol, but to hold their tokens in order to vote on future decisions that will affect things such as interest rates and other factors that may impact their future revenue.

What Gives COMP Value?

As mentioned above, one valuable aspect of COMP is that its holders can vote on decisions that will affect the future of the software.

A COMP holder may also delegate their voting power to someone else. This allows for an outside source, someone who is not a COMP holder – such as a legal, financial, or other expert – to vote on behalf of COMP holders if more sensitive issues arise.

Compound v2 and Compound v3

Compound v2 introduced two important new features to the platform:

• COMP – Compound’s token allowed for community governance of the platform and was also used to incentivize deposits, lending, and borrowing.
• cTokens – When users deposited assets (like LINK) into Compound v2, they received cTokens (like cLINK) in return. These allowed users to benefit from collecting interest at the specific market’s rates and turn and use cTokens as collateral in other DeFi protocols.

Compound v3 converted Compound from a market of many assets to a market of one base asset, setting it apart from other lending/borrowing protocols like Aave. This means that when users deposit crypto collateral (like ETH, LINK, UNI, or COMP), they can borrow up to a percentage of their deposit value only in the USDC stablecoin. Using one base asset makes the process of taking out loans more capital efficient and reduces risks of exposure to multiple potentially volatile assets.

Earning rewards

Users who provide loans to borrowers in USDC can earn rewards on their holdings, and the reward rate is set by governance and is subject to change based on market conditions. The interest paid by borrowers of the base asset conforms to similar rules.

Additionally, extra rewards may be offered to lenders and/or borrowers (in the form of COMP tokens) depending on market conditions.

Borrowing and liquidation

Compound’s stability relies on loans being overcollateralized. When loans exceed their collateral backing, users can get liquidated. This means the network will “absorb” the borrower’s collateral and returning a percentage of that collateral back to them in the form of the base asset, minus a fee (the liquidation penalty). Through this process, a borrower loses some of the original value of their collateral but is not left entirely empty-handed. Lenders are thus protected from borrower defaults.

When borrowing crypto through Compound, the platform’s borrowing specifications for each type of collateral include:

• Oracle price – the quoted price of the collateral, according to Compound’s oracle.
• Collateral factor – the portion of the collateral that can be borrowed against. For instance, if the collateral factor for ETH is 83%, then if you deposit 100 ETH you can borrow USDC up to an equivalent value of 83 ETH.
• Liquidation factor – the level at which a borrower can have their collateral liquidated. For instance, if the value of the above example’s USDC loans exceeded 90 ETH (liquidation factor of 90%) due to fluctuations in price, the user could get liquidated.
• Liquidation penalty – the fee a user pays to the protocol for being liquidated.

How is the COMP token used?

Compound’s platform token, COMP, conforms to the ERC-20 standard used by all assets on the Ethereum blockchain.

COMP is primarily used to govern the protocol through proposing and voting on changes to the platform. The protocol also provides COMP as an incentive for using the system, such that users collect distributions of COMP tokens according to how much they are lending or borrowing.

Token distribution

There is a maximum supply of 10 million COMP tokens. Of these, 42% of tokens will ultimately be distributed to users of the platform over time, 26% were allocated to the founders/team, 24% were promised to investors/shareholders, and 8% were reserved for the community and governance incentives. The tokens allocated to the founders/team and investors/shareholders are subject to a release schedule over the course of four years, ending in June 2024.

Other Technical Data

The Compound protocol utilizes 5 key factors to achieve decentralized governance:

1. COMP – an ERC-20 token that determines the voting power a user holds. The more COMP a user has in their wallet, the more weight their delegation or vote on a proposal holds.
2. Delegation – COMP holders cannot vote or create proposals until they delegate their voting rights to an address. The address can be anyone’s, or the user’s own wallet if they wish to vote themselves.
3. Proposals – proposals are executable code that modify the protocol in some manner. In order to create a proposal, a user must have at least 1% of the total COMP supply delegated to their address. There is a total of 10 million COMP in existence, so a user must have at least 100,000 COMP delegated to their address.
4. Voting – users can vote for or against single proposals once they have voting rights delegated to their address. Voting periods last for 3 days. If the majority votes for a proposal, the proposal is queued in the Timelock.
5. Timelock – all governance and other administrative actions are required to sit in the Timelock for a minimum of 2 days, after which they are able to be implemented.

How Is the Compound Protocol Secured?

Since Compound is a decentralized application (dApp) running on the Ethereum network, it is primarily secured through Ethereum itself.

Compound is able to function thanks to smart contracts that allow for the autonomous execution of every activity available in its protocol.

The future development and direction of Compound is also secured through the governance system afforded by its native COMP token.

Compound Essentials

• Compound was introduced in 2018 as a novel decentralized lending and borrowing platform which has since gone through two major updates
• The platform’s most recent version, Compound v3, allows borrowers to supply collateral in the form of multiple cryptocurrencies but borrow only one (for instance, USDC)
• The COMP token is used for governance and to incentivize use of the platform

How does Compound keep track of collateral value?

The lending platform connects to an independent network called Chainlink. 

Chainlink is a network in which computers keep track of events around the world. From geographical conditions like weather and traffic, to asset prices on various public markets like the New York stock exchange and crypto exchanges.

An army of automatic reporters collaborate to form a database of truth (with very small margins of error). This source of truth is used by Compound and many other decentralised protocols to determine the average market price of any asset, around the world, 24/7. 

Who controls or owns Compound Finance?

All decentralised finance applications are never controlled or owned by a single company, even though Compound was founded by one.

The protocol is governed by holders of the COMP token, an ERC-20 token that circulates in the Ethereum network (as well as layer-2 networks like Polygon). 

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