Compound

Compound is a protocol on the Ethereum blockchain that establishes money markets, which are pools of assets with algorithmically derived interest rates, based on the supply and demand for the asset. Suppliers (and 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.

Each money market is unique to an Ethereum asset (such as Ether, an ERC-20 stablecoin such as Dai, or an ERC-20 utility token such as Augur), and contains a transparent and publicly-inspectable ledger, with a record of all transactions and historical interest rates.

Supplying Assets

Unlike an exchange or peer-to-peer platform, where a user’s assets are matched and lent to another user, the Compound protocol aggregates the supply of each user; when a user supplies an asset, it becomes a fungible resource. This approach offers significantly more liquidity than direct lending; unless every asset in a market is borrowed (see below: the protocol incentivizes liquidity), users can withdraw their assets at any time, without waiting for a specific loan to mature.

Assets supplied to a market are represented by an ERC-20 token balance (“cToken”), which entitles the owner to an increasing quantity of the underlying asset. As the money market accrues interest, which is a function of borrowing demand, cTokens become convertible into an increasing amount of the underlying asset. In this way, earning interest is as simple as holding a ERC-20 cToken.

Primary Use Cases

Individuals with long-term investments in Ether and tokens (“HODLers”) can use a Compound money market as a source of additional returns on their investment. For example, a user that owns Augur can supply their tokens to the Compound protocol, and earn interest (denominated in Augur) without having to manage their asset, fulfill loan requests or take speculative risks.

dApps, machines, and exchanges with token balances can use the Compound protocol as a source of monetization and incremental returns by “sweeping” balances; this has the potential to unlock entirely new business models for the Ethereum ecosystem.

Borrowing Assets

Compound allows users to frictionlessly borrow from the protocol, using cTokens as collateral, for use anywhere in the Ethereum ecosystem. Unlike peer-to-peer protocols, borrowing from Compound simply requires a user to specify a desired asset; there are no terms to negotiate, maturity dates, or funding periods; borrowing is instant and predictable. Similar to supplying an asset, each money market has a floating interest rate, set by market forces, which determines the borrowing cost for each asset.

Collateral Value

Assets held by the protocol (represented by ownership of a cToken) are used as collateral to borrow from the protocol. Each market has a collateral factor, ranging from 0 to 1, that represents the portion of the underlying asset value that can be borrowed. Illiquid, small-cap assets have low collateral factors; they do not make good collateral, while liquid, high-cap assets have high collateral factors. The sum of the value of an accounts underlying token balances, multiplied by the collateral factors, equals a user’s borrowing capacity.

Users are able to borrow up to, but not exceeding, their borrowing capacity, and an account can take no action (e.g. borrow, transfer cToken collateral, or redeem cToken collateral) that would raise the total value of borrowed assets above their borrowing capacity; this protects the protocol from default risk.

Risk & Liquidation

If the value of an account’s borrowing outstanding exceeds their borrowing capacity, a portion of the outstanding borrowing may be repaid in exchange for the user’s cToken collateral, at the current market price minus a liquidation discount ; this incentives an ecosystem of arbitrageurs to quickly step in to reduce the borrower’s exposure, and eliminate the protocol’s risk.

The proportion eligible to be closed, a close factor , is the portion of the borrowed asset that can be repaid, and ranges from 0 to 1, such as 25%. The liquidation process may continue to be called until the user’s borrowing is less than their borrowing capacity.

Any Ethereum address that possesses the borrowed asset may invoke the liquidation function, exchanging their asset for the borrower’s cToken collateral. As both users, both assets, and prices are all contained within the Compound protocol, liquidation is frictionless and does not rely on any outside systems or order-books.

Primary Use Cases

The ability to seamlessly hold new assets (without selling or rearranging a portfolio) gives new superpowers to dApp consumers, traders and developers:

• Without having to wait for an order to fill, or requiring off-chain behavior, dApps can borrow tokens to use in the Ethereum ecosystem, such as to purchase computing power on the Golem network
• Traders can finance new ICO investments by borrowing Ether, using their existing portfolio as collatera
• Traders looking to short a token can borrow it, send it to an exchange and sell the token, profiting from declines in overvalued tokens