Compound was started with the goal of creating more robust credit markets, a necessary component of any functional financial system. While centralized services can offer these facilities, they are trust-based systems that compromise on the decentralized nature of cryptoassets. This can be solved by creating trustless peer to peer protocols, however, they require more active participation from borrowers and lenders needing to be matched. Compound looks to solve these problems by creating a pooled loan model that allows users to deposit into a pool that borrowers can then withdraw from provided they post sufficient collateral. This means loans do not have any maturity and users do not need to wait for a counterparty since they are interacting with the aggregate of all users. Compound allows users to earn interest on their holdings, short assets they think are overvalued, or obtain assets they need to utilize without having to purchase them.
Compound initially began as a tokenless protocol. Upgrades and changes were made unilaterally by the Compound Labs team. The protocol was still non-custodial but there was a centralized entity that retained administrative privileges. In order to remove themselves from this position, the team introduced COMP, a token used to govern the protocol. After several stages, Compound is now fully controlled by COMP holders with no remaining privileges held by Compound Labs.
The COMP token is used to propose and vote on changes to the protocol. It was explicitly not marketed as an investment, however, it is widely believed token holders will eventually vote in a mechanism of value capture providing them with some claim on the cash flows of the system.
Compound pools are created by users supplying assets in return for ERC-20 “cTokens” which entitle holders to a fixed percentage of the overall pool. As borrowers withdraw funds and repay them with interest, the total pool size increases giving cToken holders the right to a growing balance meaning they are continuously earning interest.
Borrowers can withdraw an amount up to their total capacity equaling the sum of the token balance multiplied by the collateral factor which is a number 0-1 representing the portion that can be borrowed. An asset with a high collateral factor means it is a better form of collateral and typically a relatively liquid, large market capitalization asset. In the event the collateral decreases in value past the close factor, then third parties can purchase the underlying collateral minus a liquidation discount (currently 5%) in order to repay the debt.
The interest rate paid on the debt is determined by market forces. As the ratio of borrowed assets to total pool size increases, the interest rate will increase accordingly to incentivize more lenders to come in and ensure the pool doesn’t run out.
Compound is governed entirely on-chain by COMP holders where 1 token equals 1 vote. Holders who can vote directly or delegate their voting rights to another party they deem more capable of making decisions. Example changes include adding support for additional assets, modifying interest rate models, or changing an asset’s collateral factor. All governance activity occurs through Governor Alpha, the module used to conduct these changes.
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