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What is Compound and how does borrowing on it work?

Image Credit to the Compound Development Team

By sheer its locked-in value and user base, Compound is currently the leading DeFi project. Like MakerDAO, which preceded it, it’s a decentralized lending protocol and platform, which means that anyone can use it anywhere in the world to lend to or borrow from anyone else using smart contracts.

If you haven’t heard the term “smart contract” before, in this case, it’s enough to picture a lending contract that is software. If that’s too difficult to imagine, just think of a few lines of code that allow anyone to transact with anyone else without the involvement of a bank or broker in-between.

While MakerDAO’s smart contracts only allow loans to be taken out in its DAI stablecoin, Compound takes things a step further.

Why aren’t traditional lending systems good enough?

Before going any deeper, let’s take a step back and examine why decentralized (blockchain/smart contract-based) lending systems are needed.

Traditional lending is broken in every sense.

Banks and other lending providers control who gets access to loans and who doesn’t and in general, their system is based on both your credit and your existing relationship with them. In other words, the more you do business with them and the more that business goes well from them, the more loans you will be able to get.

Generally, this typically means that in the end, those who are rich in fiat and banking connections win out, and those that aren’t, don’t.

Big businesses over small businesses.

The rich over the average.

If you’re interested in more of a primer on why traditional lending doesn’t work, you can head here, but for now, these points serve to set the scene for decentralized lending systems like Compound.

Where does Compound come from and what is it?

Compound is a decentralized lending protocol and platform.

Basically, that means that it is both a network of computers that allows direct lending as well as an app(DApp) that does the same. If you’re not familiar with any of these basic terms yet, head here or simply familiarize yourself with what Ethereum is.

While doing so, make sure to get familiar with smart contracts, which are the foundational technology behind every DeFi-related project.

Generally, a smart contract can be best understood as lines of code that enforce agreements between two parties, like contracts. Since they exist as software that’s hosted on a blockchain (typically Ethereum), they’re also secured by that blockchain’s nodes. These nodes, which are usually called “full-nodes,” can be any user that maintains a full copy of their network’s blockchain at all times.

In doing so, they also split up all of the files and software that are hosted on that blockchain, amongst themselves. This means that hosting is distributed or “decentralized” and consequently, much more resistant to hacks.

To put it another way, popular hosting systems like Cloudflare or Amazon Web Services keep files, software, and websites in one identifiable location, while blockchains like Ethereum split said files up into many pieces across every computer that can be considered a “full-node.”

Once you’ve got this information in mind, we can then circle back to Compound and say that it uses smart contracts to build its own lending-focused app. These apps, when hosted on a blockchain are called decentralized applications or “DApps” because they exist across many different locations at once.

Like all other DApps, Compound runs on its own protocol as well, which tells its smart contracts and users how to interact to create a fully functioning decentralized lending platform. Over a series of Compound-focused plans, I plan to piece together how this works out for you.

For now, however, let’s take these foundational ideas and move on to how Compound works.

How does borrowing on Compound Work?

With Compound’s DApp, anyone can borrow from or lend to anyone else in the world, at any time.

Borrowing crypto from Compound takes only a few clicks, including logging onto its DApp and sending some crypto to its smart contracts as collateral for the loan you’re seeking. In a general sense, stablecoins are often the best to use in this respect since, unlike the typical cryptocurrency, they tend to retain a value of $1 a coin.

With this in mind, let’s say you decide to borrow DAI, which is MakerDAO’s native stablecoin and currently represents 50% of Compound’s total supply.

Since DAI’s Borrow APY is presently 7.1%, that means that you have to pay your loan back with that amount of interest. So, if you take out a loan for 1000($1000) DAI, when you pay it back, you’ll have to offer up 1071 DAI($1071). For the USA at least, this is a decent rate since the average loan tends to average somewhere at or above 9%.

As suggested above, Compound loans go beyond just DAI. All in all, you can also elect to take out USD Coin, Ether, 0x, Augur, Tether, Wrapped BTC, and Basic Attention Token. Each of these assets offers varying borrow APYs, with some going as low as 2.95%.

Beyond its diversified offering, the key reason that Compound’s system is so unique is that your loan is taken directly from another user who acts as a lender. Consequently, the interest that you pay at the close of your loan is then given to the lender, and the funds are returned to them as well.

At no time are any fees given to any bank, broker, or other organization that sits in the middle.

Every simple step of the process is decentralized.

But wait, these are crypto loans! How do I use them in the real world?

Right now, crypto lending largely benefits those who already use cryptocurrencies, through generating interest for lenders and offering all sorts of options for loans to borrowers who are often active traders.

In the future, many projects want to dial into everyday services so that these loans can be used for purchases that anyone might need to make.

What’s down the road?

In my next post on this project, I’ll dig into what “collateral factors” are, how they work, and how lenders factor into Compound’s ecosystem. Once you understand their full role, then it’s easy to grasp why Compound is already such a popular service.

For now, let this discussion serve as an introduction to one of DeFi’s most promising projects, and as always, if you like my content, let me know and follow me on Twitter here.

Finally, most of my free time is now being taken up with my newsletter, which is completely free and focused on how the rise of the Metaverse improves things for everyone. Sub here.

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Ian LeViness

Ian LeViness

85 Followers

Experienced Cryptocurrency Educator- currently at @Serotonin