This will be the first product that I will be reviewing as it has established itself as a pioneer of Decentralized Finance. Compound Finance is an open-source money market protocol built on the Ethereum blockchain and has taken up a large market share in the lending category. It is one of the more widely used product in the DeFi ecosystem.
Taking it as face value — Many users are attracted to the high lending rates that are offered by several of the lending protocols out there. These rates are pretty insane, to say the least when comparing to the typical interest rates that your deposits in the bank are earning, which would not even cover the costs of inflation. This means that you are losing purchasing power as time goes on when you put your money in the bank. Your growth of money has to outpace the rate of inflation for you to be effectively earning real returns. Takes a whole new twist into saving money, isn’t it?
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Banks also try to appeal to the public by advertising higher interest rates for fixed deposits where you are required to lock up a huge amount of funds for a certain period. It is a better saving alternative but to the rich — you will be giving up liquidity and a substantial amount of money is needed to be enjoying the advertised rates. The playing field is not fair to people with a small amount of savings.
Your deposits are also being used by the bank to provide loans to businesses and they profit by taking a massive cut in the interest rates earned. Why let banks take advantage of YOUR money when you can take control over your funds by removing the middleman and gain the return you rightfully deserve?
How does Compound Finance work?
Each decentralized lending protocol has a different approach regarding their model of lending and borrowing. Unlike the traditional format of lending where users’ funds are matched to an available loan and interest rate earned are only distributed once the loan is repaid, Compound Finance allows anyone to supply listed assets to its liquidity pool and immediately earn interest upon deposit. Interest accrues every Ethereum block so your total balance will be credited with interest every 15 seconds as it is the average Ethereum block time. This also ensures there is always excess liquidity which allows ease of access to withdrawal and borrowing of funds. The assets can be withdrawn at any time, provided there are enough funds in the liquidity pool. However, this model comes with a side effect. Interest from loans is distributed across all suppliers even when their funds are not in use hence interest rate earned is lower. There are currently 7 tokens that can be supplied and used as collateral on the Compound protocol — ZRX, BAT, DAI, ETH, USDC, REP & WBTC.
Interest rates are determined algorithmically by supply and demand which is prone to real-time fluctuations. Basic economics — Low supply & high borrowing demand will lead to an increase in interest rates, vice versa. The gross supply and borrow of each listed asset can be monitored here.
The protocol safeguards the lenders’ funds through over-collateralization. Borrowers first have to deposit assets into the system to provide collateral for their loans. The amount of collateral required for a loan is based on the quality of the asset supplied which is determined by the collateral factor. The collateral factor differs for each asset as liquidity and volume of the asset on exchanges play a huge part when there is a need for liquidation. The system will work out the maximum amount of funds that can be borrowed using the collateral factor which is reflected as Borrowing Power in the dashboard. Liquidation occurs when the value of the collateral provided falls below the borrowing power to ensure that lenders are always protected from default risk. This is a great tool for borrowers to find out about their collateral ratio and calculate liquidation prices which they can take note of.
The dashboard is very intuitive — Click on the asset that you wish to supply or borrow. DAI is a soft peg to the US Dollar and the price is derived from the Maker ETH/USD price feed. Hence, DAI can fall off the peg of 1 DAI:1 USD. The collateral factor for DAI is 75% which means I can borrow up to 75% of the value of my DAI. (My borrowing power is 3/4 of my supply balance) The utilization rate shows the % of funds that are being borrowed from the liquidity pool (79.23% x 7,098,863 DAI) and directly impacts the supply & Borrow APR.
Although there are no fees associated in using the protocol, all transactions on the Ethereum blockchain require Gas which is paid in ETH. You would need some ETH in your wallet to perform the transaction of enabling and supplying the asset. The speed of the transaction depends on the gas price (gwei) set and the congestion of the Ethereum network. To find out which is the most suitable gwei to set, head over to ETH Gas Station.
Tip: Perform the transaction when the Ethereum network is not congested to incur lower transaction fees. (Safe low & standard gwei are at 1)
After the transaction of supplying the asset is completed, you will receive cTokens. This represents your balance in the protocol which accumulates interest over time and acts as collateral for borrowing. To view your cTokens balance, you would have to add them to Metamask.
The most enticing part about Compound would be seeing your interest earned increasing every 15 seconds so make sure not to be glued to your screen! :) In my case, I have tried supplying USDC and DAI. I eventually converted my USDC to DAI to earn higher interest. In a span of 2 weeks, I have earned close to 7 DAI which is around 14.8% p.a. It would take a few years to even reach this amount of interest if I were to put it in a bank. Of course, interest rates are expected to drop drastically once this has reached the masses beyond the crypto native users.
As far as empowering one’s finance goes and onboarding of the financial system onto the blockchain, we should take a step back and review the potential risks that come with it.
Smart contract risk
Just like any other code, there are bound to be bugs in the contract which could be exploited by malicious users and would lead to dire consequences if the bug is severe. Protocols in DeFi are relatively new and have not gone through the test of time.
Compound Finance has been audited by Trail of Bits and is engaging with additional auditors to ensure that the smart contracts are secure with vulnerabilities kept to the minimum. If you still have your worries, there are emerging decentralized insurance products that cover smart contract risk. An example would be Nexus Mutual. The fund currently has $1.5 million insuring $560k worth of assets and provides coverage for Compound.
Price oracle failure
The price oracle plays a crucial role in maintaining the collateral ratio for each loan as it needs to constantly update the contract with the right price of each asset at all times. Failure to do so might result in the liquidation mechanism not working as intended which could lead to a loss on the lenders’ funds.
To mitigate this risk, 10% of interest earned for each asset is set aside as reserves and can be activated to cover the losses if such an event happens. The price oracle should also be rigorously tested to ensure its robustness.
As more people uncover the wonders of DeFi, Compound Finance will most likely be one of the first products they will come across. The process would provide insights as to how decentralized lending protocols work and give a great first impression as it is user-friendly. If you have some idle crypto lying around, remember to give Compound Finance a try!
Stay tuned for more reviews of different DeFi products which I have personally tried and leave your comments down below on which product I should try next! Follow me on Twitter.