You’re missing out on Compound and DeFi, here’s why in 5 minutes
Welcome to another quick 5 minute guide to understand the compound protocol. If you’re into crypto, chances are you’ve heard about it. That’s great! if not here’s your opportunity to learn what compound is all about.
Compound is simply a tool for people to get money (borrowing) and to give it to others (lending). It’s that simple. Now there are some key aspects that make this project one of the most interesting ones in crypto right now…
It’s the biggest DeFi project. DeFi means Decentralized Finance and it’s a group of new projects focused on bringing traditional finance tools like compounding loans into crypto, in a decentralized way.
They have what’s called a Liquidity Pool which is simply a Smart Contract where all the money is stored. A single place to borrow money from. Traditionally in most decentralized banking apps, you have to make a loan to a borrower directly, peer-to-peer.
With Compound, they have a single place with all the money and people access it as they need. So if you want to borrow say, 10 ETH you can do that from the pool. Of course, you always have to have a collateral.
A collateral is some token like ETH that you provide to the liquidity pool for others to use. For instance, let’s say I want to setup as collateral 100 DAI. That money will be available to borrowers. So if someone needs 40 DAI, the Smart Contract will extract that from the pool.
You can then use that collateral to borrow some other currency. For instance, let’s say you lock 200 ETH as collateral. You are then allowed to use the 75% of that ETH to borrow other assets. If the 75% of 200 ETH is about 10,000 dollars, then you’ll be able to get 10,000 USDT or DAI or the equivalent for other tokens.
That’s essentially how you’re able to borrow and lend in a decentralized manner. This is also known as the crypto loan but decentralized.
Note that your collateral will be sold if the price of that currency drops in value. Imagine ETH dropping a 50% in a few days. Your locked ETH will not be worth as much. So the protocol will detect that change in value way before the big drop in value and sell your assets automatically.
In reality someone else is doing the selling of your collateral because the smart contract can’t execute that many actions at once. People are rewarded for it. These are called liquidators.
That way the protocol is not at risk. It literally can’t lose more than it earns.
All the money you put into the compound protocol generates you money. They give you a small % of your investment every single block and it is calculated for a yearly profit. Also known as APY, Annual Percentage Yield. Basically a percentage of how much money you’ll get after keeping your funds for a year inside the compound protocol.
Now there are 2 types of yearly yields:
- The stable APR: it stands for Annual Percentage Rate. Which essentially means you’ll get a stable, fixed percentage profit per year for your investment.
- The variable APY: it stands for Annual Percentage Yield. This provides you a variable APY which is constantly updated on every block based on the supply and demand of the protocol. You may want this if you believe the annual yield will increase because the currency is in high demand.
So depending on your risk tolerance you’ll choose one or the other. Personally I prefer the variable APY and lock it into APR once it has a huge percentage. That does happen. So be always mindful that you’ll investements can increase in a second.
Compound is named like that because every profit you generate while staking your tokens is immediately re-invested, making your base investment generate more money. For instance, let’s say you lend 200 DAI. After a month you have a total of 230 DAI. Now your profit will compount to generate a bigger profit based on that 230 DAI, not on the initial 200. Which means you’ll get more money, exponentially.
If 200 DAI at a 5% APY generates you 10 DAI per year, 230 DAI at a 5% APY generates you 11.5 DAI in profit. And the quantity compounds over your profits.
You couldn’t do that with most traditional lending platforms, at least not in a decentralized way. You simply earned interest on the initial quantity locked.
Now there’s something extremely interesting about Compound that makes it one of the best platforms ever created for investments: cTokens also known as Compound Tokens.
These are improved ERC20 tokens that you receive when you lock funds into the protocol. Basically you exchange your ETH for cETH which is a token that resembles ETH but has several functions to generate you a profit based on the APY.
The interesting part about it is that you can trade and move that asset to wherever you want! Essentially moving your locked money elsewhere to generate you more money. However this can only be done by smart contracts right now because their user interface hasn’t be updated. At least not when this articles was written.
Moreover, once you borrow money based on your collateral you can re-use that money as collateral. Let me repeat that: you can borrow money using borrowed money as collateral.
That’s huge. Because you can multiply your initial borrowed amount considerably beyond the initial collateral. This is called leverage yield farming. The main issue with this is that you’ll have to pay more fees and your investment will be more sensible to defaulting. That is, when an asset loses value, your collateral will be sold to prevent the protocol from losing money.
The reason people use leveraged collateral borrowing is because they also get COMP tokens based on their tokens locked, a very nice addition to make some extra profit while compounding.
The potential is massive. It’s up to you to accomulate a big percentage of profits by watching the movements that happen daily.
- Compound is the largest and one of the first lending platforms that allows you to compound your profits.
- You can choose between a stable and a variable APY depending on your risk tolerance.
- You get cTokens in exchange for your locked assets that can be moved elsewhere.