In my latest post I discussed how one of the core features of DeFi is allowing people to earn interest on their cryptocurrency holdings. Compound was one of the first projects to gain traction and demonstrate the feasibility of this idea at scale. The team has enjoyed great success since launch, especially since summer 2020.
source: defipulse.com, a great way to keep track of the top DeFi projects
What Is Compound?
Compound is a way for users to borrow cryptocurrency natively on the blockchain.
Advantages Compared To Traditional Loans:
You don’t need to talk to a bank
You don’t need a good credit score
You don’t need to go through a KYC (Know Your Customer) process
The smart contract offering these loans is publicly available to all, at all times
Speed — you don’t need to wait days for a loan to be approved like at a bank
Disadvantages Compared To Traditional Loans:
Today loans are still constrained to the Ethereum ecosystem, meaning you can only lend and borrow in ETH or other ERC-20 Tokens (tokens launched using the Ethereum blockchain).
Less capital efficient — in order to borrow 1 ETH, one needs to escrow collateral that is at least equivalent to 1 ETH in another currency. It is possible to get traditional loans without escrowing an equivalent amount of money. You can provide your income statements, demonstrate a promising business plan, etc.
Most Interesting Features:
Liquidity Aggregation
Pay attention here. This is one of the most fundamental and interesting design patterns that we will see consistently employed throughout top DeFi projects. Let’s walk through this with an example:
Compound offers a lending market between ETH and DAI. Alice holds ETH and wants to earn interest, so she can deposit her ETH into one of Compound’s smart contracts to begin earning interest. Immediately upon depositing her ETH into the smart contract she begins earning interest. This happens because the smart contract that she just stored her funds in holds ETH from a bunch of other people as well who already made previous loans possible. In other words, Alice doesn’t need to go find an individual who is interested in borrowing her ETH, she can just supply it to a smart contract which aggregates everybody’s ETH together to make it available for loans. To lenders like Alice this is great because she starts earning interest right away and doesn’t need to put in any other work than sending her ETH to a smart contract.
For Bob, our borrower in this example, this design is also great because there is a giant pool of ETH that is readily available to be borrowed from. He doesn’t need to go find Alice and set up loan terms with her individually, he can just talk to the smart contract and immediately have access to the loaned funds.
One exciting emergent property of this is that you can have a bunch of normal people who aren’t rich pool their funds together in a smart contract to supply loans that previously only larger institutions like banks could provide, further disintermediating banks and democratizing financial tools for ordinary people.
Position Fungibility
When Alice supplies ETH to the smart contract, she is given a new token to track and prove that she is entitled to the ETH she supplied alongside the interest she has earned. The beautiful part of this is that she can freely trade this token to other parties without removing her ETH from the lending pool.
This allows Compound to consistently maintain more funds in their system, and it allows us to build more complex financial instruments, like a portfolio of different loans which all accrue interest.
Important Takeaways
This should serve as a simple introduction as to how it is possible for DeFi to enable you to earn interest simply by holding cryptocurrency. In the coming weeks we will cover more complex projects, but don’t discount Compound for its simplicity. It is still one of the most successful DeFi projects to date with exciting plans to expand and improve its infrastructure. We won’t cover that now, but if you are curious you can learn more about their plans here.
Liquidity aggregation — allowing people to pool their funds together to create more efficient marketplaces. One of the pillars of DeFi, we will consistently see this employed by top projects in the space.