Compound (COMP) Guide: How the DeFi Lending Protocol Works

Compound is changing how lending and borrowing work by removing banks from the equation. This guide explains how Compound's decentralized protocol operates, what makes its COMP token valuable, and how you can trade it on LeveX.

What is Compound (COMP)?

Compound is a decentralized finance (DeFi) protocol that enables users to lend and borrow cryptocurrency without going through traditional financial institutions like banks. Built on the Ethereum blockchain, Compound creates markets where people can supply their crypto assets to earn interest or borrow against their holdings.

The protocol works automatically through smart contracts – self-executing code that runs on the blockchain. These contracts manage the lending pools, interest rates, and collateral requirements without human intermediaries, creating a trustless system where all transactions are transparent and verifiable.

COMP is the native token of the Compound platform. While it has value as a tradable asset, its primary purpose is governance – COMP holders can propose and vote on changes to how the protocol operates. This makes Compound a community-controlled financial platform rather than one managed by a central authority.

The Compound protocol fills an important gap in the cryptocurrency ecosystem. While Bitcoin and many other cryptocurrencies provide ways to transfer value, Compound adds financial services that previously required banks – specifically, the ability to earn interest on deposits and to borrow against existing assets.

For crypto holders, Compound transforms idle assets into productive ones. Rather than simply holding cryptocurrency in a wallet, users can deposit these assets into Compound to earn interest while still maintaining the potential upside of their crypto investments.

The History of Compound

Compound's development reflects broader trends in the evolution of decentralized finance, with a clear focus on creating more accessible financial services.

Foundation and Early Development

Compound was founded in 2018 by Robert Leshner and Geoffrey Hayes, graduates of the University of Pennsylvania with backgrounds in economics and computer science respectively. Leshner serves as CEO of Compound Labs, while Hayes contributes his technical expertise as CTO.

The project attracted substantial venture capital backing, raising nearly $71 million from prominent investors including Andreessen Horowitz, Bain Capital Ventures, and Polychain Capital. This funding helped establish Compound as one of the early leaders in the decentralized finance movement.

Protocol Evolution

Compound has undergone several significant updates since its launch:

Initial Launch (2018): The first version of Compound introduced the core concept of pooled lending markets where users could supply assets and borrow against collateral.

Compound v2 (May 2019): This major update introduced two critical features – the COMP governance token and cTokens, which represent a user's deposit in the protocol plus accumulated interest.

Compound III (August 2022): Also known as Comet, this version represented a significant shift in the protocol's design. While earlier versions created separate markets for each asset, Compound III focused on single-asset borrowing markets, with USDC (a stablecoin) as the primary borrowed asset, allowing for greater capital efficiency and risk management.

These evolutions demonstrate Compound's commitment to improving its service based on user feedback and market conditions, continuously refining its approach to decentralized lending.

How Compound Works

Compound operates through several interconnected mechanisms that together create a decentralized lending and borrowing ecosystem.

Supply and Borrow Markets

At its foundation, Compound creates liquidity pools for various cryptocurrencies. These pools function as the backbone of the lending and borrowing system:

Users supply their crypto assets to these pools, making them available for others to borrow. In return, suppliers earn interest based on the demand for that particular asset.

Borrowers can take loans from these pools by first supplying collateral worth more than what they intend to borrow. This overcollateralization protects lenders and maintains the stability of the protocol.

Interest rates on Compound adjust algorithmically based on supply and demand. When there's high demand to borrow a particular asset, interest rates increase to attract more suppliers. Conversely, when supply exceeds borrowing demand, rates decrease.

cTokens: Representing Deposits

When users deposit assets into Compound, they receive cTokens in return. For example, supplying ETH gives you cETH, supplying DAI gives you cDAI, and so on. These cTokens serve several important functions:

They represent the user's share of the lending pool, including both the original deposit and any accrued interest.

cTokens appreciate in value relative to the underlying asset over time as interest accumulates, meaning one cDAI today will be worth more DAI in the future than it is now.

They remain liquid and transferable, allowing users to move their position without withdrawing from the protocol.

cTokens can also be used in other DeFi applications, creating composability between different protocols.

Overcollateralization and Risk Management

To protect lenders and maintain system stability, Compound requires borrowers to deposit more value than they take out:

Each asset has a "collateral factor" that determines how much can be borrowed against it. For example, a collateral factor of 70% means that for every $100 worth of that asset deposited, the user can borrow up to $70 worth of other assets.

If the value of a borrower's collateral falls too close to the value of their loan due to market fluctuations, their position can be liquidated. This means some of their collateral is sold at a discount to repay the loan.

This overcollateralization system eliminates the need for credit checks or identity verification, as the protocol is secured by the locked collateral rather than trust in the borrower.

Governance Through COMP

The COMP token gives holders a say in how the protocol develops and operates:

Token holders can propose changes to the protocol, such as adding new assets, adjusting interest rate models, or modifying collateral requirements.

Proposals are voted on by COMP holders, with voting power proportional to the amount of COMP held.

This governance model allows the protocol to evolve based on community consensus rather than decisions made by a centralized team.

Approved changes are implemented through transparent on-chain transactions, ensuring all updates to the protocol are visible and verifiable.

COMP Tokenomics

Understanding the distribution and utility of the COMP token provides insight into both its value proposition and governance structure.

Supply and Distribution

COMP has a fixed maximum supply of 10 million tokens, distributed across several key stakeholder groups:

• 42% (4.2 million) allocated to users of the protocol, distributed over time as incentives for participation
• 24% (2.4 million) allocated to shareholders and investors in Compound Labs
• 26% (2.6 million) allocated to the founding team and employees
• 8% (800,000) reserved for future governance incentives and community initiatives

The tokens allocated to founders, employees, and investors are subject to a four-year vesting schedule ending in June 2024, gradually releasing these tokens into circulation.

This distribution model was designed to align incentives across different stakeholders while ensuring that long-term control of the protocol would shift toward active users rather than remaining concentrated with early investors.

Token Utility

The COMP token serves several functions within the Compound ecosystem:

Governance Rights: The primary utility of COMP is the ability to propose and vote on changes to the protocol. This includes decisions about adding new assets, adjusting interest rates, allocating community resources, and upgrading the protocol itself.

Protocol Participation Incentives: COMP tokens are distributed to users based on their activity in the protocol, with both suppliers and borrowers eligible to earn COMP. This incentivizes participation and helps distribute governance rights to active users.

Market Value: As a tradable asset, COMP has value on secondary markets, allowing holders to realize financial returns based on the protocol's success and adoption.

DeFi Integration: COMP can be used across various other DeFi protocols, whether as collateral, in liquidity pools, or for yield farming opportunities, creating additional utility beyond the Compound platform itself.

The token's value is ultimately tied to the success and adoption of the Compound protocol, as greater usage creates more demand for governance rights and potentially increases the financial value of holding COMP.

Real-World Applications of Compound

Compound has found practical applications both for individual users and within the broader DeFi ecosystem.

For Individual Users

Compound offers several use cases that solve real problems for cryptocurrency holders:

Earning Yield on Idle Assets: Rather than letting cryptocurrency sit unused in wallets, users can deposit assets into Compound to earn interest, creating passive income from their holdings.

Short-Term Liquidity: Users who need cash but don't want to sell their crypto can borrow against their holdings, allowing them to access liquidity while maintaining exposure to potential price appreciation of their assets.

Portfolio Diversification: By supplying one asset and borrowing another, users can effectively diversify their cryptocurrency exposure without selling their original holdings.

Leverage: More advanced users can amplify their position in a particular asset by repeatedly borrowing and supplying, though this strategy comes with increased risk.

Ecosystem Integration

Beyond individual use, Compound has become an important building block in the wider DeFi ecosystem:

Integrations with Wallets and Interfaces: Many cryptocurrency wallets and DeFi dashboards have integrated Compound, allowing users to access its lending and borrowing functions through familiar interfaces.

Basis for Other DeFi Protocols: Several other DeFi projects have built upon or integrated with Compound, using it as infrastructure for their own services. This demonstrates the "money lego" nature of DeFi, where protocols can be combined in novel ways.

Institutional Adoption: Some cryptocurrency companies and investment funds actively use Compound as part of their treasury management strategy, earning yield on reserves while maintaining liquidity.

These applications show how Compound has evolved from a theoretical concept to a practical financial tool used by individuals and organizations to solve real financial needs.

Trading COMP on LeveX

LeveX offers multiple ways to trade COMP based on your experience level and investment strategy:

Spot Trading

Spot trading allows you to buy and hold actual COMP tokens. This approach is suitable if you:

• Want to own the underlying asset
• Are interested in potentially participating in governance
• Prefer straightforward buy/sell trading

Perpetual Contracts

Perpetual contracts let you trade COMP price movements with leverage without owning the actual tokens. These derivatives offer:

• Leverage of up to 100x to amplify potential returns
• Ability to profit from both rising and falling prices
• No need to manage actual token storage or security

LeveX provides competitive fees and an intuitive interface for both trading options, making it easy to incorporate COMP into your trading strategy.

Advantages and Challenges

Compound's Strengths

Trustless Financial Services: Compound eliminates the need for traditional financial intermediaries, providing lending and borrowing services without requiring users to trust a central authority.

Transparency: All activities on Compound are visible on the Ethereum blockchain, creating unprecedented transparency compared to traditional financial services.

Community Governance: The COMP token enables users to have a direct say in how the protocol evolves, creating alignment between users and the platform's development.

Composability: Compound is designed to work with other DeFi protocols, allowing for integration into the broader ecosystem and creating more complex financial products.

Challenges to Consider

Collateralization Inefficiency: The requirement to overcollateralize loans means that capital is not used as efficiently as it could be in traditional finance, where unsecured loans are possible.

Smart Contract Risk: Despite audits and security measures, there's always some risk of vulnerabilities in the smart contracts that could potentially lead to loss of funds.

Gas Fees: As an Ethereum-based protocol, Compound users must pay transaction fees in ETH, which can become costly during periods of network congestion.

Regulatory Uncertainty: The regulatory status of DeFi protocols remains unclear in many jurisdictions, creating potential legal risks for users and the protocol itself.

Getting Started with Compound

Whether you're interested in Compound for its innovative approach to decentralized finance, the yield opportunities it offers, or the trading potential of the COMP token, understanding this protocol provides insight into how blockchain technology is reshaping financial services.

For traders, creating a LeveX account gives you access to both spot trading and leveraged perpetuals for COMP, with competitive fees and an intuitive interface.

If you're new to cryptocurrencies, our Help Center provides resources to help you understand trading basics and platform features. For more information about other cryptocurrencies, check out our Crypto in a Minute series.