The Compound protocol positions itself as "The money market protocol". If Maker's role is to create and destroy stablecoins through collateralization, then Compound is a more easily understandable lending market - lenders must lend out their existing assets rather than creating debt out of thin air.
Compound was launched in 2018. In mid-2019, the V2 version was launched, adding the mechanism of cTokens. Currently, Compound supports lending and borrowing functions for more than ten tokens, including ETH, USDC, and WBTC.
The functionality of Compound is easy to understand. The protocol provides two functions: Supply and Borrow.
Supply allows users to deposit tokens into the protocol to earn interest. Compound establishes a pool for each token, such as the USDC pool, where all deposited USDC tokens are pooled together. For example, if the USDC asset pool originally had 9000 USDC and User A deposits 1000 USDC into the protocol, they will own 10% of the pool's assets. After depositing, the protocol will give them a certain number of cUSDC tokens. Assuming the current price ratio between USDC and cUSDC is 1:10, they will receive 10,000 cUSDC tokens, representing 10% of the pool's assets. After some time, if the protocol earns a total profit of 5% and the asset pool contains 105,000 USDC, when they withdraw, they can exchange their 10,000 cUSDC tokens for 10% of the pool's assets, resulting in a withdrawal of 10,500 USDC.
cUSDC mentioned here is a type of cToken. cToken represents ownership of a certain quantity of an asset that a user has deposited into Compound, such as cETH, cUSDC, cWBTC, etc. cTokens can be seen as a standard practice in DeFi protocols: when a user deposits an asset into a DeFi protocol, the protocol issues a certain quantity of tokens to represent ownership, which can be used in the future to withdraw a certain quantity of the deposited asset. We can refer to this type of token as "bond-like tokens" or, more simply, a form of IOU that represents the protocol's debt to the user. These tokens can also be transferred, representing the transfer of the debt claim to another party. This type of token will be mentioned in the introduction to other protocols later on.
The other function is Borrow. Users can borrow assets from the asset pool and repay them with interest based on the borrowing duration and interest rate. Of course, before borrowing assets, users also need to deposit tokens as collateral, and they can borrow a certain quantity of assets based on the collateralization ratio. The protocol monitors the collateral through an oracle and, if the collateral is insufficient, it will reclaim the borrowed assets at a slightly lower price than the market price.
The calculation of the borrowing interest rate is based on the utilization rate of the asset pool, which is the ratio of borrowed funds (Borrow) to supplied funds (Supply). For example, if the total supply in the USDC pool is 10,000 USDC and 5,000 USDC has been borrowed, the utilization rate of the asset pool is 50%. The higher the utilization rate, the higher the borrowing demand relative to supply, and thus the higher the interest rate. Therefore, the interest rate is a function of the utilization rate, and the specific calculation method is determined through DAO governance.
The calculation of the supply-side interest rate is simple: the interest earned from borrowing is evenly distributed to the entire asset pool, which is the borrowing interest rate multiplied by the utilization rate.
Compound protocol is cautious when adding new tokens and only allows high-quality tokens to enter the lending market. This provides some market opportunities for other lending protocols. For example, the audit mechanism of the Cream protocol is relatively aggressive and adds relatively new tokens to its lending market.
Although Maker issued protocol tokens before Compound, it was the issuance of Compound's protocol token - COMP - that truly ignited the DeFi frenzy. In the summer of 2020, Compound launched the issuance of COMP. The issuance of COMP adopted an innovative method, now known as "liquidity mining". The protocol issues protocol tokens to users based on their usage, such as the amount of funds provided and borrowed. This issuance method has been adopted by almost all subsequent DeFi protocols as the most effective way to attract users to use their own protocols, and it also sparked a wave of investment frenzy in DeFi.