Compound is a decentralized protocol for borrowing and lending cryptocurrencies on the Ethereum blockchain. In technical terms, it is an "automated money market".
How does Compound work?
Compound is a two-sided market, with suppliers of capital (ie. the lenders) on one side, and demanders of capital (ie. the borrowers) on the other.
Lenders to Compound send their assets to the Compound Protocol, where the assets are held non-custodially by the Compound smart contracts. In exchange, Lenders receive cTokens. cTokens are redeemable for the underlying asset, so they are called "accounting tokens", and they accrue interest in real-time, 24/7/365.
On the other side of the market, borrowers post cryptocurrency as collateral in order to borrow, and are required to post more value as collateral than they are allowed to borrow. This over-collateralization mitigates the risks to lenders, because even if borrowers never make a repayment their collateral can be sold to repay the depositors.
Why do people use Compound?
Lenders typically use Compound for one reason: to earn interest on their crypto-assets.
Borrowers use Compound for many reasons, but some of the common reasons are:
To get leverage to speculate on cryptocurrency price fluctuations
To make large personal purchases using the gains on cryptocurrencies that have appreciated in value, without having to sell the crypto
How do interest rates work in Compound?
Interest rates are a function of asset utilization in the Compound protocol. When an asset is highly utilized, it will have a high interest rate. When its utilization rate is low, it will have a low interest rate.
Utilization can change based on changes to either supply or demand of an asset — utilization increases when either more borrowers borrow from Compound or when depositors withdraw money from Compound, and decreases when either depositors deposit money into Compound or when borrowers make repayments.
Because utilization can change every 15 seconds, interest rates also fluctuate as frequently as every 15 seconds.
What are the risks to using Compound on Dharma?
The primary risks associated with using Compound are:
Technical risk — you are using experimental software built by two companies, Dharma and Compound. While this software has been extensively tested, it is still relatively new and could have bugs or security vulnerabilities.
Borrower Default risk - when you lend on Compound, you are funding a liquidity pool from which users can borrow. In order to borrow from the liquidity pool, borrowers must post collateral, the value of which is greater than the value they are borrowing (i.e. borrowers are "over-collateralized"). Nevertheless, if the value of the collateral that borrowers have posted rapidly falls, there may be insufficient collateral value left over to repay the loans these borrowers have taken, and you may lose some or all of your investment.
Interest Rate risk — interest rates on Compound are variable, meaning they can fluctuate even after you have deposited money or taken out a loan. This means that as a depositor you may earn less than the interest rate you saw at the time you deposited, or that as a borrower you will be responsible for paying a much higher interest rate than you saw when you first borrowed money. Dharma is not responsible for these interest rate fluctuations, which are based on a preset formula that managed by the Compound protocol team.