Helping the average John guy understand the Defi space: Compound edition

DECENTRALIZED LENDING AND BORROWING : This is what John knows and believes on both of those systems at the moment :

Traditional lending and borrowing, done through banks, require trust and a credit system. Banks act as intermediaries and impose strict criteria, making it difficult for many to access funds. This system has limitations like geographical restrictions, high barriers to loans, and exclusivity. John does not really likes this system.

In DeFi (Decentralized Finance), there are no such barriers because banks are not needed. Anyone with enough collateral can access capital. Lending isn't limited to the wealthy; everyone can contribute to a pool, and borrowers can access funds at rates determined by algorithms. Now, this is how an economy should work in John's vision.

Instead of complex bank requirements like KYC and AML, DeFi only requires collateral to secure loans. The top DeFi lending protocols are Compound Finance and Aave.

Next, we will help our boy John here to understand how those 2 lending protocols work.

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"So, what is Compound fellow crypto bros?'', asked John. Here is your answer man:

Compound Finance is like a digital money market on the Ethereum blockchain. It allows people to easily lend and borrow cryptocurrencies. As of April 1, 2021, there are nine different tokens you can work with on Compound, including Ethereum (ETH), Dai (DAI), and others.

People who have extra cryptocurrency can supply it to the market and earn interest. On the other side, people who need to borrow crypto can do so and pay interest. It's like a bridge between those who want to earn interest on their crypto and those who need to borrow it for various reasons.

The interest rates are shown in Annual Percentage Yield (APY) and can vary depending on the cryptocurrency. Compound uses smart algorithms to figure out these rates based on how much crypto is available and how much is needed.

What's cool is that in Compound, you don't need to negotiate loan terms with someone else. You interact directly with the protocol, making lending and borrowing faster and more efficient.

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"How much interest will I receive, or pay? Pay??? Is this a ponzi scheme?", questioned John. Firstly, calm down John. No one is stealing your money if you will listen to the next following answers patient:

In DeFi, the amount of interest you earn or pay depends on the cryptocurrency you're using and the current supply and demand for that crypto. It's like how prices of things in a store can go up or down based on how many people want them.

For instance, let's say you're using DAI, a stablecoin. If you lend it out, you might earn 4.45% interest in a year (as of January 2021). But if you borrow DAI instead, you'd have to pay 6.44% interest in a year. So, whether you earn or pay interest depends on whether you're lending or borrowing and which cryptocurrency you're dealing with.

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"Ok, cool stuff. Do I need to register for an account to start using Compound?". No John:

No need to sign up! That's the cool thing about DeFi. Unlike regular financial apps where you have to go through a long registration process, Compound doesn't require you to sign up for anything. If you have a crypto wallet like Argent or Metamask, you can start using Compound right away. It's that simple!

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"How is the governance working over there bro?" Here is your answer :

Compound used to be more controlled by a central group, but now it's run by the community. This change happened when they introduced the COMP token in June 2020. People who hold COMP can propose ideas, discuss them, and make decisions about how Compound works by voting through a special app. Some changes they can make include adding new assets or adjusting how things like collateral and interest rates work. It's like the community steering the ship.

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"And how does it work?" Here is the answer John, don't worry :

It involves three important parts:

1. COMP Token: This is like a special coin that gives you the power to make decisions in the Compound protocol.
2. Governance Module (Governance Alpha): Think of this as a control center where people propose and discuss changes to the Compound protocol.
3. Timelock: Imagine this as a safety mechanism that prevents quick changes. It gives people time to review and decide on proposals.

To suggest a change, someone needs to have at least 1% of all the COMP tokens, which is 100,000 COMP. This step is called Governor Alpha.

Once a proposal is made, there's a 3-day time when COMP token holders vote on it. At least 400,000 votes, which is 4% of all COMP tokens, need to be in favor for the proposal to pass.

If enough votes say yes, the proposal goes into the Timelock for a 2-day waiting period. After that, the changes become part of the Compound protocol.

People can get COMP tokens by buying them or by using the Compound protocol to lend or borrow. The more they use it, the more COMP tokens they can earn. It's like a reward for being active on Compound.

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"Ok, you convinced me. How do I start earning?" It is actually really simple and easy :

1. Supply Your Assets: First, you give your digital money to Compound. They accept nine types of digital coins.
2. Earn Interest: Once your money is in, it starts making more money for you right away. You get interest on the money you've given. They calculate this interest about every 15 seconds.
3. Get cTokens: When you put your money in, you get special tokens called cTokens. For example, if you give them DAI, you'll get cDAI; if it's Ether, you'll get cETH, and so on.
4. Collect Your Earnings: The interest you earn doesn't come to you instantly. It gets added to your cTokens. But you can turn those cTokens back into your original money, plus the interest you earned.

Important Note: They don't accept USDT because there's a risk that it might not be backed by real dollars. So, they're cautious about it to protect their assets.

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"What are those cTokens?" Let me explain it to you John:

1. cTokens are Like Saving Certificates: Think of cTokens as certificates you get when you save money with Compound. When you put your money into Compound, you get cTokens in return.
2. They Earn Interest: Your cTokens don't just sit there; they actually grow over time because they earn interest. This interest doesn't come to you right away; it gets added to your cTokens.
3. Example Time: Imagine you gave Compound 1,000 DAI (a type of digital money) on January 1, 2020, and let's say the interest rate is a steady 10% for the whole year. You'd get 1,000 cDAI in exchange.
4. Interest Makes Them Worth More: After one year, those 1,000 cDAI would be worth more because they earned 10% interest. So, they'd be worth 1,100 DAI on January 1, 2021.
5. Easy to Transfer: These cTokens aren't just numbers; they are like special coins you can easily give to someone else. If someone wants to take over your savings in Compound, you can give them your cTokens.

In simple words, cTokens are like special certificates that grow in value over time, and you can give them to someone else if you want.

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"And if I want to borrow as my first time?" I would not do this as a beginner John. But if you really insist in doing so:

1. Collateral First: Before you can borrow, you need to put some of your digital assets into the system as a guarantee, like a deposit. The more you put in, the more you can borrow. Each type of asset you supply has a different value that decides how much you can borrow.
2. Get Your Borrowed Money: Once you've put in your collateral, you can borrow other digital assets. These borrowed assets go directly into your Ethereum wallet. You can use them however you want, just like any other digital money.
3. Pay Attention to Interest: When you borrow, you have to pay some extra money called interest. Part of this interest goes into a special fund called the reserve, kind of like insurance. Compound token (COMP) holders control this reserve. The amount that goes into the reserve depends on the type of asset you're borrowing.

In simple terms, you give some of your digital money as collateral, and in return, you can borrow other digital money. Just remember, you'll need to pay some interest, and a part of that interest goes into a safety fund controlled by Compound token holders.

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"What happens if there are price movements?" That's a good one John. Here is what happens:

1. When Your Stuff Goes Up in Value: If the things you used as security become worth more, it's all good. Your security level goes up too, and you can even get a bigger loan if you want to.
2. When Your Stuff Goes Down in Value: But if the things you used as security become worth less, and your security level falls below what's needed, they might sell some of your stuff to cover it. This is called "liquidation," and they'll also charge you an 8% fee for doing this.

So, if your security becomes less valuable, they might sell some of it to make sure everything's still safe, and you'll have to pay a fee for that.

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"Can I get liquidated?" John, that is a briliant question. You are smart. Here is how it works:

Liquidation is like a safety measure. It kicks in when the value of the stuff you put up as security for a loan is not enough to cover the money you borrowed.

Here's why it's important: Imagine you lend your stuff to someone, and they promise to give it back with some extra. If they can't give it all back, we sell some of their stuff to make sure you get your money back.

In the world of Compound, if this happens, they charge a fee of 8% for doing the selling. This way, they make sure there's always enough money in the system for people to take out and put in, and it also keeps lenders safe from the risk of not getting their money back.

That's pretty much how Compound works.

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"Thank you. I want to start using this. Can you give me a step-by-step guide?" Sure thing John:

Supplying Funds to the Pool:

Step 1:

• Go to https://app.compound.finance.
• Connect your wallet. Just follow the wallet's instructions.
• Put your digital money into the pool. You can use any of the nine types of tokens they accept.

Step 2:

• You'll get something called cTokens. Think of them like certificates you get when you make a fixed deposit at a bank.
• These cTokens show the type and amount of digital money you deposited.
• They also keep track of the interest you're earning. When you want your money back, you use these cTokens to get it.

Step 3:

• You start earning interest right away when you deposit your money and get cTokens in return.
• Your interest keeps growing as long as you hold onto those cTokens.

Step 4:

• Over time, the interest adds up, and each cToken becomes worth more of the digital money you deposited.
• When you want your money back, you can turn in those cTokens, and you'll instantly get your digital money back with the interest you earned.

Borrowing Funds from the Pool:

• Before you can borrow, you need to put some of your digital money into the Compound as collateral (like a deposit). But you can't use USDT for this.
• Each type of digital money has its own rule about how much you need to put in as collateral to borrow.
• You can't put in digital money and borrow the same kind at the same time.

Step 1:

• Go to Compound's main page at https://app.compound.finance/.
• Choose which digital money you want to borrow from the right sidebar. Let's say you pick USDC.

Step 2:

• A pop-up about USDC will appear.
• You need to enable each digital money type separately, but you only have to do this once for each type.

Step 3:

• Type in how much you want to borrow. For example, let's say you want to borrow 2 USDC.
• Confirm the transaction with your wallet.

Step 4:

• You're done! You can see how much you put in as collateral and how much you borrowed on Compound's main page.

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"And what about Aave?" Ok, slow down buddy and process what you have learned for now. I will explain Aave later.

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TL;DR :

• DeFi is open to all, no banks needed.
• Lend or borrow crypto easily.
• Earn interest on deposits, pay interest on loans.
• No need for a complex registration.
• Governance is community-driven.
• cTokens represent your deposits.
• Watch out for collateral value; avoid liquidation.
• No need to negotiate terms; it's all automated.

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All of the info above was written by me with the help of the How to Defi book from Coingecko. Hope it helped others like it did for our boy John here!