Before Compound (launched 2018), earning interest on crypto required trusting a centralized platform. Compound demonstrated that algorithmic money markets — where interest rates adjust automatically based on supply and demand — could function on-chain without any company custody. The 'liquidity mining' innovation (distributing COMP tokens to users) triggered the 2020 DeFi Summer and changed how the entire DeFi ecosystem thought about user acquisition and incentives.
How Compound Works: Algorithmic Interest Markets
Compound operates a set of money markets — one per asset (ETH, USDC, DAI, WBTC, etc.). Each market has a supply rate (interest earned by lenders) and a borrow rate (interest paid by borrowers). These rates adjust algorithmically based on utilization: when more capital is borrowed relative to total supply (high utilization), rates rise — incentivizing more deposits and fewer borrowings. When utilization is low, rates fall.
Depositing earns cTokens (cUSDC, cETH, cDAI etc.) — ERC-20 tokens that accrue interest over time. The cToken exchange rate increases continuously as interest accrues. 100 cUSDC deposited today might be worth 105 USDC after a year at 5% APY. cTokens can be transferred, used in other DeFi protocols as collateral, or redeemed for the underlying asset plus interest at any time.
Borrowing: depositors can use their collateral (cToken deposits) to borrow other assets. Each asset has a collateral factor (USDC: 85%, ETH: 80%, etc.) — the percentage of collateral value available to borrow. Borrowing requires maintaining a healthy account value above the liquidation threshold. If your account becomes under-collateralized (due to collateral price drop or debt growth), liquidators can repay part of your debt and claim discounted collateral.
- ✓Money markets: one per asset, algorithmic interest rate determined by utilization
- ✓cTokens: deposit receipt that automatically accrues interest
- ✓Utilization curve: higher utilization → higher rates (encourages supply/discourages borrowing)
- ✓Collateral factors: asset-specific borrowing limits (USDC 85%, ETH 80%, etc.)
- ✓Liquidation: 5-8% discount for liquidators clearing unhealthy positions
- ✓No lockup: deposit or withdraw at any time; borrow rates can change every block
COMP Token and DeFi Governance
In June 2020, Compound launched COMP liquidity mining: distributing COMP tokens to every lender and borrower daily. Users could earn COMP just by using Compound, then sell COMP for profit. This created a 'yield farming' frenzy — users borrowed at high rates specifically to earn more COMP, often making the COMP earnings exceed the borrowing cost.
COMP is a pure governance token — no direct fee claims or staking yields. COMP holders propose and vote on protocol changes: adding new assets, adjusting collateral factors, changing interest rate models, spending from the protocol's reserve fund, and technical upgrades. Governance has been active — Compound has made dozens of governance proposals over its lifetime.
The COMP distribution schedule was designed to distribute tokens over 4 years to suppliers and borrowers proportionally to their activity. COMP mining rewards have declined as the emission schedule progresses, reducing the yield-farming incentive but creating a more organic protocol user base.
- ✓COMP launch (June 2020): launched DeFi Summer via liquidity mining concept
- ✓COMP governance: propose and vote on all protocol parameters
- ✓No fee sharing: COMP doesn't directly receive protocol revenue
- ✓Declining emissions: COMP rewards distributed over 4+ years, declining over time
- ✓Timelock: 2-day delay between governance approval and implementation
- ✓Community grant program: COMP reserved for ecosystem development grants
Compound III (Comet): The Simplified Architecture
Compound III, also called Comet, introduced a fundamentally different architecture. Instead of a pool per asset, Compound III has a single base asset (USDC) that users borrow. Collateral assets are supplied to borrow USDC but don't earn interest — they just enable borrowing. This creates a cleaner risk model and removes the complex cross-asset interest rate interactions of Compound V2.
The benefit: Compound III is simpler to reason about, has lower gas costs, and eliminates the risk of cross-asset liquidation cascades. Borrowers get a single USDC debt position; suppliers provide collateral with no yield. The simplification sacrificed feature breadth for security and clarity.
Compound III deployed on Ethereum mainnet, Arbitrum, Polygon, and Base — taking advantage of L2 low fees to make DeFi lending viable for smaller deposit sizes.
- ✓Compound III (Comet): single USDC base asset borrowing model
- ✓Collateral: supplied for borrowing capacity only (doesn't earn interest)
- ✓Simplification trade-off: less feature-rich than V2 but clearer risk model
- ✓Multi-chain: Arbitrum, Polygon, Base deployments for low-fee access
- ✓Coexistence: V2 and V3 both active — V2 for multi-asset lending, V3 for USDC borrowing
- ✓Governance: COMP holders govern both V2 and V3
Frequently Asked Questions About Compound Finance
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