This article will give UX Designers an understanding of DeFi lending protocols on Ethereum, specially Compound Finance. This is part of an overall Web3 Design Bootcamp that teaches UX Designers about Web3 concepts and design patterns so they can land a job in the rapidly merging field.
Compound creates a peer-to-peer lending marketplace for a variety of Web3 tokens. Suppliers are paid interest for depositing their tokens into lending pools. This has become a popular passive income strategy for Web3 users in DeFi.
Similar to how Uniswap liquidity providers receive LP tokens, Compound suppliers receive cTokens for depositing tokens into lending pools. At any point, users can burn their cTokens for their initial deposit, plus the interest that has accrued. For example, cETH represents ETH that is actively earning interest in Compound.
On the other end of things, borrowers take loans out on these lending pools. Borrowers first must supply tokens to a lending pool, and select to use the token as collateral for a loan.
Just like with MakerDAO, all Compound loans must be over-collateralized based on a collateral factor (similar to collateralization ratio). The collateral factor varies by token, but let’s say it’s 75%. It means I can only borrow up to 75% of the collateral I have deposited. So with $100-worth of Token A collateral, I can borrow at most $75-worth of Token B. This borrow limit is indicated to the user at the bottom of the modal (“Borrow Limit Used”) in the picture above. If the value of a borrower’s collateral drops then he is at risk of liquidation.
To close the position, borrowers repay the token loan back into the lending pool plus the interest payment they owe. Note that interest, for suppliers and borrowers, is paid in the token that is being lent/borrowed. Since I borrowed DAI in the example above, I made a small interest payment of DAI.
Compound is powered by smart contracts that automatically set interest rates based on the liquidity of tokens in the lending pools. Tokens with lower liquidity will have higher interest rates, as supply and demand dictate. These are “floating” interest rates meaning they change over time. Compound calculates an interest rate for each lending pool at every Ethereum block.
You can see why liquidity is important here. The lower the token liquidity, the more it will cost to borrow the token. This issue of liquidity is a challenge for all DeFi protocols – token liquidity is required to get the protocol off the ground, and to continue offering a usable service. Generally, the more liquidity the better, so DeFi protocols compete to attract liquidity to their platform.
So how do DeFi protocols attract liquidity in the first place? Compound was the first to try out liquidity mining. Compound distributes COMP – its native governance token – to its current suppliers and borrowers. This strategy worked well for Compound, and other DeFi protocols followed suit, leading to an explosion in liquidity in summer of 2020 (i.e. DeFi Summer).