Compound Finance: discover the interest-earning tech behind Flex

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Remember those halcyon days when banks paid 5% or more on deposits?

Today, you’re lucky to get half that. The 08/09 banking crisis put paid to sensible interest rates, and now you need to lock your money away to get close to past returns.

Some good did come out of the financial crisis, though: Bitcoin and the blockchain technology it’s built on. Together, they’ve created a new generation of financial applications that exploit blockchain tech for better returns.

Take your Flex account, for instance. It earns you 5% (as of 7 Jan 2020, the Flex rate is 4%)APY through an open-source, blockchain protocol called Compound Finance. So how does blockchain manage to beat a centuries-old banking system?

Let’s take a look…

Compound Finance is a technology, not a bank

Compound Finance is not a bank nor does it hold any institutional licenses. It’s simply a protocol — a set of rules and instructions executed by blockchain programs called smart contracts. So how can a technology earn you better interest than a bank?

Well, it all boils down to the use of digital assets rather than physical ones. Just how Spotify has replaced vinyl and CDs, so are digital assets replacing things like money and property — and for good reason:

  1. They’re borderless, efficient, and flexible. Imagine the potential of programmable assets — they can go anywhere, near-instantly, and for free, and without any human interaction. The efficiency savings alone are huge (no branches, staff, or outdated tech to maintain).
  2. They can be tied to real-world assets. Think USD-backed stablecoins like our very own Constant (CONST). The world is tokenizing rapidly and you can now find everything from gold to fine art represented by tokens on the blockchain.
  3. They can adapt to our global, interconnected, and rapidly-changing world. Many digital assets, including bitcoin and ethereum, aren’t classed as securities. This frees them from old-world rules that would’ve inhibited innovation, making them fit for the needs of today and tomorrow.

Compound Finance is one of many projects taking advantage of these benefits to help you earn better returns. So let’s take a look at how this works in Flex…

How Compound Finance handles your Flex deposits

When you deposit money into Flex, three things happen:

  1. First, we convert your deposit into a supported asset on Compound Finance, though always a USD-backed stablecoin to preserve its value.
  2. Then, we send your deposit to the Compound Finance liquidity pool — a fancy name for a pool of assets. For Flex, it helps to think of it as a lending pool, since that’s the function it performs.
  3. Once in the pool, your money converts to cTokens. These represent your balance, and allow the protocol to handle multiple asset types with ease.

Borrowers take loans from the pool in return for collateral, and the quality of the collateral determines how much they can borrow (called the loan-to-value ratio). This includes factors such as the value and liquidity of the collateral.

Investors — that’s you — earn the interest borrowers pay for the privilege of a loan from the pool. This rate varies, but for the moment is fixed at 5% (as of 7 Jan 2020, the Flex rate is 4%) APY.

This model isn’t new. Your bank does this already. They pool yours and others’ deposits together, lend them to borrowers, and keep most of the interest. But with Compound Finance, you get the lion’s share.

Since it’s a lending pool, your deposits aren’t immediately committed to a borrower. That’s why you can withdraw your money anytime, for free and without penalty. As of today, the protocol manages around $152 million of stablecoins and other cryptocurrencies, of which your deposits will become a part.

Compound Finance handles everything — it escrows collateral, processes deposits, transfers funds, and sets interest rates. Best of all, it’s all done automatically, saving a fortune on wasted admin costs, materials, and staff hours.

Algorithmic interest rates and anytime withdrawals

Compound Finance doesn’t discriminate between deposits. If your money is in the pool — whether borrowed or not — you earn interest on it, which is why it’s such a rewarding product.

The protocol sets interest rates algorithmically, according to supply and demand. The more people borrow, the higher the interest rate and vice versa. This encourages borrowing when the pool is liquid, and encourages repayment when the pool is running low.

The algorithmic interest rate therefore protects the promise of anytime withdrawals. Imagine if all the pool’s assets were borrowed — you’d need to wait for a repayment before you could withdraw your funds. But the more people borrow from the pool, the higher the rate, deterring further borrowing and encouraging people to repay.

So now we’ve covered interest, what about the security of the technology itself?

Is Compound Finance secure?

Blockchains are by nature secure technologies. Of course, there are extreme circumstances where they might be abused, but even the traditional banking system isn’t immune to vulnerability.

However, what makes most blockchains special is that they’re decentralized, meaning not controlled by any one person, group, or organization. Instead, transactions are validated by all the people connected to the network, so it’s very difficult to defraud.

However, there are some centralized points of failure to consider. One is the administrators of the Compound Finance protocol. They hold private keys that access administrator functions, such as interest rate setting and so on. If these keys were stolen, there’s a risk of theft in the same way a bank manager might embezzle customer deposits.

In both cases, however, they’re motivated to not commit such acts, otherwise their multi-million dollar businesses would fail. Also, Compound Finance has gone one step further by promising to pass administrator functions to users of the protocol in the future. So it will eventually become a Decentralized Autonomous Organization (DAO).

And what about the protocol’s smart contracts? How secure are they?

Smart contracts are similar to standard contracts except they’re digital and executed autonomously. They’re only as good as the code they’re written in, however, so Compound Finance has had their smart contracts independently verified. They regularly publish security audits from Trail of Bits and OpenZeppelin, and post bug bounties to squash flaws in the protocol’s code.

Compound Finance is just one example of bleeding-edge technology helping people achieve their financial goals. It’s not a bank, but it doesn’t need to be — its programming and incentive models automate financial services in ways most banks can only dream of. So, we’re proud to bring you Compound Finance through Flex, and hope you achieve greater financial freedom as a result.

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