Key Takeaways
Compound Finance is a decentralized, algorithmic money market protocol that allows users to lend and borrow crypto assets without a central intermediary.
Suppliers deposit assets into liquidity pools and earn interest automatically, while borrowers must provide overcollateralized positions to take out loans.
Compound V3 (Comet) introduced a single-borrowable-asset model per market, expanding across Ethereum, Base, and Arbitrum with approximately $1.3B in total value locked as of 2026.
The COMP token gives holders governance rights, allowing them to vote on protocol upgrades, interest rate adjustments, and new market listings through on-chain proposals.
Interest rates on Compound are set algorithmically based on supply and demand, meaning rates can fluctuate as market conditions change.
Introduction
Borrowing and lending in decentralized finance (DeFi) have grown from a niche experiment into one of the most active sectors in crypto. Compound Finance is one of the protocols in this space, offering users a way to earn interest on digital assets or borrow against them without relying on a bank or custodial platform.
The original Compound V2 protocol introduced the cToken model and permissionless lending to a wide audience. Compound V3, known as Comet, refined the architecture with improved risk isolation and multi-chain support. Today, the protocol spans Ethereum, Base, and Arbitrum, and its COMP token continues to play a central role in on-chain governance.
This article explains how Compound Finance works, what the COMP token does, and what risks users should consider before interacting with the protocol.
What Is Compound Finance?
Compound Finance is a DeFi lending protocol. More precisely, it is an algorithmic money market protocol where users can deposit crypto assets to earn interest or borrow other assets against their holdings. The protocol automates the storage and management of deposited capital through smart contracts, removing the need for a third party to hold or control funds.
Because anyone with a Web3 wallet and an internet connection can interact with Compound directly, it operates as a permissionless protocol. Suppliers and borrowers don’t negotiate terms with each other. Instead, both sides interact with the protocol itself, which manages collateral requirements and adjusts interest rates automatically.
Interest rates on Compound are set algorithmically, adjusting based on supply and demand in real time. When more borrowing activity occurs, rates rise; when there is excess supply relative to demand, rates tend to fall.
How Compound Finance Works
Compound V2 and cTokens
The original Compound V2 protocol tracked user positions using cTokens, which are ERC-20 tokens representing a claim to a portion of an asset pool. For example, depositing ETH would give you cETH; depositing DAI would give you cDAI. As the pool earned interest over time, cTokens became redeemable for a growing amount of the underlying asset. In late 2025, V2 was deprecated, with borrows paused and reserve factors set to 100% to encourage migration to V3.
Compound V3 (Comet)
Compound V3, also called Comet, introduced a single-borrowable-asset model per market. Each market is structured around one primary borrowable asset, such as USDC or USDT, with multiple collateral types accepted. This design improves gas efficiency, simplifies the architecture, and contains risk within each market. Assets held in smart contracts are directly accessible from a user’s connected wallet, with no custodial intermediary involved.
Compound V3 is currently deployed on Ethereum, Base, and Arbitrum. Active markets include USDC, USDT, and WETH, with supported collateral assets such as ETH, WBTC, COMP, UNI, and LINK.
Lending and borrowing
Lending on Compound is straightforward. A user connects their wallet, selects an asset, and supplies it to the relevant pool. Once deposited, the assets begin earning interest automatically based on the current supply rate for that asset.
Borrowing is more involved. First, users must deposit collateral to establish a borrowing position. The protocol calculates a maximum loan amount based on the collateral value and the loan-to-value ratio assigned to each asset. Like most DeFi lending protocols, Compound uses overcollateralization, meaning borrowers must deposit more value than they wish to borrow. If the collateral value falls below the required threshold, the position can be liquidated.
Each asset on Compound carries its own annual percentage rate (APR) for both lending and borrowing, which adjusts continuously based on current utilization.
The COMP Token and Governance
COMP is the governance token of the Compound protocol. Each COMP token represents one vote in the Compound DAO. Token holders can submit and vote on on-chain proposals covering a range of protocol parameters, including which asset markets to list, interest rate models, collateral requirements, and oracle configurations.
Compound began as a company founded by Robert Leshner, but governance has been progressively decentralized through the COMP token. In early 2026, the Compound DAO voted to create a $5M USDC emergency security fund, illustrating the kind of operational decisions the DAO handles. COMP holders can also delegate their voting power to other addresses, enabling more active participation in governance without requiring every holder to vote directly.
COMP tokens are distributed to protocol users as an incentive for supplying and borrowing on Compound, with distribution amounts adjusting based on protocol activity.
Risks to Consider
Using Compound involves several risk categories that users should understand before getting involved.
Smart contract risk is inherent to any DeFi protocol. Although Compound has been audited by firms such as Trail of Bits and OpenZeppelin, no audit can guarantee that code is entirely free of vulnerabilities. Bugs or exploits in smart contracts could result in loss of funds.
The platform also faced multiple security incidents, including frontend website compromises and phishing attacks on its social media. As of April 2026, Compound has significant bad debt from a cross-chain hack related to a bridge configuration problem of the liquidity staking platform KelpDAO.
Liquidation risk applies to borrowers. If the value of collateral falls relative to the borrowed amount, a position can be liquidated. Borrowers should monitor their collateral ratio carefully, especially during periods of high market volatility.
Interest rate risk applies to both suppliers and borrowers, since rates fluctuate based on real-time supply and demand. Borrowing costs can rise unexpectedly during periods of high demand.
As with any digital asset interaction, users should only allocate funds they can afford to lose, and should understand the mechanics of the protocol before supplying or borrowing.
FAQ
What is the difference between Compound V2 and V3?
Compound V2 used a shared pool model with cTokens representing positions across multiple assets. Compound V3 (Comet) introduced separate markets, each built around a single borrowable asset, with multiple collateral types. This approach improves risk isolation and gas efficiency. V2 was deprecated in late 2025, with users migrating to V3.
What can COMP token holders vote on?
COMP holders can vote on protocol upgrades, new market listings, interest rate parameters, collateral factors, the choice of price oracles, and treasury allocations. Each COMP token represents one vote, and proposals require a quorum to pass.
Do I need to verify my identity to use Compound?
Compound is a permissionless protocol. No identity verification or account registration is required to supply or borrow assets. Users only need a compatible Web3 wallet and sufficient funds to interact with the protocol.
What happens if my collateral loses value?
If the value of your collateral falls below the minimum collateral ratio required by the protocol, your position becomes eligible for liquidation. A third party can repay part of your loan in exchange for a portion of your collateral at a discount. To avoid liquidation, borrowers should maintain a healthy buffer above the minimum collateral ratio.
Is Compound available on networks other than Ethereum?
Yes. As of 2026, Compound V3 is deployed on Ethereum, Base, and Arbitrum. Each chain hosts its own set of markets with independent interest rates and collateral configurations.
Closing Thoughts
Compound Finance is a prominent protocol in decentralized finance, offering a model for permissionless lending and borrowing that has influenced many projects that followed. The transition from V2 to V3 reflects the protocol’s ongoing development, with a focus on improved risk management, multi-chain access, and more efficient architecture.
As the DeFi ecosystem continues to mature, protocols like Compound may play an increasingly important role in on-chain financial infrastructure. However, like all smart contract protocols, Compound carries inherent risks, and users should approach it with an understanding of those risks.
Further Reading
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