cTokens in compound: understanding basic concept

Hi there, I am not new to the cryptocurrency space in general but completly new to Defi. I finished the course defi 101. I don’t understand the concept behind compound:

I understand that I will get cTokens as a representation of my deposited assets in Compound. But what I don’t understand is how is it then possible to spend/trade these cTokens in other protocols? Isn’t it the case that my deposited assets are used and given to borrowers? Why can I still spend them through cTokens?

Hello @Dijana_Indijana
In the case of cTokens, as you indicate, you are given the equivalent of those deposited in the protocol.
This is a sign that you are the owner or owner of these tokens or crypto that you left frozen and generating interest, the great thing about the DeFi ecosystem is that it allows us to generate profits in many ways for it; It is possible, for example, to generate a pool or provide liquidity to an existing one in Uniswap and / or Balancer and thus earn interest from them and governance tokens in the case of Balancer and Compound.

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Hi @Thaddeus19
Many thanks for your reply. I did understand what these cTokens represent and that they can be used on other protocols to generate profits. But I don’t understand the economic behind. Let me ask it differently:

What happens with my locked up ETH when I freeze them in Compound? Are these ETH gonna be used to lend out to borrowers? If so, how I am then able to get cETH at the same time and trade them in other protocols?

I don’t understand the economic behind. To me it feels like it’s the same approach as banks are doing: Using more money than there is available. If my initial deposited ETH is used by borrowers I should not be able to use the same funds to trade on other protocols. So I am getting interest on my deposit while I am still able to spend them. This concept I don’t understand.

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as stated on compund.finance’s website:

By holding or receiving a cToken, you can borrow from the Compound protocol.

This means that if somebody owns cTokens this somebody or a completely different person transferred his ETH or other Tokens to the Compound smart contract and therefore minted these Tokens.
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Therefore a cToken holder is now able to take out an over collateralized loan on Compound or transfer back his cTokens to get out full collateral or part of his collateral back.
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As a market earns interest, its cToken becomes convertible into an increasing quantity of the underlying asset.

Let’s say you supply 1,000 DAI to the Compound protocol, when the exchange rate is 0.020070; you would receive 49,825.61 cDAI (1,000/0.020070).

A few months later, you decide it’s time to withdraw your DAI from the protocol; the exchange rate is now 0.021591:

  • Your 49,825.61 cDAI is now equal to 1,075.78 DAI (49,825.61 * 0.021591)
  • You could withdraw 1,075.78 DAI, which would redeem all 49,825.61 cDAI
  • Or, you could withdraw a portion, such as your original 1,000 DAI, which would redeem 46,315.59 cDAI (keeping 3,510.01 cDAI in your wallet)

Also under stand that:

When sending your cTokens exercise caution! By transferring cTokens, you’re transferring your balance of the underlying asset inside the Compound protocol. If you send a cToken to your friend, your balance (viewable in the Compound Interface) will decline, and your friend will see their balance increase.

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As @cryptoseph indicates, if you trade or send the ctoken, you must do it carefully because you would be altering the balance of your collateral in Compound, even more so if you have requested a loan in it.

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Hi @Dijana_Indijana,
If I may try to answer your question as trickish as possible regarding the Economics behind the cTokens.

First the question and issue of liquidity or market making needed a solution please keep that in 1 part of your mind as we will have to merge couple of thoughts to arrive at your requested answer.

Then if you own anything of Value in this case Ethereum,such that with the way new usecase is evolving,you may start to see it as a property which you love dearly because it can appreciate in value.Instead of it sitting idle you can then use certain percentage NOT and NEVER all of you ETH as collateral which means it is still your property in as much as you did not default in payment to borrow extra value in this case money i.e equivalent of cTokens.

If you do are savy you will then use this extra value to generate some returns in some new business or venture so you have created extra value elsewhere from an initial ETH which you have frozen if all goes well and ETH value was increasing then you are safe.But if the unforeseen happen and the Value of ETH goes down and your are in this position then you will have to have extra fund to keep up your position so as not to loose your ETH partial value that you have secured against the loan to get the cToken.

So therefore to gain a new value of another token you would have taken a risk which with it comes opportunity while remembering it is a risk in the 1st place.If you don’t take the risk and the value of ETH goes down you do not loose you ETH altogether as you would have by taking the risk you only loose ETH VALUE.

Therefore,it is a complex process which one needs to have a firm understanding of trends and just be expose in a minimal size to it.

But also I find out about another Option ETH site where u can edge your ETH POSITION TOO AGAINST DECLINE should incase you will get some CToken hedge the risk can be another alternative to an unforseen circumstances and you can be perfectly protected both ways.

I hope I answer it a bit.

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Many thanks for this explanation. It was very helpful. What I understand now is that

  1. cTokens are automatically minted due to the over collateralized asset I deposit into Compound - thus I have taken out a loan (I borrow cTokens) - I hope this understanding is correct.

  2. there are two use cases. The first use case I understand, the second one maybe not:

Use case 1
I supply an asset to Compound > will get cTokens > earning interest on that

Use case 2
I supply an asset to Compound (ETH) > will get cTokens (cETH) > I take these cTokens as a collateral to take out another loan (DAI). Am I right, that in this case I don’t earn interest on my initial deposit (ETH) since I used it as a collateral for a loan?

Thanks for the hint concerning transfer of cTokens. I was not aware. But now it’s a no-brainer :slight_smile:

Thank you very much! I was not aware, but now it’s clear!

Hi there, many thanks for your explanation. I understand that my position could be liquidated due to a decrease in value of the underlying assset.

As I replied to @cryptoseph there seem to be two use cases:

  1. I supply an asset to be borrowed by others and get interest on it (keep cTokens to earn interest).
  2. I supply an asset, but not to be used by other borrowers. Instead I supply it as a collateral for myself to take out a loan to get for example DAI (use cTokens as my collateral to borrow DAI).

Is my understanding correct that if I have use case 2 then my deposited funds are not going to be used by other borrowers like in use case 1? That’s at least my understanding. Otherwise the deposited asset would have been used to lend out to others while at the same time beeing a collateral for my loan (borrowing DAI with cTokens).

In both cases, the deposited token or currency (for example ETH) will generate interest, whether you just freeze it on the platform or take a loan. Moreover, some farmers generate a loop by depositing, for example, DAI, then taking out a loan from DAI and re-depositing, increasing the collateral. This to get more out of the COMP token.
In my case, I don’t recommend this practice because if any situation occurs in the market (we know that it is very volatile) they can liquidate the loan and lose the collateral.

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Thank you. It’s so confusing to me hearing that I get interest also in use case 2.
Same concept in real world:

  • I supply 100.- to you (I lend it out to you)
  • I don’t have them anymore
  • I go to the bank to take out a loan. I will give my 100.- as collateral (but I don’t own it anymore - I have lend it out to you)

This is my struggle I have :slight_smile: How is this possible in Compound?

Because you have the ctokens, the platform uses the ETH or DAI or any of the collaterals to lend it to another user and pays you the interest earned in cToken. The platform knows that you have a certain amount of tokens, it calculates its equivalent in dollars and based on that, it allows you to obtain a loan. If I’m not mistaken, it can’t be more than 75% of what you have deposited on the platform. When you pay the loan and decide to withdraw the collateral, the platform converts all the cTokens back to the original token.
as I mention cryptoseph here:
"Let’s say you supply 1,000 DAI to the Compound protocol, when the exchange rate is 0.020070; you would receive 49,825.61 cDAI (1,000 / 0.020070).

A few months later, you decide it’s time to withdraw your DAI from the protocol; the exchange rate is now 0.021591:

Your 49,825.61 cDAI is now equal to 1,075.78 DAI (49,825.61 * 0.021591)
You could withdraw 1,075.78 DAI, which would redeem all 49,825.61 cDAI
Or, you could withdraw a portion, such as your original 1,000 DAI, which would redeem 46,315.59 cDAI (keeping 3,510.01 cDAI in your wallet) "

For example:
Deposit 1ETH -> Compound
compumd returns you 49.858501 cETH ->to your wallet (at today’s exchange rate)
Compund has to loan another user 1 ETH
You earn interest on your 49.858501 cETH ($ 412.32 USD)
You have two options to keep them only earning interest or take a loan for the maximum of $ 309.24 USD in some other token.
Days later you pay it and you have the option to keep your cETH earning interest or withdraw it.

If your loan is liquidated, the cTokens go to the liquidator:
“When collateral is seized, the liquidator is transferred cTokens, which they may redeem the same as if they had supplied the asset themselves”
source: https://compound.finance/docs/ctokens#liquidate-borrow

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Thank you for the last example. I got it now! :smiley: I did not understand the interaction between the participants and tokens of such a protocol… Who gets when what token and why :nerd_face: This was very helpful! Many thanks guys :pray: :blue_heart: :muscle: @Thaddeus19 @cryptoseph @bolyx

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Great !!!
That is what it is about helping each other so that soon there is a massive adoption of technology.

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