In the Compound protocol, users have the option to participate as lenders or borrowers by depositing and withdrawing their crypto. Instead of lending directly to individual borrowers, lenders pool their assets together, creating asset pools from which borrowers can obtain funds.
Each specific asset, eg. BAT or USDC, has its own dedicated pool. Borrowers are limited to borrowing a crypto amount in USD value that is lower than the collateral they provide (up to 60% of their collateral). The borrowing amount is influenced by factors like liquidity and the market capitalization of the collateral. In contrast to traditional borrowing services, Compound's interest rates are not fixed or pre-agreed by the involved parties. Instead, the interest rate is determined by supply and demand and continuously adjusted by a complex algorithm.
As a general guideline - higher demand for an asset results in increased interest rates for both lenders and borrowers. This system incentivizes lenders to provide funds and discourages excessive borrowing. Lenders also retain the flexibility to withdraw their assets at any time.
If a user borrows an amount exceeding the permissible limit due to a decline in the collateral's value, they face the risk of collateral liquidation. Holders of the borrowed asset have the option to liquidate the collateral by purchasing it at a reduced price. Alternatively, borrowers can repay a portion of their debt to increase their borrowing capacity beyond the liquidation threshold and continue their operations as usual.
So as you can see this is a complex Defi mechanism and from what I see particularly in bull markets it often results in a lot of greed which causes people to get liquidated when asset prices start to reverse with haste. Show Less
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