What is a decentralized money market and how does it work?
The continuous flow of capital between borrowers and lenders is a key aspect of a vibrant economy. Anyone with an additional asset can lend it out to grow their idle capital, while people who need it to grow their business or meet operational costs can easily access it.
Money markets are the platforms where borrowers and lenders can meet. Throughout history, money markets have been generators of economic activity. Although the structure of money markets has changed over time, their role has remained unchanged.
How does the money market work?
Traditionally, money markets were centralized structures facilitating transactions between lenders and borrowers. Borrowers would approach money markets for a short-term (less than a year) loan that could be secured. If borrowers cannot repay their loans, lenders can sell collateral to recover the loaned funds. When the loan is repaid, the collateral is returned.
Borrowers are required to pay interest to lenders (to provide them with working capital) and money market fees (to facilitate the transaction). The interest rate provides adequate liquidity to borrowers as well as lenders. The commission paid to the money market helps them meet their operating expenses.
There is, however, a problem with the centralized structure. It simply puts too much power and influence regarding user funds in the hands of a single entity that can change the terms and conditions for other stakeholders arbitrarily. Worse, they may even siphon off funds from their custodial earnings. A decentralized structure offers a solid alternative to centralized money markets.
What is a decentralized money market?
Powered by blockchain technology, a decentralized money market is a self-propelled structure run by a smart contract, software. Once running, a smart contract cannot be interfered with, making it free from human bias.
Managed by a global community of stakeholders through a network of highly decentralized nodes, the market excludes any role for intermediaries. In popular jargon, the money market is placed under the domain of decentralized finance (DeFi).
Related: The DeFi Stack: Stablecoins, Exchanges, Synthetics, Money Markets and Insurance
Let’s understand how a decentralized money market works through an example. Fringe Finance ($FRIN) is a decentralized money market that unlocks dormant capital in cryptocurrency assets at all levels by deploying collateralized loans. The platform facilitates decentralized lending and borrowing. Fringe Finance is a primary lending platform where anyone can lend additional funds and earn interest or collateralize altcoins to take out a stable loan.
As mentioned, decentralized financial lenders and borrowers operate via on-chain programmatic code controlled by decentralized nodes, thereby ending the monopoly of a single controlling entity and reducing points of failure. Here are some advantages brought by decentralized money markets:
In a decentralized environment, users do not need to seek permission from a central authority before engaging in money market activity. Anyone online can earn interest on their capital and/or borrow funds for their needs seamlessly. Decentralized protocols have an inherent censorship-resistant structure.
In centralized money markets, user funds are in the custody of the central custodian. However, DeFi protocols like money markets are not custodians and funds are directly under the control of borrowers and lenders. On-chain smart contracts, operating according to a predefined logic, guarantee funds that cannot be compromised while users have full control over them.
Centralized financial markets have generally operated under-collateralized and with fractional reserves. These markets, under peer pressure to win more business, allow borrowers to withdraw more funds than they have deposited as collateral. Decentralized money markets are the successor to overcollateralisation, bringing stability to the system. The smart contract simply liquidates collateral from borrowers who fail to repay debts.
Composability is a design principle that allows components of a system to interact with each other. Various applications and protocols can interact seamlessly without permission. DeFi applications are composable, creating a blank canvas with endless possibilities for new mechanisms such as yield mining and complex derivatives.
How the Coming Decentralized Money Markets Are Entering Uncharted Territory
In the early years of DeFi, money market protocols were tilted in favor of better-known cryptocurrencies with large market caps and high liquidity. The upcoming currency markets, however, are looking to try out new models. Fringe Finance, for example, focuses on altcoins with smaller market caps and lower liquidity. Most DeFi money market protocols do not support altcoins and this is where Fringe Finance comes in.
Related: What is an altcoin? A Beginner’s Guide to Cryptocurrencies Beyond Bitcoin
As altcoins apply to a niche use case, they tend to be more speculative than large-cap digital coins. However, since few decentralized financial lenders and borrowers cared for these altcoins, the capital locked up in them remained untapped. Despite this, Fringe Finance has changed this scenario. Please note that altcoins are inherently more volatile, which comes with some associated stability risks that the profit potential can balance out.
How does an altcoin money market maintain financial stability?
To neutralize the volatility of altcoins, the money market protocol uses a multitude of borrowing parameters and relevant mechanisms. Let’s continue the example of Fringe Finance to understand it better. The parameters applied by Fringe Finance include a platform-wide maximum borrowing capacity for each collateral asset and the automated calculation of the LVR (loan to value ratio). For an adequate implementation of these mechanisms, the system takes into account the available liquidity of the asset, its historical volatility and other non-subjective measures.
The platform offers a sustained model of economic incentives for all participants such as lenders, borrowers, altcoin projects, stablecoin holders, stakers, and liquidators. For example, it is rolling out incentives for liquidators to help stabilize the platform, such as allowing native $FRIN token holders to stake coins to earn rewards through fees. To expand its operational base, a DeFi money market could include cross-chain collateral, loans against NFTs, fixed interest loans, integrated insurance, and a decentralized user interface as the platform grows.
The Future of Decentralized Money Markets
In an environment where people are wary of self-serving biases in centralized money markets, DeFi protocols have given them a lucrative option. The latter generally provides governance rights to everyone who holds native coins and showcases a blockchain-based ecosystem in its true decentralized philosophy.
Similar to money markets which used to focus on popular cryptocurrency projects with large market capitalization, new projects are now focusing on altcoins, unlock the value stored there. Going forward, the next DeFi money market protocols can be expected to explore hitherto untouched territory.