What is a decentralized money market and how does it work?
The smooth flow of capital between borrowers and lenders is a key aspect of a dynamic economy. Anyone who has an extra fortune can lend it to use their idle capital, while those who need it to grow the business or cover operating expenses have easy access to it.
Money markets are the platforms where borrowers and lenders can meet. Money markets have been engines of economic activity throughout history. Although the structure of money markets has changed over time, their role has remained the same.
How does the money market work?
Traditionally, money markets were centralized structures that facilitated transactions between lenders and borrowers. Borrowers would turn to the money markets for a short-term loan (less than a year) that could be collateralised. If the borrowers cannot repay their loans, the lenders can sell the collateral to recover the borrowed funds. The collateral is returned when the loan is repaid.
Borrowers have to pay lenders interest (for providing working capital) and a fee to the money market (for settling the deal). The interest rate provides ample liquidity for both borrowers and lenders. The fee paid to the money market helps them cover their operating costs.
However, there is a problem with the centralized structure. It simply puts too much power and influence over user funds in the hands of a single entity that can arbitrarily change the terms of business for other stakeholders. Worse, they can even siphon off the funds in their custody account profits. A decentralized structure offers a robust 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, a software program. Once executed, a smart contract can no longer be influenced and is therefore free from human bias.
The market is governed by a global community of stakeholders through a highly decentralized network of nodes and excludes any role for intermediaries. The money market is popularly classified in the domain of decentralized finance (DeFi).
Related: The DeFi Stack: Stablecoins, Exchanges, Plastics, Money Markets and Insurance
Let’s understand how a decentralized money market works with an example. Fringe Finance ($FRIN) is a decentralized money market that unlocked the dormant capital in all-tier cryptocurrency assets through the introduction of secured lending. 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 stablecoin loan.
As mentioned earlier, decentralized financiers and borrowers work with programmatic on-chain code controlled by decentralized nodes, ending the monopoly of a single entity under control and reducing the sources of error. Here are some advantages that decentralized money markets bring:
In a decentralized environment, users do not need to seek permission from a central authority before engaging in money market activity. Anyone online can seamlessly earn interest on their capital and/or borrow funds for their needs. The decentralized protocols have an inherent censorship-resistant structure.
In centralized money markets, users’ funds are held in the custody of the central gatekeeper. However, DeFi protocols like money markets are not custodial and funds are directly under the control of borrowers and lenders. Smart on-chain contracts running on pre-defined logic ensure funds cannot be compromised while users have full control over them.
Centralized financial markets have typically been undercollateralised and operated with fractional reserves. These markets, under pressure to do more business, allow borrowers to withdraw more money than they put up as collateral. Decentralized money markets follow the overcollateralization and bring stability to the system. The smart contract simply liquidates the collateral of borrowers who fail to repay the debt.
Composability is a design principle that allows components of a system to interact with each other. Different applications and protocols can interact seamlessly and without permission. DeFi apps are combinable, creating a blank canvas with endless possibilities for novel mechanisms like yield extraction and complex derivatives.
How emerging decentralized money markets are venturing into uncharted territory
In the early years of DeFi, money market protocols were tipped in favor of better-known, large-cap, high-liquidity cryptocurrencies. However, the upcoming money markets are trying to try new models. For example, Fringe Finance 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
Because altcoins are considered a niche use case, they tend to be more speculative than large-cap digital coins. However, since only a few decentralized financiers and borrowers took care of such altcoins, the capital tied up in them remained unused. Despite this, Fringe Finance has changed this scenario. Please note that altcoins are inherently more volatile, which has some inherent stability risks that may offset the upside potential.
How does an altcoin money market ensure financial stability?
In order to neutralize volatility in altcoins, the money market protocol uses a number of borrowing parameters and relevant mechanisms. Let’s continue the Fringe Finance example to understand it better. The parameters applied from Fringe Finance include a platform-wide maximum borrowing capacity for each collateral value and an automated calculation of the LVR (Loan to Value Ratio). For an appropriate implementation of these mechanisms, the system takes into account the available liquidity of the asset, historical volatility and other non-subjective metrics.
The platform provides a sustainable model of economic incentives for all participants such as lenders, borrowers, altcoin projects, stablecoin holders, stakers and liquidators. For example, incentives for liquidators are introduced to help stabilize the platform, such as: B. Allowing native $FRIN token holders to stake coins to earn rewards from fees. To expand its operational base, a DeFi money market could include cross-chain collateralization, lending against NFTs, fixed-rate loans, embedded insurance, and a decentralized user interface as the platform grows.
The future of decentralized money markets
In an environment where people have become wary of selfish bias in centralized money markets, DeFi protocols have presented them with a lucrative option. The latter typically grants governance rights to anyone holding native coins, showcasing a blockchain-based ecosystem in its true decentralized ethos.
Similar to money markets, which used to focus on popular cryptocurrency projects with significant market caps, novel projects are now focusing on altcoins, unlock the value stored there. Looking ahead, expect the upcoming DeFi money market protocols to explore previously uncharted territory.