What is a decentralized money market and how does it work?
Decentralized money markets function without a custodian, allowing only the original user to withdraw funds deposited by lenders and borrowers.
The seamless flow of capital between borrowers and lenders is a key aspect of a vibrant economy. Anyone with an extra asset can lend it to put their idle capital to work, while people needing it to grow 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 activities. Though the structure of money markets has altered with time, their role has remained unchanged.
How does the money market work?
Conventionally, money markets were centralized structures facilitating the deals between lenders and borrowers. Borrowers would approach money markets to get a short-term loan (under a year) that might be collateralized. If the borrowers can’t pay back their loans, the lenders can sell the collateral to recover the loaned funds. When the loan is repaid, the collateral is returned.
Borrowers are required to pay interest to the lenders (for providing them working capital) and a fee to the money market (for facilitating the deal). The interest rate provides adequate liquidity for borrowers as well as lenders. The fee paid to the money market helps them meet their operating expenses.
There is a problem with centralized structure, though. 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 in an arbitrary manner. Worse, they can even siphon off the funds in their custody gains. A decentralized structure provides 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 it is running, a smart contract cannot be interfered with, thus making it free of human prejudices.
Managed by a global community of stakeholders through a highly decentralized network of nodes, the market rules out any role for intermediaries. In popular lingo, 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 the functioning of a decentralized money market through an example. Fringe Finance ($FRIN) is a decentralized money market that unlocks the dormant capital in all-tier cryptocurrency assets by rolling out collateralized loans. The platform facilitates decentralized lending and borrowing. Fringe Finance is a primary lending platform where anyone can lend extra funds and earn interest or collateralize altcoins to take a stablecoin loan.
As mentioned, decentralized finance lenders and borrowers operate through on-chain programmatic code controlled by decentralized nodes, thus ending the monopoly of a single entity in control and reducing the points of failure. Here are a few benefits that decentralized money markets bring in:
In a decentralized environment, users don’t need to ask permission from a central authority before engaging in any money market activity. Anyone online can earn interest on their capital and/or borrow funds for their needs seamlessly. The decentralized protocols have an inherent censorship-resistant structure.
In centralized money markets, users’ funds lie in the custody of the central gatekeeper. However, DeFi protocols like money markets are noncustodial, and funds are directly in the control of borrowers and lenders. On-chain smart contracts, running on pre-defined logic, assure funds that cannot be compromised while users have full control on them.
Centralized financial markets have usually functioned in an undercollateralized and fractional reserve manner. These markets, under peer pressure to gain more business, allow borrowers to withdraw more funds than what they have deposited as collateral. Decentralized money markets follow overcollateralization, bringing stability to the system. The smart contract simply liquidates the collateral of the borrowers who fail to pay back the debts.
Composability is a design principle that allows for components of a system to interoperate with one another. Various applications and protocols can interact seamlessly in a permissionless way. DeFi apps are composable, creating a blank canvas with endless possibilities for novel mechanisms like yield extraction and complex derivatives.
How upcoming decentralized money markets are stepping into unexplored territory
In the initial years of DeFi, money market protocols were tilted in favor of better known cryptocurrencies with large market capitalizations and high liquidity. Upcoming money markets, however, are looking to try new models. Fringe Finance, for instance, focuses on altcoins having smaller market capitalizations and lower liquidity. Most DeFi money market protocols do not support altcoins and this is where Fringe Finance moves 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, as few decentralized finance lenders and borrowers were catering to such altcoins, the capital locked in them had gone untapped. Despite that, Fringe Finance has altered this scenario. Please be aware that altcoins are inherently more volatile, which does bring in some associated stability risks that the potential of profit can balance.
How does an altcoin money market maintain financial stability?
To neutralize volatility in altcoins, the money market protocol uses a slew of borrowing parameters and relevant mechanisms. Let’s continue the Fringe Finance example to better understand it. The parameters applied by Fringe Finance include a platform-wide maximum borrowing capacity for each collateral asset and automated computation of the LVR (loan to value ratio). For adequate implementation of these mechanisms, the system takes into account the asset’s available liquidity, historic volatility and other non-subjective metrics.
The platform offers a sustained model of economic incentives for all participants like lenders, borrowers, altcoin projects, stablecoin holders, stakers and liquidators. For instance, it rolls out incentives for liquidators to help stabilize the platform like allowing native $FRIN token holders to stake coins to earn rewards from fees. To widen its operational base, a DeFi money market could include cross-chain collateralization, lending against NFTs, fixed-interest loans, embedded insurance and a decentralized UI as the platform grows.
The future of decentralized money markets
In an environment where people have become wary of self-serving biases in centralized money markets, the DeFi protocols have given them a lucrative option. The latter usually provides governance rights to all holding native coins and presents a blockchain-based ecosystem in its true decentralized ethos.
Similar to the money markets that used to focus on popular cryptocurrency projects with significant market capitalization, novel projects are now focusing on altcoins, unlocking the value stored there. Going forward, it can be expected that upcoming DeFi money market protocols will explore territories previously untouched.