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 vibrant economy. Anyone with an additional asset can loan it to run their idle capital, while people who need it to grow their business or meet operating 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. Although the structure of money markets has changed over time, their role has remained unchanged.
How does the money market work?
Traditionally, money markets have been centralized structures that facilitate transactions between lenders and borrowers. Borrowers will approach the money markets for a short-term loan (less than a year) that can be secured. If borrowers cannot repay their loans, lenders can sell the collateral to get back the money borrowed. When the loan is repaid, the collateral is returned.
Borrowers are required to pay interest to lenders (to provide them with working capital) and a money market fee (to facilitate the transaction). The interest rate provides sufficient liquidity to borrowers as well as lenders. The fees paid to the money market help to meet their operating expenses.
However, there is a problem with the central structure. It simply puts a lot of power and influence with respect to user funds in the hands of one entity that can arbitrarily change the terms and conditions for other stakeholders. Even worse, they can even withdraw the money in their custody earnings. A decentralized structure provides a powerful alternative to centralized money markets.
What is a decentralized money market?
Powered by blockchain technology, the decentralized money market is a self-propelled structure managed by a smart contract, a software program. Once turned on, a smart contract cannot be interfered with, making it free from human biases.
Managed by a global community of stakeholders through a highly decentralized network of nodes, the market excludes any role for intermediaries. In popular parlance, the money market is placed under the domain of decentralized finance (DeFi).
Related: The DeFi Stack: stablecoins, exchanges, synthetics, money markets, and insurance
Let us understand the functioning of the decentralized money market through an example. Fringe Finance ($FRIN) is a decentralized money market that unlocks passive capital in crypto assets of all levels by offering secured loans. The platform facilitates decentralized lending and borrowing. Fringe Finance is a basic lending platform where anyone can lend extra money and earn interest or guarantee alternative currencies for a stable currency loan.
As mentioned, decentralized finance lenders and borrowers operate through on-chain code that is controlled by decentralized nodes, ending a single entity’s monopoly of control and reducing points of failure. Here are some of the benefits that decentralized money markets bring:
without prior authorization
In a decentralized environment, users do not need to seek permission from a central authority before engaging in any money market activity. Anyone online can earn interest on their capital and/or borrow money to meet their needs smoothly. Decentralized protocols have an inherent censorship-resistant architecture.
In central money markets, users’ funds lie in the custody of the central gatekeeper. However, DeFi protocols such as money markets are not trusted, and funds are directly under the control of borrowers and lenders. On-chain smart contracts, which run on pre-defined logic, ensure the funds cannot be hacked while users have complete control over them.
Central financial markets usually operate in an unsecured and partial reserve fashion. These markets, under peer pressure to win more business, allow borrowers to withdraw more money than they have deposited as collateral. Decentralized money markets track excess collateral, which brings stability to the system. The smart contract simply liquidates the collateral of borrowers who fail to repay the debt.
The ability to compose
Compatibility is a design principle that allows system components to interact with each other. Various applications and protocols can interact seamlessly without permission. DeFi applications are buildable, creating a blank canvas with endless possibilities for new mechanisms such as yield extraction and complex derivatives.
How is the next decentralized money market moving into unexplored territory
In the early years of DeFi, money market protocols skewed in favor of well-known cryptocurrencies with large market capitalization and high liquidity. However, the upcoming money markets are looking forward to trying out new models. Fringe Finance, for example, focuses on cryptocurrencies with smaller market capitalization and lower liquidity. Most DeFi money market protocols do not support altcoins and this is where Fringe Finance moves in.
Related: What is an alternative currency? A Beginner’s Guide to Cryptocurrency Beyond Bitcoin
Since altcoins apply to a niche use case, they tend to be more speculative than large-cap cryptocurrencies. However, since few decentralized financial lenders and borrowers were servicing these altcoins, the capital trapped in them was not being tapped. Despite this, Fringe Finance has changed that scenario. Please keep in mind that altcoins are inherently more volatile, which leads to some associated stability risks that can offset potential profit.
How does the alternative currency market maintain financial stability?
To neutralize the volatility of altcoins, the money market protocol uses a large number of borrowing parameters and related mechanisms. Let’s continue with the example of Fringe Finance to understand it better. Parameters applied by Fringe Finance include maximum platform-wide borrowing capacity for each security asset and an automated LVR (Loan to Value Ratio) calculation. For the proper implementation of these mechanisms, the system takes into account the available liquidity of the asset, historical volatility and other non-subjective metrics.
The platform offers a sustainable model of economic incentives to all participants such as lenders, borrowers, altcoin projects, stablecoin holders, underwriters and liquidators. For example, it offers incentives to liquidators to help stabilize the platform such as allowing holders of original FRIN dollar tokens to get coins to earn rewards from fees. To expand its operating base, the DeFi money market could include cross-chain collateral, lending against NFT, fixed-interest loans, built-in 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 the subjective biases of the central financial markets, DeFi protocols have given them a lucrative option. The latter usually provides governance rights to all who hold the original 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 a large market capitalization, new projects are now focusing on altcoins, to open The value is stored there. From now on, the upcoming DeFi protocols for the money market are expected to explore previously untouched areas.