The smooth flow of capital between borrowers and lenders is a key aspect of a vibrant economy. Anyone with an extra asset can borrow it to use their unused capital, while people who need it to grow their business or cover operating expenses 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?
Typically, money markets are centralized structures that facilitate transactions between lenders and borrowers. Borrowers would turn to the money markets to obtain a short-term loan (less than one year) that could be secured. If borrowers cannot repay their loans, lenders can sell the collateral to recover the borrowed funds. When the loan is repaid, the security is returned.
Borrowers are required to pay lenders interest (to provide working capital) and a money market fee (to facilitate the transaction). The interest rate provides adequate liquidity for borrowers as well as 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 consumer funds in the hands of one entity that can change the terms and conditions for other stakeholders in an arbitrary way. Worse, they can even siphon off the funds from their custodial earnings. The decentralized structure provides a stable alternative to centralized money markets.
What is a decentralized money market?
Powered by blockchain technology, the decentralized money market is a self-powered structure governed by a smart contract, a software program. Once launched, a smart contract cannot be tampered with, making it free from human bias.
Managed by a global community of stakeholders through a highly decentralized network of nodes, the marketplace eliminates any role for intermediaries. In popular jargon, the money market is placed under the domain of decentralized finance (DeFi).
Related: DeFi Stack: Stable Coins, Exchanges, Synthetics, Money Markets & Insurance
Let us understand the functioning of a decentralized money market through an example. Fringe Finance ($FRIN) is a decentralized money market that unlocks dormant capital in all levels of cryptocurrency assets by issuing collateralized loans. The platform facilitates decentralized lending and borrowing. Fringe Finance is a major lending platform where anyone can borrow additional funds and earn interest or collateralize altcoins to borrow against stablecoins.
As mentioned, the lenders and borrowers of decentralized finance operate through on-chain programming code controlled by decentralized nodes, thereby ending a single entity’s monopoly of control and reducing points of failure. Here are a few 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 earn interest on their capital and/or borrow funds seamlessly for their needs. Decentralized protocols have an inherent censorship-resistant structure.
In centralized money markets, users’ funds are held by a central gatekeeper. However, DeFi protocols like money markets are non-custodial and funds are directly under the control of borrowers and lenders. On-chain smart contracts operating on pre-defined logic provide funds that cannot be compromised while users have full control over them.
Centralized financial markets typically operate in an undercollateralized and fractional reserve fashion. These markets, under peer pressure to win more business, allow borrowers to withdraw more funds than they have deposited as collateral. Decentralized money markets follow the over-collateralization that ensures system stability. The smart contract simply liquidates the collateral of borrowers who fail to repay debts.
Composability is a design principle that allows system components to interact with each other. Different applications and protocols can seamlessly interact in a permissionless manner. DeFi applications can be composed, creating a blank canvas with endless possibilities for new mechanisms such as income mining and complex derivatives.
How upcoming decentralized money markets are entering uncharted territory
In the early years of DeFi, money market protocols were skewed in favor of better-known cryptocurrencies with large market caps and high liquidity. However, upcoming money markets are looking to try out new patterns. Fringe Finance, for example, focuses on altcoins with lower market capitalization and lower liquidity. Most DeFi money market protocols do not support altcoins and this is where Fringe Finance steps in.
Related: What is an Altcoin? A Beginner’s Guide to Cryptocurrencies Outside of Bitcoin
Because altcoins apply to a niche use case, they tend to be more speculative than large-cap digital coins. However, since few lenders and borrowers of decentralized finance cared about such altcoins, the capital locked in them remained unused. However, Fringe Finance has changed that scenario. Please note that altcoins are inherently more volatile, which carries some associated stability risks that the profit potential can balance.
How does the altcoin money market maintain financial stability?
To neutralize the volatility of altcoins, the money market protocol uses a set of borrowing parameters and corresponding mechanisms. Let’s continue the example of Fringe Finance to understand it better. Parameters applied by Fringe Finance include platform-wide maximum lending capacity for each collateralized asset and automated LVR (loan-to-value ratio) calculation. For adequate application of these mechanisms, the system takes into account the available liquidity of the asset, historical volatility and other non-subjective indicators.
The platform offers a sustainable model of economic incentives for all participants such as lenders, borrowers, altcoin projects, stablecoin holders, bettors and liquidators. For example, it introduced incentives for liquidators to help stabilize the platform, such as allowing local $FRIN token holders to stake coins to earn fee rewards. To expand its operational base, the DeFi money market could include cross-chain collateral, lending against NFTs, fixed-rate 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 self-serving bias of centralized money markets, DeFi protocols have given them a lucrative option. The latter typically grants governance rights to all local coin holders and presents a blockchain-based ecosystem in its true decentralized ethos.
Like the money markets that focused on popular cryptocurrency projects with significant market capitalization, new projects are now focusing on altcoins, unlocking the value stored there. In the future, it can be expected that the upcoming DeFi money market protocols will explore territories that have not been touched before.