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 work on their idle capital, while those who need it to grow their businesses or cover 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 activity. Although the structure of money markets has changed over time, their role has remained unchanged.
How does the money market work?
Conventionally, money markets have been centralized structures that facilitate transactions between lenders and borrowers. Borrowers would approach the money markets to obtain a short-term loan (less than a 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 collateral is returned.
Borrowers are required to pay lenders interest (for providing them with working capital) and a money market fee (for facilitating the deal). The interest rate provides sufficient liquidity to both borrowers and lenders. The fee paid in the money market helps them cover their operating costs.
However, there is a problem with the central structure. It simply leaves too much power and influence over 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 take away the funds that are in their custodian’s earnings. A decentralized structure provides a powerful alternative to centralized money markets.
What is decentralized money market?
Working on a blockchain, a decentralized money market is a self-propelled structure operated by a smart contract, a software program. Once executed, a smart contract cannot be tampered with, making it free of human bias.
Managed by a global community of stakeholders through a highly decentralized network of nodes, the marketplace eliminates any role for middlemen. In popular language, the money market is placed in the field of decentralized finance (DeFi).
Related: The DeFi Stack: Stablecoins, exchanges, synthetics, money markets and insurance
Let us understand the working of a decentralized money market through an example. Fringe Finance ($FRIN) is a decentralized money market that unlocks the idle capital in cryptocurrency assets of all levels with the provision of secured loans. The platform facilitates decentralized lending and borrowing. Fringe Finance is a leading lending platform where anyone can lend additional funds and earn interest or collateralize altcoins to receive a stablecoin loan.
As mentioned, decentralized finance lenders and borrowers operate via on-chain programming code controlled by decentralized nodes, thus ending a single entity’s monopoly on control and reducing points of failure. Here are some benefits of decentralized money markets:
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 funds for their needs seamlessly. Decentralized protocols have an inherent censorship-resistant structure.
No jail time
In centralized money markets, users’ funds are in the custody of the central gatekeeper. However, DeFi protocols, like money markets, are non-binding and funds are directly in the control of borrowers and lenders. On-chain smart contracts, which operate with predefined logic, secure funds that cannot be tampered with while users are in full control of them.
Central financial markets typically operated underinsured and fractional reserve. These markets, under peer pressure to acquire more businesses, allow borrowers to withdraw more capital than they have deposited as collateral. Decentralized financial markets follow hypersecurity, bringing stability to the system. The smart contract simply liquidates the collateral of defaulting borrowers.
Composability is a design principle that allows components of a system to work together. Various applications and protocols can seamlessly interact in a permissionless manner. DeFi applications are composable, creating a blank canvas with endless possibilities for new mechanisms such as yield extraction 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 the more well-known cryptocurrencies with large market caps and high liquidity. Upcoming financial markets, however, are trying to test new models. Fringe Finance, for example, focuses on altcoins that have smaller market caps and lower liquidity. Most DeFi money market protocols do not support altcoins and this is where Fringe Finance comes into play.
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 profitable than large-cap cryptocurrencies. However, as few decentralized lenders and borrowers fueled such altcoins, the capital locked in them had gone untapped. However, Fringe Finance has changed that scenario. Keep in mind that altcoins are inherently more volatile, which carries some relative stability risks that can balance out your profit potential.
How does an altcoin money market maintain financial stability?
To neutralize volatility in altcoins, the money market protocol uses a number of lending parameters and related mechanisms. Let’s continue the example of Fringe Finance to understand it better. The parameters applied from Fringe Finance include maximum platform-level lending capacity for each collateral asset and automated LVR (loan-to-value ratio) calculation. To adequately implement these mechanisms, the system takes into account the asset’s available liquidity, historical volatility and other non-subjective metrics.
The platform offers a stable financial incentive model for all participants such as lenders, borrowers, altcoin projects, stablecoin holders, stakers and liquidators. For example, it provides incentives for liquidators to help stabilize the platform, such as allowing $FRIN token holders to stake coins to earn fee rewards. To broaden its operational base, a DeFi money market could include cross-chain collateral, lending against NFTs, fixed-rate loans, embedded insurance, and a decentralized user interface as the platform develops.
The future of decentralized money markets
In an environment where people have become wary of self-serving biases in centralized money markets, DeFi protocols have given them a lucrative option. The latter typically grants governance rights to all native coin holders and presents a blockchain-based ecosystem in its true decentralized ethos.
Similar to the money markets that focused on popular cryptocurrency projects with significant capitalization, new projects are now focusing on altcoins, unlocking the value stored there. In the future, it can be expected that upcoming DeFi money market protocols will explore previously untouched areas.