What is a decentralized money market and how does it work?

The continuous flow of capital between borrowers and lenders is a key aspect of a vibrant economy. Anyone with an extra resource can lend it to put their dormant capital to work, while people who need it to grow their business or meet operating costs can access it easily.

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 were centralized structures that facilitated agreements between lenders and borrowers. Borrowers would go to the money markets to get a short-term (less than a year) loan that could be secured. If the borrowers cannot repay 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 lenders (for providing them with working capital) and a money market commission (to facilitate the deal). The interest rate provides adequate liquidity to both borrowers and lenders. The commission paid to the money market helps them meet their operating expenses.

There is a problem with the centralized structure, however. It simply puts 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 way. Worse, they can even steal funds from their custody earnings. A decentralized structure provides a solid 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 running, a smart contract cannot be interfered with, thus making it free from human bias.

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 rule of decentralized finance (DeFi).

Related: The DeFi stack: stablecoins, exchanges, synthetics, money markets and insurance

Let’s understand how a decentralized money market works through an example. Fringe Finance ($ FRIN) is a decentralized money market that unlocks dormant capital in cryptocurrency assets at all levels by launching collateralized loans. The platform facilitates decentralized lending and lending. Fringe Finance is a primary lending platform where anyone can lend extra funds and earn interest or secure altcoins to take out a stablecoin loan.

As mentioned, decentralized lenders and borrowers operate through an on-chain programmatic code controlled by decentralized nodes, ending the monopoly of a single entity in control and reducing points of failure. Here are some benefits that decentralized money markets bring:

Without 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 funds for their own needs without any hassle. Decentralized protocols have an inherent censorship-resistant structure.

Not custodial

In centralized money markets, user funds are in the custody of the central gatekeeper. However, DeFi protocols such as money markets are not custodial and the funds are directly under the control of borrowers and lenders. On-chain smart contracts, executed on predefined logic, ensure funds that cannot be compromised while users have full control over them.

Overcollateralized

Centralized financial markets have generally operated in an under-guaranteed and fractional-reserve manner. These markets, under peer pressure to get more business, allow borrowers to withdraw more funds than they have deposited as collateral. Decentralized money markets follow excessive collateral, bringing stability to the system. The smart contract simply liquidates the guarantee of borrowers who are unable to repay debts.

Modularity

Modularity is a design principle that allows the components of a system to interact with each other. Various applications and protocols can interact seamlessly without authorization. DeFi apps are modular, creating a blank canvas with endless possibilities for new mechanisms such as yield extraction and complex derivatives.

How the upcoming decentralized money markets are entering uncharted territory

In the early years of DeFi, money market protocols were geared towards more well-known cryptocurrencies with large market capitalizations and high liquidity. The next money markets, however, are looking to try out new models. Fringe Finance, for example, focuses on altcoins with lower market capitalizations and lower liquidity. Most DeFi money market protocols don’t support altcoins and this is where Fringe Finance comes in.

Related: What is an altcoin? A beginner’s guide to cryptocurrencies beyond Bitcoin

Since altcoins apply to a niche use case, they tend to be more speculative than large-cap digital currencies. However, because few decentralized financial lenders and borrowers dealt with such altcoins, the capital locked into them had not been exploited. Despite this, Fringe Finance has changed this scenario. Keep in mind that altcoins are inherently more volatile, which carries some associated stability risks that the profit potential can balance.

How does an altcoin money market maintain financial stability?

To neutralize the volatility of altcoins, the money market protocol uses a number of relevant lending parameters and mechanisms. Let’s continue the example of Fringe Finance to understand it better. The metrics applied by Fringe Finance include a platform-level maximum borrowing capacity for each collateral and the automated calculation of the loan to value ratio (LVR). For an adequate 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 sustained model of economic incentives for all participants such as lenders, borrowers, altcoin projects, stablecoin holders, stakers and liquidators. For example, it offers liquidator incentives to help stabilize the platform, such as allowing native $ FRIN token holders to stake coins to earn commission rewards. To broaden its base of operations, a DeFi money market could include cross-chain guarantees, loans against NFTs, fixed rate loans, integrated 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 biases in centralized money markets, DeFi protocols have offered them a profitable option. The latter usually provides governance rights to all who hold native coins and features a blockchain-based ecosystem in its true decentralized ethics.

Similar to money markets which focused on popular cryptocurrency projects with significant market capitalization, new projects now focus on altcoins, unlock the value stored there. Moving forward, the upcoming DeFi money market protocols can be expected to explore previously pristine territories.