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

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 extra asset can lend it to put their idle capital to work, 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 meet. Throughout history, money markets have been generators of economic activities. Although the structure of money markets has changed over time, their function has remained unchanged.

How does the money market work?

Conventionally, money markets were centralized structures that facilitated dealings between lenders and borrowers. Borrowers turned to the money markets for a short-term loan (less than a year) that could be collateralized. If borrowers can’t repay their loans, lenders can sell collateral to recoup the borrowed funds. When the loan is repaid, the collateral is returned.

Borrowers must pay interest to lenders (for providing them with working capital) and a fee to the money market (for facilitating the operation). The interest rate provides adequate liquidity to both borrowers and lenders. The commission paid to the money market helps them cover their operating expenses.

Nevertheless, the centralized structure has a problem. It simply puts too much power and influence over user funds in the hands of a single entity that can arbitrarily change the terms and conditions for other stakeholders. And what’s worse, it can even siphon off funds from your escrow earnings. A decentralized structure offers a strong alternative to centralized money markets.

What is a decentralized money market?

Powered by blockchain technology, a decentralized money market is a self-powered structure powered by a smart contract, a software program. Once in place, a smart contract cannot be interfered with, making it free from human bias.

Managed by a global community of stakeholders through a highly decentralized network of nodes, the market discards any role of intermediaries. In popular jargon, the money market falls under the domain of decentralized finance (DeFi).

Let us understand the operation of a decentralized money market through an example. Fringe Finance ($FRIN) is a decentralized money market that unlocks latent capital in cryptocurrency assets of all tiers through the deployment of 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 points of failure. Here are some of the benefits that decentralized money markets bring:

no permissions

In a decentralized environment, users do not need to seek permission from a central authority before engaging in any activity on the money market. Anyone online can earn interest on their principal and/or borrow funds for their needs with no problem. Decentralized protocols have an inherent censorship-resistant structure.

uncensored

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

Overguarantee

Centralized financial markets have typically functioned on an under-collateralized basis and with fractional reserves. these markets, under peer pressure to win more business, they allow borrowers to withdraw more funds than they have put up as collateral. Decentralized money markets follow overcollateralization, bringing stability to the system. The smart contract is limited to liquidating the collateral of borrowers who do not repay the debts.

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Composability

Composability is a design principle that allows the components of a system to interoperate with each other. Various applications and protocols can interact seamlessly and without permissions. DeFi applications are composable, creating a blank canvas with endless possibilities for novel mechanisms like yield mining and complex derivatives.

How the next decentralized money markets are entering uncharted territory

In the early years of DeFi, money market protocols skewed in favor of well-known cryptocurrencies with large market caps and high liquidity. Nevertheless, upcoming money markets seek to test new models. Fringe Finance, for example, focuses on altcoins with smaller market capitalization and less liquidity.. Altcoins are not supported by most DeFi money market protocols and this is where Fringe Finance comes into play.

Since altcoins are niche in use, they tend to be more speculative than large-cap digital currencies. However, as few decentralized finance lenders and borrowers cater to these altcoins, the capital locked in them has gone untapped. Despite this, Fringe Finance has changed this scenario. Keep in mind that altcoins are inherently more volatile, which comes with some associated stability risks that can be offset by profit potential.

How does an altcoin money market maintain financial stability?

To neutralize the volatility of altcoins, the money market protocol uses a series of lending parameters and relevant mechanisms. Let’s continue with the example of Fringe Finance to understand it better. The parameters applied by Fringe Finance include a platform-wide maximum lending capacity for each collateral and the automated calculation of the LVR (loan-to-value ratio). For the proper application of these mechanisms, the system takes into account the available liquidity of the asset, the 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, deploys incentives for liquidators to help stabilize the platform, such as allowing native $FRIN token holders to stake coins for commission rewards. To broaden its operating base, the DeFi money market could include cross-chain collateral, lending against NFTs, fixed-rate lending, 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 the selfish biases of centralized money markets, DeFi protocols have given them a lucrative option. The latter typically provide governance rights to all native coin holders and feature a blockchain-based ecosystem in its true decentralized ethos.

Just like money markets used to focus on popular cryptocurrency projects with significant market capitalization, newfangled projects are now focused on altcoins, unlocking the value stored in them. Going forward, upcoming DeFi money market protocols can be expected to explore hitherto uncharted territory.

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