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

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The seamless flow of capital between borrowers and lenders is an important aspect of a vibrant economy. Anyone with an extra asset can borrow it to put their idle capital to work, while people who need it to grow business or cover operational costs have easy access to it.

Money markets are the platforms where borrowers and lenders can meet. Throughout history, money markets have been generators of economic activity. While 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 the deals between lenders and borrowers. Borrowers would approach money markets to get a short-term loan (less than a year) that could be secured as collateral. If the borrowers cannot repay their loans, the lenders can sell the collateral to get the borrowed money back. When the loan is repaid, the collateral is returned.

Borrowers are required to pay interest to the lenders (to provide them with working capital) and a fee to the money market (to facilitate the deal). The interest rate provides sufficient liquidity for both borrowers and lenders. The fee paid to the money market helps them to cover their operating expenses.

However, there is a problem with the centralized structure. It simply puts too much power and influence over user funds in the hands of a single entity that can arbitrarily change the terms for other stakeholders. Worse, they can even siphon the money into their custody gains. A decentralized structure provides a robust alternative to centralized money markets.

What is a decentralized money market?

A decentralized money market, operating on top of a blockchain, is a self-driving structure managed by a smart contract, a software program. Once it’s up and running, a smart contract cannot be disrupted, leaving it free of human bias.

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Operated by a global community of stakeholders through a highly decentralized network of nodes, the market excludes any intermediary role. In popular slang, the money market is placed under the domain of decentralized finance (DeFi).

Related: The DeFi Stack: Stablecoins, Exchanges, Plastics, Money Markets and Insurance

Let us understand the workings of a decentralized money market through an example. Fringe Finance ($FRIN) is a decentralized money market that unlocks dormant capital in cryptocurrency assets at all levels by rolling out collateralised loans. The platform facilitates decentralized lending and lending. Fringe Finance is a primary lending platform where anyone can borrow extra money and earn interest or collateral altcoins to take out a stablecoin loan.

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

Without permission

In a decentralized environment, users do not need to seek permission from a central authority before engaging in money market activities. Anyone online can seamlessly earn interest on their capital and/or borrow money for their needs. The decentralized protocols have an inherent censorship-resistant structure.

not custodial

In centralized money markets, users’ money is held by the central gatekeeper. However, DeFi protocols such as money markets are non-custodial and funds are directly under the control of borrowers and lenders. On-chain smart contracts, which run on predefined logic, ensure money that cannot be compromised while users have full control over it.

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overcollateralized

Centralized financial markets have usually functioned in a collateral and fractional reserve manner. These markets, pressured by peers to bring in more business, allow borrowers to withdraw more money than they have deposited as collateral. Decentralized money markets follow overcollateralization and bring stability to the system. The smart contract simply liquidates the collateral of the borrowers who fail to repay the debts.

Composability

Composability is a design principle that ensures that components of a system can work together. Different applications and protocols can work together seamlessly without permission. DeFi apps can be curated, creating a blank canvas with endless possibilities for new mechanisms such as yield extraction and complex derivatives.

How emerging decentralized money markets are entering virgin territory?

In the early years of DeFi, money market protocols were tilted in favor of better-known cryptocurrencies with large market caps and high liquidity. However, emerging money markets are looking for new models. For example, Fringe Finance focuses on altcoins with smaller market caps 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

Since altcoins apply to a niche use case, they tend to be more speculative than big cap digital coins. However, because there were few decentralized financial lenders and borrowers dealing with such altcoins, the capital locked into them had gone untapped. Despite this, Fringe Finance has changed this scenario. Keep in mind that altcoins are inherently more volatile, which does come with some associated stability risks that can offset the earning potential.

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How does an altcoin money market maintain financial stability?

To neutralize the volatility in altcoins, the money market protocol uses a whole range of borrowing 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 borrowing capacity for each collateral and automated calculation of the LVR (loan to value ratio). For an adequate implementation of these mechanisms, the system takes into account the available liquidity of the asset, historical volatility and other non-subjective measures.

The platform provides a sustainable model of economic incentives for all participants such as lenders, borrowers, altcoin projects, stable coin holders, strikers and liquidators. For example, it is rolling out incentives for liquidators to help stabilize the platform, such as allowing native $FRIN token holders to wager coins to earn rewards with fees. To broaden the operating base, a DeFi money market could include cross-chain collateralization, lending against NFTs, fixed-rate lending, built-in insurance, and a decentralized user interface as the platform grows.

The future of decentralized money markets

In an environment where people are wary of self-righteous biases in centralized money markets, the DeFi protocols have given them a lucrative option. The latter usually offers administrative rights to anyone who owns native coins and presents a blockchain-based ecosystem in its true decentralized ethos.

Just like the money markets that used to focus on popular cryptocurrency projects with significant market capitalization, new projects now focus on altcoins, unlock the value stored there. Going forward, upcoming DeFi money market protocols can be expected to explore areas previously untouched.