A vibrant economy is dependent on the seamless flow of capital between lenders and borrowers. Anybody with extra capital can lend it out to help grow their business, or to meet operational costs.
The money markets are where lenders and borrowers can meet. Money markets have been a generator of economic activity throughout history. Although the structure of money market has changed over time, its role has not.
How does the money market function?
Money markets were central structures that facilitated deals between lenders, borrowers and other parties. Borrowers might approach money markets for a short-term loan, usually less than one year. The collateral might be offered to them. Lenders can also sell collateral to recover loaned funds if the borrowers are unable to repay their loans. The collateral is returned once the loan has been repaid.
The interest rate borrowers pay to lenders to provide them with working capital and the fee to the money market to facilitate the deal. Both lenders and borrowers have sufficient liquidity because of the interest rate. They can meet their operating expenses by paying a fee to the money market.
However, centralized structures can be problematic. This central structure gives too much power to one entity, which can alter the terms and conditions of other stakeholders in an arbitrarily controlled manner. They can also siphon funds from their custody gains. Decentralized structures offer a strong alternative to central money markets.
What is a decentralized currency market?
A decentralized money market, which is built on a blockchain, is a self-propelled structure that is managed by a smartcontract, a program. A smart contract is indestructible once it is running. This makes it immune to human biases.
Markets are managed by a global network of stakeholders via a highly decentralized network nodes. They eliminate any role for intermediaries. The money market falls under the umbrella of decentralized finance (DeFi), according to popular lingo.
Related: The DeFi Stack – Stablecoins and exchanges, synthetics. Money markets. Insurance.
Let’s look at an example to show how a decentralized money exchange works. Fringe Finance ($FRIN), a decentralized money marketplace, unlocks all-tier crypto assets’ dormant capital by rolling out collateralized loans. This platform allows for decentralized borrowing and lending. Fringe Finance allows anyone to lend additional funds, earn interest, or collateralize altcoins in order to obtain a stablecoin loan.
Decentralized finance lenders and borrowers work through an on-chain programmatic code that is controlled by decentralized nodes. This eliminates the monopoly of one entity and reduces the risk of financial failure. These are some of the benefits decentralized money markets offer:
Permissions are not required
Users don’t have to seek permission from the central authority in order to engage in money market activities. Anybody can easily earn interest on their capital or borrow money for their needs. The inherent security of the decentralized protocols is protected from censorship.
Users’ funds are held in the custody by the central gatekeeper in centralized money markets. DeFi protocols, such as money markets, are not custodial. Instead, funds are in the direct control of lenders and borrowers. Smart contracts on-chain that run on pre-defined logic assure funds cannot be compromised and users have full control over them.
Financial markets centralized in a fractional reserve and undercollateralized manner have often functioned. Under peer pressure to increase business, these markets allow borrowers to withdraw more money than they have deposited as collateral. Decentralized money markets follow overcollateralization, bringing stability to the system. Smart contracts simply liquidate the collateral of borrowers who are unable to repay their debts.
Composability refers to a design principle that allows components of a system interoperable with each other. Multiple protocols and applications can interoperate in an unrestricted manner. The DeFi apps can be compiled, which opens up a wide range of possibilities for new mechanisms such as yield extraction or complex derivatives.
The future decentralized money market is stepping into unknown territory
In the early years of DeFi money market protocols were biased in favor of more well-known cryptocurrencies with high market capitalizations, and high liquidity. Future money markets are however looking for new models. Fringe Finance, in particular, is focused on altcoins with smaller market capitalizations, and lower liquidity. Fringe Finance is a new company that supports altcoins.
Related: What’s an altcoin? A guide for beginners to cryptocurrency beyond Bitcoin
Altcoins are more speculative because they can be used for a specific purpose. The capital in these altcoins was not yet being used by borrowers or decentralized finance lenders. Fringe Finance changed this situation. Altcoins can be volatile by nature, and this may lead to volatility risks. However, the potential for profit can balance.
How can an altcoin money exchange maintain financial stability?
The money market protocol employs a variety of borrowing parameters and related mechanisms to neutralize volatility in altcoins. Let’s look at Fringe Finance again to get a better understanding. Fringe Finance applies parameters such as a platform-wide maximum borrowing capability for each collateral asset, and an automated calculation of the LVR (loan-to-value ratio). The system considers the asset’s liquidity, historical volatility, and other non-subjective factors to ensure that these mechanisms are properly implemented.
It offers an economic incentive model that provides sustained incentives to all participants, including lenders, borrowers and stablecoin holders. To help stabilize the platform, it offers incentives to liquidators like native $FRIN token holders being able to stake coins and earning fees. A DeFi money market would allow for cross-chain collateralization, lending against NFTs and embedded insurance to expand its operational base.
Future of decentralized money markets
The DeFi protocols offer a lucrative alternative in an environment that has seen people become more cautious about self-serving biases in central money markets. This protocol gives governance rights to all native coins, and creates a blockchain-based ecosystem with its decentralized ethos.
Like the money markets, which used to be focused on popular cryptocurrency projects that had significant market capitalizations, new projects now focus on altcoins and unlock the value they hold. It is possible to expect that the DeFi money market protocols in the future will expand into previously unexplored territories.