Seamless capital flow between borrowers and lenders is a key aspect of a vibrant economy. Anyone with additional assets can lend it out to put idle funds to work, and anyone who needs it to grow a business or meet operating costs can easily acquire it.
Money markets are platforms where borrowers and lenders can meet. Throughout history, currency markets have been the engine of economic activity. Although the structure of currency markets has changed over time, their role has not.
How do money markets work?
Traditionally, money markets are centralized structures that facilitate transactions between lenders and borrowers. Borrowers approach the money market for short-term loans (under one year) that may be secured. If the borrower cannot repay the loan, the lender can sell the collateral to recoup the loan funds. When the loan is paid off, the collateral will be returned.
Borrowers have to pay lenders interest (to provide them with working capital) and fees to the money market (to facilitate transactions). Interest rates provide ample liquidity for borrowers and lenders. The fees paid to the money market help them cover their operating expenses.
However, there are problems with the centralized structure. It simply hands too much power and influence over user funds to an entity that can change the terms and conditions of other stakeholders in arbitrary ways. To make matters worse, they can even take money out of custody earnings. Decentralized structures provide a powerful alternative to centralized currency markets.
What is a decentralized currency market?
The decentralized currency market working on top of the blockchain is a self-contained structure run by smart contracts, software programs. Once a smart contract is running, it is undisturbed and thus immune to human bias.
Governed by a global community of stakeholders through a highly decentralized network of nodes, the marketplace excludes any role for intermediaries. In popular terms, money markets fall under the umbrella of Decentralized Finance (DeFi).
related: DeFi Stack: Stablecoins, Exchanges, Synthetic Currencies, Money Markets and Insurance
Let’s go through an example to understand the workings of the decentralized currency market. Fringe Finance ($FRIN) is a decentralized money market, unlock Dormant capital in all tiers of crypto assets by launching collateralized loans. The platform facilitates decentralized lending. Fringe Finance is a major lending platform where anyone can lend additional funds and earn interest or collateralize altcoins for stablecoin loans.
As mentioned earlier, decentralized finance lenders and borrowers operate through on-chain program code controlled by decentralized nodes, thereby ending monopoly control by a single entity and reducing points of failure. Here are some of the benefits that a decentralized currency market brings:
In a decentralized environment, users do not need permission from a central authority before participating in any currency market activity. Anyone online can earn interest on their capital and/or borrow money for their needs seamlessly. Decentralized protocols have inherently censorship-resistant structures.
In a centralized currency market, users’ funds are kept by a central gatekeeper. However, DeFi protocols like money markets are non-custodial and funds are directly controlled by borrowers and lenders. On-chain smart contracts that operate on predefined logic ensure that no compromise is made while the user is in full control of the funds.
Centralized financial markets typically operate with undercollateralization and fractional reserves. These markets, under pressure from their peers to get more business, allow borrowers to withdraw more money than they have deposited as collateral. Decentralized currency markets follow over-collateralization, bringing stability to the system. Smart contracts are simply collateral to liquidate borrowers who fail to pay their debts.
Composability is a design principle that allows components of a system to interoperate. Various applications and protocols can interact seamlessly in a permissionless manner. DeFi applications are composable, creating a blank canvas of endless possibilities for novel mechanisms such as yield extraction and complex derivatives.
How the Upcoming Decentralized Currency Market Enters Unexplored Territories
In the early years of DeFi, money market protocols tended to favor better-known cryptocurrencies with large market caps and high liquidity. However, the upcoming currency market is looking to try out new models. For example, Fringe Finance focuses on altcoins with smaller market caps and less liquidity. Most DeFi money market protocols do not support altcoins, and this is where fringe finance comes in.
related: What are altcoins?A Beginner’s Guide to Cryptocurrencies Beyond Bitcoin
Since altcoins cater to niche use cases, they tend to be more speculative than large-cap digital tokens. However, with few decentralized finance lenders and borrowers catering to this altcoin, the funds locked in them have yet to be utilized. Still, fringe finance changed that. Note that altcoins are more volatile by nature, which does bring some associated stability risks, which the profit potential can balance out.
How does the altcoin currency market maintain financial stability?
To counteract the volatility of altcoins, money market protocols use a range of lending parameters and associated mechanisms. Let us continue with the example of fringe finance to understand it better.parameter application Automatic calculation of platform-wide maximum borrowing capacity and LVR (loan-to-value ratio) for each collateral asset provided by Fringe Finance. To fully implement these mechanisms, the system takes into account the asset’s available liquidity, historical volatility, and other non-subjective metrics.
The platform provides an ongoing model of economic incentives for all participants such as lenders, borrowers, altcoin projects, stablecoin holders, stakers and liquidators. For example, it introduced incentives for liquidators to help stabilize the platform, such as allowing native $FRIN token holders to stake coins to earn rewards from fees. To expand its operational base, as the platform grows, the DeFi money market may include cross-chain staking, loans against NFTs, fixed-rate loans, embedded insurance, and a decentralized UI.
The future of decentralized currency markets
In an environment where people are becoming wary of selfish bias in centralized currency markets, DeFi protocols offer them a lucrative option. The latter typically provide governance for all who hold the native token and present a blockchain-based ecosystem in its true decentralization spirit.
Similar to the money market in the past, which focused on popular cryptocurrency projects with significant market capitalization, the new project now focuses on altcoins, unlock the value stored there. Going forward, it can be expected that the upcoming DeFi money market protocol will explore previously untouched areas.