Decentralized money markets enable users to borrow and lend on-chain digital assets with just an Internet connection.
One of the most fundamental mechanisms of a healthy economy is the ability to put idle capital to work, enabling people to borrow money to grow their businesses and pay for expenses, and enabling others to lend assets to earn yield and grow their savings. In order to meet these needs, money markets—venues that connect borrowers and lenders—were created to meet this demand and over the centuries have generated significant economic activity.
While money markets have changed over time, their purpose and fundamental design remains largely the same. Borrowers use money markets to take out a short term loan (typically under a year) in order to borrow one currency (e.g. dollars), while putting up another currency (e.g. Euros) or an asset (e.g. real estate) as collateral. This collateral is required in the event the borrower fails to pay back their debts, in which case the collateral is sold to make the lender whole. Otherwise the collateral is returned when the loan is paid off by the borrower.
In exchange for the ability to borrow working capital from lenders, borrowers are required to pay a fee, usually in the form of an annual interest rate (e.g. 7% a year), which generates yield for lenders and incentives deposits. This interest rate is typically a function of supply and demand to ensure sufficient liquidity is available to both borrowers and lenders. A high supply and low demand of an asset leads to lower interest rates, while low supply and high demand of an asset leads to a higher interest rate. Various money markets compete based on the interest rates they offer, as well as other parameters such as how much collateral is required for loans.
With the rise of the Decentralized Finance (DeFi) ecosystem, decentralized money market protocols like Aave and CREAM enable users to borrow and lend their on-chain cryptocurrency (and tokenized assets) with just an internet connection. Today, billions of user funds are flowing through these on-chain money markets, which have been a rapidly growing use case of smart contracts alongside the growth of DeFi as a whole. However, to truly understand the benefits of decentralized money markets, it is key to examine the benefits they bring over traditional lending and borrowing venues.
The Benefits of Decentralized Money Markets
While traditional money markets have been a net positive for the global economy over the centuries, enabling business to expand and allowing citizens to save their money, the money markets of today are typically operated by a centralized institution, granting a significant amount of power and influence over user funds to a single entity. This design increases costs for borrowers/lenders and requires a high degree of trust in a single party.
In response to these limitations, developers are now utilizing blockchain-based smart contracts to create decentralized money markets that operate as code on a highly decentralized network of nodes around the world. Instead of being operated by a centralized institution, decentralized money markets are operated through on-chain programmatic code that is upgraded and managed by a global community of stakeholders, decentralizing control and reducing points of failure. Below represent a few of the primary advantages decentralized money markets bring to consumers.
Decentralized money markets operate in a non-custodial manner where deposited funds from borrowers and lenders can only be withdrawn by the original user themselves. Instead of a centralized institution deciding where and how funds are used, decentralized money markets follow predefined logic of on-chain smart contracts, granting a large degree of assurance that funds cannot be improperly used and ensuring that users keep full control over when and how they can withdraw.
Through these smart contracts, on-chain money markets are also able to operate in an inherently permissionless manner where users do not need to ask permission from a central gatekeeper. This enables anyone with access to the internet to earn yield and/or borrow working capital with minimal friction. This censorship-resistance creates a wider market of users, including the underbanked, generating more economic activity and higher yields as a result.
Unlike the traditional financial system which commonly operates in an undercollateralized and fractional reserve manner where users can borrow more funds they deposit as collateral, decentralized money markets operate in an overcollateralized manner. By depositing more collateral than what is being borrowed, borrowers who are unable to pay back their debts simply have their collateral liquidated, providing a high degree of security for lenders.
Smart contract powered financial applications like decentralized money markets have the unique advantage that deposited funds can be tokenized (e.g. tokens deposited on Aave becomes fungible aTokens). These tokenized deposits become interest-bearing representations of the underlying assets and can then be used within other applications within the decentralized finance ecosystem. This creates what is known as composability and allows for the creation of more advanced applications such as no-loss lotteries like PoolTogether, where user funds are pooled in a money market to generate interest which is then distributed to one winner a week, while all users can withdraw their full original deposit at any time.
With all of these advantages in combination, decentralized money markets have become one of the most widely used applications in the DeFi economy alongside decentralized exchanges and stablecoins. However, beyond the on-chain smart contract logic itself, decentralized money markets also need an additional piece of core infrastructure in order to function properly.
The Importance of Price Feeds for Decentralized Money Markets
To ensure decentralized money markets stay overcollateralized and do not become insolvent, they require real-time price data on each supported asset on the exchange. This price data is used to determine when borrowers should have their position liquidated—where collateral is sold to liquidators who pay back the user’s debt for a fee—which can occur if the collateral falls in value and/or the debt rises in value.
However, because of the blockchain oracle problem, smart contracts cannot natively access off-chain information such as price data, necessitating the usage of an oracle to relay this data on-chain. If a decentralized money market utilizes an insecure oracle mechanism that only provides low quality data, then user funds can be at risk of loss. As an example, if the price oracle deviates below the market wide price, borrowers can become falsely liquidated, and if the price oracle deviates above the market wide price, then users can create undercollateralized toxic positions on the protocol. Because liquidations play such a crucial role in ensuring the health of decentralized money markets, it is imperative pricing data is received from a highly secure oracle mechanism.
As the most widely used decentralized oracle solution, Chainlink Data Feeds provide numerous on-chain money markets, such as Aave and CREAM, with a highly secure and reliable source of price data on a multitude of crypto assets. Chainlink mitigates any single point of failure by being decentralized at both the node operator and data source levels, with quality control measures in place to ensure a consistently high level of manipulation resistance. Additionally, Chainlink Price Feeds are able to ensure money markets receive price data with full market coverage by fetching from multiple professional data aggregators that each track all trading venues, taking into account volume, liquidity, and time differences across exchanges.
Through Chainlink’s time-tested and battle-hardened Price Reference Data Feeds, communities managing decentralized money markets can invest their resources in onboarding new collateral types and ensuring a healthy protocol. Chainlink’s oracle framework guarantees that these markets source pricing information that will continue to operate as designed, with the additional ability to rapidly launch new feeds as needed. Using this approach, decentralized money markets such as Aave, which now secures over a billion in deposited funds, has been able to rapidly expand and include new unique collateral types such as real-world mortgages and decentralized exchange liquidity pool tokens.
Decentralized money markets provide the DeFi ecosystem with a crucial building block on which advanced financial products can be built. While lending and borrowing is useful on its own, it becomes even more powerful when combined with other DeFi “money legos” to create a sum greater than its parts. As these money markets expand, they will not only grow in liquidity and provide more utility and opportunity for more users, but they will also be the forefront of innovation in DeFi as yields in the real-world economy become increasingly unpredictable. The future for decentralized money markets is brighter than ever.