Borrowing and lending money has long played a crucial role in global economies. Taking out a loan gives people the freedom to do anything they want with their money, whether that’s making good on their word to customers or investing in the growth of their business or idea. If they are successful in earning enough money to repay the loan, the borrowers will be relieved of their obligation to the lender.
Borrowers take out short-term loans in order to acquire some primary currency, and they place another currency or asset, like as real estate, in the collateral space. This arrangement ensures that the lender will be repaid in full if the borrower is unable to repay the principal amount of the loan. In the event that the loan is repaid in full, the collateral is released back to the original borrower.
Lenders also have the option of self-financing through earning interest, which can be a fixed rate or fluctuate with market conditions. Now that digital assets like cryptocurrencies have skyrocketed in popularity around the world, developments in the field of decentralized finance (DeFi) have made it possible for individuals to borrow or lend cryptocurrencies in simpler ways, freeing them from the restrictions imposed by traditional banks.
Here’s when decentralized financial markets prove useful. Let’s go on to defining them and discussing their role in the financial system.
All About Money Markets That Are Not Government-Owned
Borrowers and lenders can connect with one other on a far more fundamental level thanks to decentralized money marketplaces. Since their inception, financial markets have helped millions of people realize their dreams of starting businesses and expanding their ideas, all while fostering the growth of prosperous economies all around the globe. The basic notion is the same, even though the framework has had to adapt to the realities of modern technology.
Originating with blockchain technology, decentralized money markets use a software-based solution known as smart contracts to power their decentralized structure. Smart contracts have the advantage of being very secure and efficient, protected from any unauthorized change efforts, once they have been initialized.
For the most part, in decentralized money markets, a collection of stakeholders from different parts of the world keep an eye on things through nodes located inside a massively decentralized network structure, which does away with the need for a centralized authority to oversee trades and transactions.
Given that it is often characterized as decentralized, it typically belongs to decentralized financial systems (DeFi). There is no central authority over these money markets, thus both lenders and borrowers can freely withdraw their funds at any time. A country’s economy thrives when money flows freely between lenders and borrowers.
Functionality of a Distributed Financial System
Users with excess cash can lend them to others in exchange for interest, and the borrowers can utilize the money to start a business or take care of other pressing needs in a simple, efficient manner, without the hassle of dealing with a bank or complying with its rules. Some instances of decentralized money market protocols can help illustrate this point.
Fringe Finance is one such example of a cryptocurrency loan marketplace that operates on a decentralized system of lending and borrowing and facilitates the extraction of latent wealth from a wide variety of cryptocurrencies. Anyone with some extra cash can use Fringe Finance to get a loan secured by a stablecoin or earn interest on their money.
Anchor is another example of a decentralized money market that offers returns on deposits of Terra stablecoin with low levels of volatility. Anchor’s transparency and permissionless operation make it ideal for third-party applications to connect to the protocol and have access to potential interest opportunities.
Anchor offers significantly more stable savings than other money markets because to the diverse rewards pouring in from the most prominent blockchains operating on the Proof-of-Stake (PoS) mechanism.
To eliminate the possibility of a single point of failure and to lessen the number of moving parts, these platforms rely on on-chain programs that are independently monitored by various authoritative nodes. Users can borrow or lend with little effort thanks to the widespread improvement in the accessibility and speed of internet connections, which allows users to access these platforms from anywhere in the world.
Currently, people are employing these on-chain money exchanges to transfer billions of dollars’ worth of cash throughout the world in a simple and secure manner, thereby aiding in the development of cutting-edge technology and decentralized finance.
Now that we’re familiar with the terminology and basic concept of decentralized money markets, we can move on to discussing the positive effects that these markets can have on the economy as a whole.
The advantages of decentralized financial markets
Traditional markets, while their beneficial effects on the global economy, helping businesses expand and providing avenues for consumers to preserve wealth, are challenged by decentralized alternatives since they rely on a centralized organization to control the user funds. One problem with this is that it raises costs for everyone involved, from borrowers to lenders, who must work to earn the central organization’s trust in order to conduct business and secure financing.
To combat this, blockchain-enabled smart contracts are being used to construct decentralized financial markets that put control back in the hands of the users where it belongs rather than a centralized institution. The following are some of the main advantages that have led to the rising popularity of decentralized money markets.
Absence of Authorization
To further on the concept of decentralization, users of these protocols and platforms do not need to seek authorization from any one institution before engaging in specific monetary transactions. Because of this, anyone with access to the internet may invest their money and earn interest, and anyone can readily borrow money from anywhere in the globe. These protocols are built in a way that makes censorship impossible.
Nothing Holding It Custody
In contrast to decentralized markets, centralized ones act as a central hub for all financial transactions. In a centralized money market, all of the users’ money is managed by a single authority. Users on both sides of a decentralized money market bear full risk and responsibility for their investments because the market does not act as a custodian. To prevent users from abusing this power, however, “smart contracts” are utilized, which are based on logic and cannot be modified after they have been set up.
Additionally, this feature distinguishes centralized markets from decentralized ones. By implementing an undercollateralized structure, centralized markets allow their members to withdraw more money than they have put up as collateral. Overcollateralization is a key feature of decentralized money markets; in the event that a borrower is unable to repay a loan on time, their collateral is sold to recoup some of the money lent to them.
As a key design principle, composability in decentralized money markets facilitates interoperability between diverse decentralized apps and protocols by making internal system components more compatible with each other. Increasing the system’s composability allows for a wider variety of approaches, which in turn promotes its own evolution.
These are just a few of the reasons why decentralized money markets are gaining favor with both individuals and businesses.
- The ability of trading partners to communicate and trust one another is enhanced by decentralized money markets.
- With a decentralized system, your funds are safe from prying eyes.
- Traders can now do their business without being subject to as many restrictions.
- The current market environment bodes well for a planned new wave of technical advancement projects.
- Blockchain-based and cryptocurrency trading opportunities are well-suited to decentralized money markets.
- In other words, investors need not fret over losing access to their money.
- Transactions using smart contracts are secure, rapid, and nearly difficult to interfere with in real time.
The Role of Price Reports in Decentralized Financial Markets
Real-time pricing data and information of each individual asset should be included in exchanges to ensure the benefit of overcollateralization is preserved in these decentralized money markets.
Valuations updated in real time are used to determine when a user’s borrowing should be liquidated, and the collateral is sold to the liquidators, who then pay the user back, minus their fee. It’s possible for this to occur if the value of the debt or the collateral changes.
Despite this, the problem of the blockchain oracle still exists: since smart contracts can’t access off-chain data like real-time prices, an oracle must be used to get this data into the blockchain.
Not all oracles are safe enough to deal with sensitive information, putting user funds at risk if they are used. For the sake of the decentralized money market’s stability, liquidations play a significant role, making it crucial to use real-time price valuation data via an oracle that can reliably manage high-quality data feed in a safe environment.
If the price oracle falls below the market value, those who are borrowing may be liquidated erroneously, while if it rises above the market value, it will allow users to create undercollateralized positions in the protocol, which is risky.
One of the most widely used decentralized oracles today is Chainlink Data Feeds, which is in charge of numerous on-chain money marketplaces like Aave and CREAM and boasts an extremely safe system with real-time pricing valuation data for many different cryptocurrencies. Chainlink is able to do this because it achieves decentralization at both nodes and data sources. Chainlink also has stringent quality control procedures in place to protect your data from sabotage by third parties.
In order to ensure that the prices being used are accurate and current, it pulls information from a number of well-known data aggregators that are always in contact with trading venues in terms of volume, liquidity, and time.
Because of the trust they’ve earned over time, the communities that run decentralized money markets are willing to invest in expanding the sorts of collateral they accept and maintaining reliable, secure protocols thanks to Chainlink Data Feeds. The oracle framework guarantees the markets have a reliable price reference for driving price feeds. As a result, protocols like Aave have been able to attract investments totaling over a billion dollars and launch into new markets.
Money market protocols in the early days of decentralized finance favored more well-known, larger market cap and more liquid cryptocurrencies. However, recently, various new money markets have begun to turn their attention to other means. For instance, the aforementioned Fringe Finance likewise puts significant effort towards developing altcoins with far lower market capitalisation and liquidity.
While the majority of decentralized currency exchanges do not back cryptocurrencies, Fringe Finance is not one of them. There is still a lot of work to be done before we can fully understand the potential wealth backed by altcoins, as their values are thought to be more uncertain compared to coins with considerably greater market caps.
Keep in mind, nevertheless, that there is a risk to your financial security and stability due to the higher volatility of cryptocurrencies in general.
Maintaining Financial Security with Alternative Coins
The inherent volatility of altcoins is something that money market protocols use a set of borrowing rules and specialized techniques to combat. Again using Fringe Finance as an example, the platform has established a borrowing limit with regard to the collateral of each asset, with the loan to value ratio being automatically calculated (LVR). The asset’s liquidity, historical volatility, and other parameters are tracked by the system, among others, in order to properly implement such techniques.
Fringe Finance also has a fantastic approach for rewarding platform participation. It enables liquidators, for instance, to contribute to stability by allowing holders of native $FRIN tokens to stake their coins for return benefits from charges.
Cross-chain collateralization, lending against NFTs, fixed interest rates with loans, integrated insurance, and a decentralized user interface are just some of the ways in which decentralized money markets might grow in scope.
Perspectives on the Future
Successfully countering the inherent selfishness of centralized money markets, decentralized finance protocols have succeeded in offering their consumers a more desirable alternative. All holders of the local currency in a blockchain-powered system with decentralization as its basic idea can exercise voting rights in elections.
New initiatives are exploring altcoins as a way to gain access to the untapped capital potential represented by venues such as the money markets, which previously exclusively supported cryptocurrencies with larger market capitalisation and greater liquidity. Consequently, the future of decentralized money makers is generally seen as venturing further into the unknown and seeking new and unique prospects for cash.
With the aforementioned advantages in mind, decentralized money markets have created significantly new and improved use cases for smart contracts, allowing them to become one of the most widely used solutions in the DeFi industry.
Finally, the use of decentralized money markets allows the decentralized finance ecosystem to benefit from the principle of evolutionary development, which in turn facilitates the introduction of more technically advanced financial solutions. Although lending and borrowing have always played a significant role in conventional finance, their incorporation into decentralized finance opens up an infinite number of possibilities for innovative thought and problem solving.
While these alternative money markets expand, they will become more liquid, providing more opportunities for users and being at the forefront of innovation in the field of decentralized finance, even as yields in the real economy become more difficult to anticipate than they have ever been before. The vast majority of participants in the financial sector view these decentralized money markers as holding a bright future for those who are eager to make the most of them.