Facilitating the smooth movement of capital between borrowers and lenders is a crucial element in fostering a dynamic economy. Individuals with surplus assets have the opportunity to lend them out, allowing their idle capital to generate returns. At the same time, those in need of funds to expand their businesses or cover operational expenses can easily access the required capital.
Money markets serve as the platforms where borrowers and lenders converge. These markets have played a significant role in driving economic activities throughout history. While the structure of money markets has evolved over time, their fundamental purpose of connecting borrowers and lenders remains unchanged.
How money markets operate within the DeFi system?
Lenders contribute their crypto-assets to a shared pool and, in return, receive interest earnings generated from borrowers. To represent their share of the assets supplied, lenders are issued tokens, which can be redeemed to retrieve their funds when desired.
The tokens contributed to the lending pool serve as resources that borrowers can utilize. To secure the borrowed funds, borrowers are required to provide collateral in the form of crypto-assets. Upon repaying the loan, borrowers regain access to their collateral.
However, if a borrower fails to fulfill their repayment obligation and the value of their collateral depreciates, they may face the risk of liquidation. Typically, another user can step in and liquidate a portion of the loan in exchange for receiving tokens at a discounted rate. Consequently, borrowers must ensure that their borrowing positions maintain a higher collateral value than the amount borrowed to avoid the possibility of liquidation.
What are the benefits?
- Fair and Transparent Loan Parameters: Since the loan terms are determined by on-chain smart contracts, discrimination against borrowers is eliminated. The protocols operate in a decentralized manner, ensuring equal treatment for all participants.
- Granular Interest Payments: Lenders receive interest payments in crypto-assets based on the prevailing supply and demand dynamics. Unlike traditional financial markets where changes in interest rates may not be passed on to customers, DeFi money markets enable lenders to benefit from more accurate and responsive interest earnings.
- Collateralized Borrowing with Retained Exposure: Users can utilize their crypto-assets as collateral while still maintaining exposure to their price movements. This flexibility allows individuals to access funds, even in unexpected emergencies, without completely divesting their holdings.
- Composability for Innovative Applications: The composability of DeFi money markets opens the door to the creation of diverse applications on top of lending protocols. For instance, PoolTogether leverages Aave’s lending protocol as a foundational element to offer a no-loss lottery. By utilizing the yield generated from supplying funds to Aave’s USDC lending pool, PoolTogether rewards users with USDC prizes on a daily basis.
What is the risk?
- Over-Collateralization: Lending in DeFi requires over-collateralization, meaning borrowers can only borrow a fraction of the collateral value. Consequently, if the value of the collateral drops significantly compared to the loan amount, there is a risk of losing the deposited assets. For instance, depositing ETH as collateral and borrowing DAI exposes the position to liquidation if there is a substantial decrease in the price of ETH. Each protocol has its own maximum loan-to-value ratio (LTV), and exceeding this limit can potentially result in the loss of deposited assets.
- Smart Contract Risks: Like any DeFi protocol, money markets carry smart contract risks. It is crucial to conduct thorough research (DYOR – Do Your Own Research) before participating. Carefully review the audit reports of the money market protocol and consider sticking with projects that have an established community and a solid track record.
- Utilization Imbalance: Lending pools in DeFi can experience over- or under-utilization based on the balance between the demand for and supply of loanable funds. If a lending pool is over-utilized, meaning borrowers have nearly depleted the funds provided by lenders, new users may face difficulties borrowing or redeeming. On the other hand, under-utilized lending pools result in reduced yield for lenders, as there are excess funds in the pool but limited borrowing demand.
Key players in DeFi money market
Aave, the prominent lending protocol, has established its dominance in the DeFi space with a total value locked (TVL) exceeding $5 billion, making it the third-largest DeFi application in terms of TVL. This leading DeFi money market is accessible on multiple chains, including Ethereum, Optimism, and Polygon, providing users with a wide range of options.
In January 2023, Aave V3 was launched, introducing several significant enhancements. These include reduced gas fees, the implementation of isolated and siloed modes to enhance security and prevent price oracle manipulations, the introduction of supply and borrow caps, and the inclusion of an efficiency mode, among numerous other features.
Compound Finance, like Aave, is a prominent player in the DeFi money markets, boasting a total value locked (TVL) of $1.8 billion. It is currently deployed across three different chains, namely Arbitrum, Ethereum, and Polygon. Compound was initially launched in September 2018, followed by the release of its second version in May 2019. In August 2022, after a governance proposal, Compound introduced its third version, known as ‘Comet’.
With the deployment of Comet, Compound transitioned from a pooled risk model where any asset could be borrowed. Unlike Aave and other popular money markets, Compound’s third version restricts borrowing to USDC, while allowing a variety of assets such as ETH, WBTC, or LINK to be used as collateral. The liquidation engine was also redesigned to prioritize security and enhance borrower-friendliness, aligning with the protocol’s goals.
The future of borrowing and lending
DeFi lending protocols, including the ones highlighted earlier, represent the future of money markets, enabling seamless access to borrowing and lending services for everyone without limitations. Undoubtedly, the landscape of DeFi lending will continue to witness ongoing innovation, and as these protocols gain further resilience through experience, they are poised for broader adoption in the coming times.
