Today I am going to take a look at how money markets work in Decentralized Finance (DeFi). These are the places you can borrow and lend crypto and either make returns or pay interest, depending on which side of that line you find yourself.
For the usual disclosure, I am not a financial advisor, I don’t even work in finance at all. My day job is as a telecommunications software engineer. Treat everything you read here as some educational resources and not financial advice.
What Is A Money Market
A money market is a place where borrows and lenders can come together and make deals. In traditional finance, this would generally be a bank, acting as both the market and the lender. The borrower would have to pay a fee for the service, in the form of interest, while the borrower would earn that fee. The borrower also generally has to provide some form of collateral to secure the loan, depending on the size of the loan, credit score, and whatever other factors.
In Decentralized Finance (DeFi), the money market is run by smart contracts, and both the borrowers and lenders can be whoever wants to either put up their crypto to be borrowed, or wants to put up collateral to borrow from the pool. Some of the bigger protocols are AAVE and Compound.
There are also Centralized Finance (CeFi) protocols such as BlockFi and Celsius, which operate closer to how banks do, and will be something I visit in more detail in a later post, but basically they take custody over your crypto to handle all the lending, as opposed to running it all through smart contracts.
How Do They Work
DeFi money markets works by deploying smart contracts to act as the money markets. They are deployed to hold any crypto in them, and act as the focal point for the system.
If a user wants to become a lender to earn interest on their crypto, they deposit their funds into the contract. The contract will in turn issue the user a token to represent their deposit plus the interest they have earned. On Compound these are called CTOKENS while on AAVE they are called ATOKENS, and can be turned back into the contract to get your crypto back, plus whatever interest you have earned.
These tokens both work slightly differently. With ATOKENS, the balance of them in your wallet increases over time as you earn interest, while with CTOKENS, they simply become worth more of the underlying asset over time. Other than that slight difference, they are just standard ECR-20 tokens, and have all the usual functionality of any other token.
For a borrower, the first step is to provide collateral in the form of some other crypto. These loans are generally over collateralized, so you have to put in more upfront, than you will be able to borrow. Once you pay back the loan, plus the necessary interest, you get your collateral back.
Why Borrow Crypto
The first question you may be asking yourself as you’ve gotten this far into the article is, why? Why would you want to borrow crypto, if you have to provide collateral worth more than what you can borrow? Wouldn’t it be better to just convert whatever crypto you have into the one that you want?
There can be lots of reasons for you may want to do a crypto loan instead of swapping between them. Maybe you feel very strongly that the one that you hold is going to be worth a lot more later on down the line, but you really need some stablecoin to take part in another DeFi venture. Rather than sell off your crypto that would be worth more if you held onto it, you can use it as collateral to get the other crypto you need.
You could also use the borrowed funds to cover some unexpected real world expense, and rather than sell all your hard earned Bitcoin (BTC) at a loss today, when you are pretty confident the price is going to go back up, so you take a loan of some stablecoin to cash out to fiat to use for the expense, while letting your Bitcoin (BTC) just accrue you interest to pay back, instead of losing out on all the gains.
The interest rates that are required to be paid by borrowers, and earned by the lenders, are determined by the ratio between the provided liquidity, and how much of it has been borrowed out. There is also no real risk to someone defaulting on their loan and the pool losing out, as the supplied collateral would simply be liquidated and used to pay back the pool.
There are, of course, a number of other factors to consider when looking at these protocols. The first is if there is enough liquidity in the pool for you to be able to take a loan the size that you need. Generally, if you stick to one of the big protocols, this would not be a factor, unless you are looking to take out a substantially large loan.
You need to consider the collateral factor when you are taking out a loan, as that will determine how much more collateral you will need in order to take out a loan the size you want. This will also vary based on the crypto you are supplying collateral in, based on how volatile it is.
On the borrow side, you also have to keep track of your collateral ratio, which is the value of your supplied collateral, as compared with the value you have borrowed out, plus any accrued interest, multiplied out by the collateral factor. You always need to have the collateral side of that be higher than the borrowed side of that, or you risk being liquidated. This is an especially big factor when you are supplying collateral in a volatile crypto, when it goes down in value.
On both sides of the fence, you have all the standard Decentralized Finance (DeFi) risks, such as hackers taking advantage of a defect in the smart contract and being able to drain all the liquidity. These tend to be seen more in flash loans, but it’s still something to consider.
DeFi money markets can be a very useful thing, but as with all things in DeFi, there are risks involved. You can earn some returns by loaning out your crypto, in a fairly low risk scenario, but if a hacker were to drain the contract, you could lose it all in an instant.
On the borrowing side, there is obviously the ever possible risk of liquidation, but as long as you manage your collateral ratio properly, and don’t just let it go and never check it, you can mitigate this risk. But again, a hacker could drain the contract somehow and get all your collateral.
No matter which side of the fence you are on, lending or borrowing, never put in more than you are comfortable having going to zero. Diversifying your portfolio is important, and this can be something good to allocate a portion of your portfolio to, but make sure you are Doing Your Own Research on any protocol that you think you may want to throw some of your hard earned crypto into.
Socials And Other Links
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