Money market

Banks have long sat between savers and borrowers, setting rates and deciding who gets credit. A DeFi money market does the same job with a smart contract and a formula. Anyone can supply assets, anyone with enough collateral can borrow, and the interest rate updates on its own as conditions change.

Two meanings

In traditional finance, the money market is the market for short-term borrowing and lending: Treasury bills, commercial paper and repurchase agreements. Money market funds invest in these instruments. In DeFi, money market refers to lending protocols such as Aave, Compound and Morpho, where borrowing and lending happen onchain. The two share an idea, short-term credit priced by the market, but their mechanics and risks are very different.

How a DeFi money market works

Lenders supply an asset to a market, and it begins to earn interest. Borrowers supply collateral, usually worth more than what they borrow, and draw a loan in another asset. There is no credit check; the collateral is the protection. An oracle prices the collateral continuously, and if a loan grows too large relative to it, the position is liquidated.

How the rate is set

Most markets set rates by utilization: the share of supplied assets that is currently borrowed. When utilization is low, borrowing is cheap and lenders earn little. As it rises, rates climb, and past a target level they climb steeply, which encourages repayments and new supply. Lenders earn what borrowers pay, minus any protocol fee, so the rate is a variable yield that follows demand.

A simple example

A market holds 10 million dollar tokens supplied by lenders, and borrowers have taken 8 million. Utilization is high, so the borrowing rate is elevated. Lenders earn somewhat less than borrowers pay, because the interest on 8 million is shared across all 10 million supplied. If a large borrower repays 3 million, utilization falls, rates fall and lenders' income drops. If borrowers instead take nearly all 10 million, rates rise sharply and lenders who want to leave may have to wait for repayments.

Pooled and isolated markets

Older designs pool many assets together, so every lender shares the risk of every collateral type. Newer designs, such as Morpho's markets, isolate each pair of loan asset and collateral with its own oracle and liquidation threshold, so a problem in one market stays there. Curated vaults can then spread supply across several isolated markets, a direct use of composability.

Risks and limits

• Liquidity: lenders can withdraw only what is not lent out, so at very high utilization exits wait for repayments.
• Bad debt: if collateral falls faster than liquidations can sell it, the market is owed more than the collateral is worth, and lenders absorb the loss.
• Oracle and code risk: a wrong price or a bug can drain a market.
• Rate risk: income changes constantly and can fall sharply.

A market's size, often measured as TVL, says little about any of these.