Limited Asset Money Markets

First Generation Money Markets

The First Generation of OpFi Money markets as a financial primitive allowed the ability for users to borrow and lend. This functionality is a key component for any financial system. In OpFi, trusted third parties needed in TradFi to facilitate trust between borrowers and lenders are no longer needed. Permissioned third-parties and banks have been replaced by immutable self-executing smart contracts, opening up the ability for borrowing/lending at scale, in a decentralized way. Incumbent first-generation protocols like AAVE and Compound facilitated decentralized borrowing and lending functionality for users. However, these initial protocols were limited in their capabilities to offer markets on all ERC20 tokens. They opened up money markets to all, however - the assets offered are limited to only the most liquid tokens. These money market protocols were not designed for a more exotic OpFi market. As such, they are unable to offer borrowing and lending markets for more long-tail assets, which tend to be both more illiquid and volatile.

The key to understanding the limitations of traditional OpFi borrowing / lending protocols is by understanding two important concepts: Interest Rate and Collateral Ratio.

Interest Rate

The interest rate is the amount a lender charges a borrower and is a percentage of the principal—the amount loaned. The interest rate on a loan is typically noted on an annual basis known as the annual percentage rate (APR).

Traditional Borrowing/Lending markets, are based on dynamic interest rates. The interest rates are market-driven based on supplied liquidity (supply side) and borrowed amount (demand side).

Collateral / Collateral Ratio

In OpFi, users lend crypto or stablecoins against crypto used as collateral. Should the borrower default, then the collateral is used to fulfill the borrower's debt obligations (principal and interest payments).

The collateral ratio shows how big is the value of the collateral compared to the loan. The higher this ratio, the more the borrower has to put down his assets for borrowing a certain amount of funds. The collateral ratio is typically fixed by the protocol's governance.

In this kind of borrowing / lending - lenders deposit assets to the liquidity pool, and borrowers deposit collateral in order to borrow the supplied asset. Lenders earn yield and borrowers pay down their debt with interest. If the borrower’s market value of collateral goes below a certain price relative to the amount borrowed, then the protocol will automatically liquidate the loan.

In traditional OpFi lending, the lenders are the Liquidity Providers.

Due to the above protocol mechanics. Traditional money markets are unable to protect users from the risks associated with borrowing/lending of long-tailed assets (more volatile + less liquid).

These protocols offer a permissioned listing system, which only offers the most liquid tokens, decided by protocol governance.