An Introduction to Money Markets in DeFi

Lending pools are the foundational liquidity reservoirs where users deposit assets to earn interest. These are automated, smart contract-based pools that aggregate funds from many lenders.

• Users deposit assets like ETH or USDC to become liquidity providers.
• The pooled funds are then available for borrowers to take out loans.
• Interest rates are typically algorithmically determined by supply and demand.
• This matters as it creates a permissionless marketplace for capital, enabling platforms like Aave and Compound to function.

Collateralization is the process where borrowers lock up crypto assets as security for a loan. This mechanism protects lenders from default risk in a trustless environment.

• Borrowers must over-collateralize, meaning the collateral value exceeds the loan value.
• Common collateral assets include ETH, wBTC, and various LP tokens.
• If the collateral's value falls below a certain threshold (the liquidation ratio), it can be automatically sold.
• This is crucial for maintaining system solvency and enabling undercollateralized loans through innovative models.

Interest rate models are algorithms that dynamically adjust borrowing and lending rates based on real-time pool utilization. They are essential for balancing supply and demand.

• Rates often increase as more of a pool's liquidity is borrowed to incentivize more deposits.
• Models can be linear, kinked, or adaptive, as seen in Compound's jump-rate model.
• This automated pricing ensures efficient capital allocation and competitive yields for lenders.
• For users, it means interest rates that reflect true market conditions without a central authority.

Liquidation mechanisms are automated processes that sell a borrower's collateral if its value drops too close to the loan value, ensuring lenders are always repaid.

• Triggered when the collateral's health factor or collateralization ratio falls below a safe threshold.
• Liquidators are incentivized with a discount or bonus to repay the bad debt and seize the collateral.
• This process is critical for managing risk and maintaining the protocol's financial health.
• For the ecosystem, it prevents systemic insolvency, as seen in MakerDAO's liquidation auctions.

Governance tokens are native assets that grant holders voting rights over a money market protocol's development and parameters, decentralizing its control.

• Token holders can propose and vote on changes to interest models, supported assets, or fee structures.
• Examples include AAVE for Aave and COMP for Compound.
• Holding tokens often also provides fee-sharing or staking rewards.
• This matters as it aligns the protocol's evolution with its community, moving away from centralized decision-making.

Oracles are external data feeds that provide reliable, real-time price information for collateral assets to the smart contracts. They are the critical link between off-chain data and on-chain execution.

• They supply accurate asset prices to calculate collateralization ratios and trigger liquidations.
• Decentralized oracle networks like Chainlink are commonly used to prevent manipulation.
• A failure in oracle data can lead to incorrect liquidations or undercollateralized loans.
• For users, reliable oracles are essential for the security and fair operation of the entire system.

Smart contract vulnerabilities are flaws in the code that powers lending protocols, which can be exploited to drain funds.\n\n- Reentrancy attacks where a function is called repeatedly before the first execution finishes.\n- Oracle manipulation feeding incorrect price data to trigger unfair liquidations.\n- Logic errors in interest rate models or collateral calculations.\nThis matters because users' deposited assets are directly at stake; a single bug can lead to catastrophic, irreversible losses, as seen in historical exploits.

Liquidation risk occurs when a borrower's collateral value falls below the required threshold, triggering an automatic sale at a discount.\n\n- Volatility spikes can rapidly drop collateral value below the loan-to-value (LTV) ratio.\n- Liquidation penalties often result in users losing a portion of their collateral.\n- Network congestion may delay attempts to add more collateral or repay.\nThis is critical as it can quickly erase a user's position, emphasizing the need for conservative borrowing and active monitoring.

Oracle risk stems from reliance on external data feeds for asset pricing, which if inaccurate or manipulated, can destabilize the entire protocol.\n\n- Price feed lag during high volatility causing outdated valuations.\n- Flash loan attacks to artificially manipulate an asset's spot price on a DEX.\n- Centralized oracle failure creating a single point of failure.\nThis matters because faulty price data leads to improper liquidations, bad debt, and systemic insolvency, as was a factor in the Mango Markets exploit.

Governance risk involves the concentration of decision-making power, which can lead to changes that harm users.\n\n- Vote manipulation through token accumulation or delegation.\n- Admin key risk where a multi-sig or team can upgrade contracts or withdraw funds.\n- Proposal apathy leading to low voter turnout and centralized control.\nThis is vital because it threatens the decentralized ethos; users must trust that governance acts in the protocol's long-term health, not for short-term gain.

Interest rate risk refers to the volatility in borrowing and lending rates, which can unpredictably affect returns and costs.\n\n- Algorithmic rate models that can change rapidly with market supply and demand.\n- Negative real yield where inflation outpaces the earned interest on deposits.\n- Rate arbitrage opportunities that can dry up, leaving lenders with lower income.\nThis impacts users' profitability and planning, making it essential to understand the protocol's specific rate model and market conditions.

Counterparty risk in DeFi is the chance that the other side of a transaction (like the protocol itself) becomes insolvent and cannot fulfill obligations.\n\n- Protocol insolvency from a cascade of bad debt after mass liquidations.\n- Over-collateralization requirements that may still fail in extreme market crashes.\n- Interconnectedness where one protocol's failure impacts others through integrated assets.\nThis is fundamental as it questions the ultimate safety of deposited funds, highlighting the need for audits, insurance, and diversification.