Author: Chaos Labs Source: X, @chaos_labs Translation: Shan Oppa, Golden Finance

In the traditional In finance, money markets provide short-term lending opportunities, usually for highly liquid, low-risk assets, with the goal of providing the highest possible return while being safe. In decentralized finance (DeFi), this concept has evolved, mainly referring to the permissionless, decentralized lending of various digital assets without specific time limits. These platforms allow users to deposit cryptocurrencies into the protocol and earn income through interest paid by borrowers, who are required to provide sufficient collateral as security.

The money market uses a dynamic interest rate model to automatically adjust lending rates based on liquidity utilization in a specific market or capital pool. These models ensure that capital is deployed efficiently while incentivizing borrowers to return assets as quickly as possible when liquidity is scarce. A key feature of the interest rate curve is the "inflection point," where when utilization reaches a certain threshold, interest rates begin to rise significantly to control the leverage in the system: interest rates may rise gradually as utilization increases, but then spike sharply beyond the inflection point , causing borrowing costs to increase significantly.

It should be noted that the money market is different from unsecured loans: the money market requires the borrower to provide collateral to ensure the solvency during the loan period; while in the traditional sense Loans are typically unsecured and rely on a credit score or other form of security.

Why money markets are a key DeFi “Lego” module

By letting users earn income on idle assets and release liquidity without selling assets, Money markets play a crucial role in DeFi’s capital efficiency. The ability to lend and borrow against a specific token is a highly requested feature in the industry and often determines whether a crypto asset is considered a “blue chip” asset.

Money markets allow users to leverage their assets at low cost, high-net-worth individuals integrate it into tax planning, while also allowing funds to be abundant but liquid Underserved teams borrow against their assets to fund projects, while also being able to earn interest on their collateralized positions (Curve and Maker have been prime examples of this model over the past few years).

In addition, money markets are the basis for other DeFi tools, such as Collateralized Debt Positions (CDPs), yield farming strategies (supporting multiple pseudo-market neutral strategies), and chainOn margin trading.

Therefore, the money market is considered one of the most important building blocks in DeFi, the "financial Lego". In terms of scale, the total value locked (TVL) of lending protocols in the crypto space has exceeded $32.6 billion, as shown in the figure below.

Design Choices in Cryptocurrency Markets: Shared vs. Independent Liquidity Pools

Although cryptocurrencies The basic objectives of markets are the same, but their design choices can differ significantly, particularly in terms of liquidity structure. The biggest difference is between currency markets that use a single shared liquidity pool (such as Aave) and markets that implement independent liquidity pools (such as Compound v3). Each model has its advantages and disadvantages, influenced by liquidity depth, asset flexibility and risk management.

Independent liquidity pools: flexibility and risk isolation

In the independent liquidity pool model, each market or asset operates in its own liquidity isolation zone . This approach was adopted by Compound v3 as well as some more extreme platforms such as Rari Capital (although the latter failed).

The main advantage of independent liquidity pools is their flexibility, allowing the market to be tailored to specific asset classes or user needs. For example, independent pools could support specific asset groups (such as memecoins) or only tokens that contain certain unique risk characteristics or needs. This customization enables independent liquidity systems to meet the needs of specific communities or sectors that may not be achievable within the broader framework of a shared liquidity pool.

In addition, independent liquidity pools also provide better risk isolation. By zoning each market, the risk associated with a specific asset is limited to the market in which it is located. If the value of a certain token drops sharply or fluctuates excessively, its potential impact is limited to that market and avoids affecting the entire protocol.

However, these benefits come with a price: independent liquidity means fragmentation. For independent markets, the cold start problem needs to be solved repeatedly as each new market is created, because each market can only rely on its own participants and liquidity may not be sufficient to support significant lending activity.

As mentioned earlier, some protocols take the concept of independent lending markets to the extreme , allowing users to create such marketplaces without permission.

In these cases, like Rari or Solendprotocol, users can create their own de-licensed market, deciding on their own asset whitelists, risk parameters (such as loan-to-value ratios LTV and collateralization ratios CR), and manage corresponding incentive mechanisms.

Shared liquidity pool: Deep liquidity from day one

Another On the one hand, a single shared liquidity pool provides ample liquidity support from day one. By integrating all assets into a unified pool, the shared liquidity system can support large-scale lending activities, and even newly added assets are less subject to liquidity constraints.

For users who provide liquidity, shared pools are also beneficial: a larger liquidity base attracts more borrowers, thus generating higher and more stable returns. , because these earnings are supported by diversified borrowing needs.

This is the main advantage of the shared liquidity model. Although it has only one core advantage, its importance cannot be underestimated. In all markets, liquidity is paramount, especially in the cryptocurrency space.

However, the main disadvantage of shared liquidity pools is systemic risk. Since all assets are connected to the same liquidity pool, problems with a certain asset (such as sudden depreciation) may trigger a chain reaction of liquidations, especially when bad debts arise, which may affect the entire system.

Thus, these pools are less suitable or even completely inappropriate for niche or experimental assets compared to highly liquid, established tokens.

Finally, governance and risk monitoring of shared liquidity systems are often more complex, as the impact of any protocol changes can be significant.

The trend of hybrid models?

The trade-offs between independent and shared liquidity pools are significant, and no single approach is perfect. This is why, as the market matures, currency markets are increasingly moving toward hybrid models (or at least introducing hybrid features) that balance the liquidity advantages of shared pools with the customization and risk isolation capabilities of independent markets.

Aave's approach is a perfect example of this trend, introducing carefully designed independentmarket. The Aave system typically operates as a single shared liquidity pool, providing deep liquidity for major assets. However, Aave recognizes the need for greater flexibility in supporting assets with different risk profiles or usage scenarios and therefore creates markets for specific tokens or collaborative projects.

Another key feature that aligns with this trend is Aave’s eMode, designed for handling highly correlated assets to optimize capital efficiency. eMode allows users to unlock higher leverage and borrowing capabilities for assets whose prices are closely correlated (and therefore have significantly lower liquidation risk), thereby significantly improving capital efficiency by isolating specific positions.

Similarly, protocols like BenqiFinance and VenusProtocol, although traditionally falling into the shared liquidity category, also address the needs of specific sub-domains by introducing independent pools . For example, these independent markets could focus on niche areas such as GameFi, real world assets (RWA), or “ecosystem tokens” without impacting the operations of the main pool.

Meanwhile, money markets in independent markets (such as Compound or Solend) often have a "master pool" that serves as a shared liquidity pool. Take Compound, for example, which recently started adding more assets to its most liquid pool, effectively moving closer to a hybrid model.

Business Model of Money Markets

The core business model of cryptocurrency markets revolves around generating revenue through a variety of mechanisms related to lending and collateralized debt positions (CDPs).

1. Interest rate difference

•Mechanism: The main source of income of the money market is loans and The difference between borrowing rates.

•Process: Users can earn interest by depositing assets into the protocol, and borrowers need to pay interest to obtain liquidity. The protocol makes money from the difference between the interest rate charged to borrowers and the interest rate paid to depositors.

•Example: On Aave v3 Ethereum, the deposit rate for $ETH is currently 1.99%, while the borrow rate is 2.67%, resulting in an interest rate difference of 0.68%. Although the difference is small, this revenue will gradually accumulate as the number of users increases.

2. Liquidation fee

•Mechanism: When the borrower's collateral falls below the required threshold due to market fluctuations, the protocol will initiate liquidation Procedure to maintain the solvency of the system. The liquidator receives part of the borrower's collateral at a discount in exchange for paying off part of its debt.

• Sources of income: Typically, protocols take a share of the liquidation rewards and sometimes run their own liquidation bots to ensure timely liquidation and earn additional revenue.

3 . CDP-related fees

•Charge method: The agreement may charge fees for its CDP products. These fees may be a one-time charge, accumulated over time, or both. Yes.

4. Flash Loan Fees

•Mechanism: Most protocols allow users to perform flash loans for a small but significant fee

•Function: A flash loan is a loan that must be repaid in the same transaction, allowing users to instantly obtain the capital they need to perform certain operations (such as liquidation).

5. Treasury income

•Operations: Protocols often invest their treasury funds in finding safe sources of yield, thereby further increasing revenue.

These mechanisms make the lending market the crypto space One of the most profitable protocols in

These fees sometimes come with governance fees. Coins are shared and recycled as incentives or used only to pay for operating expenses

Risk<>Money MarketAs said, the business of operating cryptocurrency markets can be one of the most profitable businesses, but it is also undoubtedly one of the most risky.

The first obstacle faced by new money markets is the cold start problem. This refers to the difficulty of bootstrapping liquidity in a new protocol or market due to concerns about low liquidity, reduced lending opportunities, and potential for liquidity. Security vulnerabilities, early users do notBe willing to deposit funds into a capital pool that has not yet reached critical size. Without a sufficient initial deposit, interest rates may be too low to attract lenders, and borrowers may find that they are unable to obtain the loan they seek, or face interest rates that are too volatile due to changes in liquidity. Protocols often solve the cold start problem through liquidity mining incentives, where users are rewarded with native tokens by providing liquidity or borrowing liquidity (the incentives of one party are indirectly reflected on the other party, especially if the cycle is available). However, reliance on such incentives can produce unsustainable emissions if not carefully managed, a trade-off that protocols need to consider when designing their launch strategies.

Timely liquidation is another key factor in maintaining the solvency of the agreement. When the value of a borrower’s collateral falls below a certain threshold, the protocol must liquidate the position to prevent further losses. This raises two main issues: First, the success of this process depends heavily on the presence of a liquidator, whether run by the protocol or managed by a third party, who monitors the protocol and executes liquidation quickly.

In order to achieve these goals, they need to be fully incentivized through liquidation bonuses, which require Balanced with protocol revenue. Second, the liquidation process must be triggered when it is still safe to liquidate the position from an economic perspective: if the value of the collateral seized is too close to or the same as the outstanding debt liquidated, the risk of the position slipping into bad debt territory is higher. In this regard, defining safe and up-to-date risk parameters (LTV, CR, establishing liquidation buffers between these parameters and liquidation thresholds) and applying a rigorous selection process for whitelisting the assets available on the platform play a fundamental role .

In addition, in order to ensure that the protocol runs smoothly, liquidations occur in a timely manner, and users do not abuse the functionality, money markets rely heavily on functional oracles to provide real-time valuations of collateral. value and indirectly provide the health and liquidity of loan positions.

Oracle manipulation is an important issue of concern, especially for low-liquidity assets or protocols that rely on single-source oracles, where attackers can distort prices to Trigger liquidation or borrow at the wrong collateral level. This has happened many times in the past, most notably with Eisenberg's Mango Markets breach. Latency and wait times are also critical; during periods of market volatility or network congestion, delayed price updates can lead to inaccurate valuations of collateral, causing liquidation delays or mispricing and resulting in bad debts. To compensate for this, protocols often use a multi-oracle strategy, aggregating data from multiple sources to improve accuracy orBuild a backup oracle in case of outage from the primary source, and use a time-weighted price feed to filter out sudden changes in asset value due to manipulation or outliers.

Finally, we have security risks: currency markets are the main victims of vulnerabilities after bridges.

The code that handles money markets is extremely complex, and only a few protocols can boast a perfect class, while we see many protocols, especially the analysis of complex lending products. Forks can create multiple vulnerabilities when editing or mishandling the original code. The protocol mitigates these risks through measures such as bug bounties, regular code audits, and a complex process for approving changes to the protocol. However, no security measure is foolproof, and the potential for vulnerability exploitation remains an ongoing risk factor that teams need to be careful about.

How to deal with losses?

When a protocol suffers a loss, whether due to bad debt due to a failed liquidation or due to an unexpected event such as a hack, there is usually a standard provision for allocating the loss. Aave's approach can again serve as an example. Aave’s security module acts as a reserve mechanism to cover potential protocol shortfalls. Users can stake AAVE tokens in the security module and receive rewards, but if necessary, their staked tokens may be slashed by up to 30% to cover the deficit. This acts as a layer of insurance and has recently been further enhanced with the introduction of stkGHO. These mechanisms essentially introduce a “higher risk, higher reward” stance for users and align their interests with those of the entire protocol.

Chaos Labs <> Money Markets

Chaos Labs provides money market clients with a holistic approach: comprehensive solutions to optimize and protect their protocols. The most innovative is the Edge Risk Oracles invented by Chaos Labs, which can automatically optimize the parameter update process of the protocol, thereby narrowing the user experience (UX) and capital gap between decentralized and centralized financial platforms. efficiency gap. With the launch of Edge, Chaos has expanded into oracle provision, leveraging the team's expertise in risk monitoring to provide accurate, secure price data feeds with real-time anomaly detection to ensure accuracy and reliability. Chaos Labs also performs mechanism design reviews, asset onboarding management, and parameter recommendations for new and existing assets, ensuring that appropriate assets are only integrated after thorough risk assessment, and provides safe optimization of variables such as loan-to-value ratios; Chaos’ A unique approach is to conduct real-time risk monitoring through detailed dashboards and design liquidity incentive plans to drive sustainableGrowth and user engagement, solving cold start problems and market competition.