What are DeFi Money Markets?

Money markets are the third largest sub-sector of DeFi by total value locked after decentralized exchanges and liquid staking, with over $14.2 billion locked in these protocols. DeFi money markets allow anyone to borrow or lend crypto-assets without requiring a credit check, the submission of personal information or involvement of any intermediaries.

In what follows, we’ll describe a simple outline of how money markets in DeFi work. Lenders supply their crypto-assets to a pool and earn interest income from borrowers. In return for their deposits into lending pools, lenders receive a token that represents a claim on the asset supplied, which is then burned when a lender wants to reclaim their funds.

Tokens supplied to the lending pool can be utilized by borrowers and to incentivize them to repay the loan, they must deposit some crypto-assets as collateral. Once the loan is repaid, the borrower can then reclaim their collateral.

However, if a borrower fails to repay their loan and the value of their collateral decreases, they may face liquidation. Usually, another user can liquidate part of the loan to earn a discounted amount of tokens. As a result, borrowers need to ensure over-collateralization of their borrow positions to avoid being liquidated.

Benefits and Risks of DeFi Money Markets

Money markets in DeFi offer many benefits over traditional finance. First, there’s no need to hand over any sensitive personal information. To take part, all you need is:

  1. A Web3 wallet,

  2. Some crypto-assets as collateral, and

  3. An internet connection.

Secondly, DeFi money markets are also more inclusive and permissionless. In the world of traditional finance, entrepreneurs often have difficulty obtaining funding and individuals with no credit scores are denied access to capital. But this is not the case for on-chain lending protocols, since anyone can borrow from these money markets given they have the three things listed above.

Some other benefits of money market protocols in DeFi are:

  • On-chain smart contracts determine the parameters of a loan, so there’s no scope for discrimination against borrowers.

  • Lenders receive granular interest payments denominated in crypto-assets based on supply and demand. In traditional financial markets, interest rate changes are often not passed on to their customers. For instance, if the supply of loanable funds increases, this should translate into a low rate of interest for borrowers. However, lending firms may not facilitate lower borrowing rates to maximize their profits.

  • The ability to use crypto-assets as collateral and retain exposure to their price while also borrowing funds (e.g., for an unexpected emergency).

  • Because of the composability of DeFi money markets, other interesting applications can be built on top of lending protocols. For example, PoolTogether uses Aave’s lending protocol as a building block to offer a no-loss lottery. The yield generated by supplying funds to Aave’s USDC lending pool is used to award PoolTogether users USDC prizes every day.

While DeFi money markets offer many advantages over traditional finance, there are also some risks to be aware of:

  • Lending in DeFi is over-collateralized, which means you can only borrow a fraction of the collateral amount. As a result, there’s a risk you could lose the deposited assets if the value of your collateral drops sharply in relation to the value of your loan. For example, when depositing ETH as collateral and borrowing DAI, a large drop in the price of ETH exposes your position to liquidation. Each protocol has their own parameters for the maximum permitted loan-to-value ratio (LTV) and if you exceed this maximum, then you can potentially lose the assets deposited.

  • As with any DeFi protocol, there are smart contract risks. Always DYOR! Closely examine a money market’s audit reports, stick with the projects that have an established community and a long track record.

  • Lending pools can become over- or under-utilized, depending on the balance between the demand for and the supply of loanable funds. If a lending pool is over-utilized, that means borrowers have exhausted almost all the funds deposited into the pool by lenders, meaning new users cannot borrow or redeem. On the flip side, under-utilized lending pools result in reduced yield for lenders, as there are funds in the pool but there’s very little borrowing demand.

Examples of DeFi Money Markets

In the following sections, we’ll introduce you to the most popular and innovative money market protocols.


Aave is the most dominant lending protocol by total value locked (TVL) with over $5 billion, being the third largest DeFi application by this measure. The leading DeFi money market is available across 8 different chains, such as Ethereum, Optimism, and Polygon. Initially launched in May 2017 as ETHLend with a peer-to-peer lending model, the architecture was revamped to a peer-to-contract model and the protocol relaunched under the name of Aave in early 2020.

In January 2023, Aave V3 was launched which introduced lower gas fees, isolated and siloed modes, supply and borrow caps for enhanced security (to combat price oracle manipulations), as well as efficiency mode, among many other features.

Isolated borrowing enables assets with less liquidity to be used as collateral, placing a debt ceiling on specific collaterals and only allowing loans denominated in stablecoin. The idea behind isolated borrowing is to prevent the collapse of one low-grade collateral from affecting the overall solvency of the Aave.

Efficiency mode (also known as ‘E-Mode’) can be activated through an on-chain transaction and allows your LTV for a selected category of assets to be increased to 97%. However, if E-Mode isn’t activated, users can only borrow up to 80% of their collateral value.

When depositing to Aave’s lending pools, lenders receive aTokens. For example, when lending USDC, you’ll receive a transferable token called aUSDC. As yield-bearing tokens, aTokens entitle the holder to their initial deposit and any interest or rewards earned.

If a lender wants to remove their assets from a pool, the aTokens are burned and the lender receives their original deposit back plus any interest and their share of flash loan fees (collectively, lenders earn 0.09% of the flash loan volume).

Source: Aave Docs

As another feature of Aave specifically designed for developers, flash loans can be created by building a contract that essentially borrows any available amount of assets without the need to put up any collateral, with the requirement being that the liquidity is returned to the protocol within a one block transaction.

The contract built by a developer needs to execute the instructed steps and pay back the loan, interest and fees, all within the same transaction. Interested readers can learn more about flash loans here. Non-developers can also use flash loans through no-code platforms, such as Furucombo.

When borrowing crypto-assets through Aave, users can select between stable or variable interest rates (where the latter fluctuates depending on the amount of liquidity in the reserve). They’ll also earn yield on their supplied collateral, but usually the APY for borrowing assets outweighs this.

If the value of the collateral for a loan on Aave drops below a certain LTV, the protocol automatically repays part of the loan through liquidation. Up to 50% of the pledged collateral can be used to repay the loan and bring the LTV back within the limits of the loan agreement. Liquidations are processed by "liquidators”, which are users that can repay the loan and claim the collateral (plus a 5% bonus).

To add more security to the protocol, the project’s native AAVE token and the LP token for Balancer’s AAVE-ETH pool (BPT) can be staked on Ethereum’s mainnet to earn safety incentives (i.e., more AAVE tokens). The staking module is a backstop in case the protocol experiences a shortfall event. Another benefit for AAVE stakers: a discount on the borrow rate for the upcoming decentralized stablecoin GHO.

While AAVE stakers can earn an estimated 6.10% APR at the time of writing, they take on the risk of slashing. Of the total amount of staked tokens, up to 30% may be used to backstop the protocol in the event of a shortfall. Another factor to consider is a 20-day cooldown period when unstaking AAVE.

As well as staking, the AAVE token and its staked version are also used in governance, specifically for launching proposals and voting on Aave Improvement Proposals. Therefore, tokenholders have a direct say in how the protocol operates, such as decisions on which assets can be added as collateral, launching the protocol on new chains and adjusting risk parameters, such as borrow or supply caps.

Compound Finance

Alongside Aave, Compound Finance is another leader in the DeFi money markets that currently has a TVL of $1.8 billion and is deployed across 3 different chains: Arbitrum, Ethereum, and Polygon. Compound was launched in September 2018, while a second version was released in May 2019 and, following a governance proposal, a third version (known as ‘Comet’) was deployed in August 2022.

With the launch of Comet, Compound shifted away from a pooled risk model where any asset can be borrowed. Unlike Aave and other popular money markets, Compound’s third release only enables its users to borrow USDC, although a range of assets can be used as collateral (such as ETH, WBTC or LINK). The liquidation engine was also redesigned to focus on security and to make the protocol more borrower friendly.

Source: Instadapp

Lenders who deposit assets into the protocol’s smart contract receive cTokens (similar to Aave’s aTokens). For example, if you deposit USDC to Compound v2’s lending pools, you’ll receive an interest-bearing cUSDC in return, which can be exchanged for the deposited USDC and any interest earned.

However, for Comet other assets that are accepted as collateral do not earn interest payments, so lenders cannot earn yield on assets other than USDC. The flipside is that there are fewer risks taken on by the protocol. For example, illiquidity risk is avoided since if a lender supplies ETH as collateral, they truly own their supplied assets, as borrowers can only utilize USDC for loans.

There’s also a minimum borrow amount (preventing the protocol from owning a small amount of under-collateralized debt that’s too expensive to liquidate) and supply caps to improve safety as compared to earlier versions.

Collateral factors on Compound vary depending on the asset supplied, ranging from 65% for the project’s native COMP token all the way up to 82.5% for ETH. Compound v3 introduces the liquidation collateral factor, which introduces a gap between the maximum collateral factor and the point of liquidation.

For example, while the collateral factor is 82.5% for ETH, the borrower will only be liquidated if their LTV reaches 90%, ensuring a buffer and allowing such a user to hold on to their positions for longer.

The liquidation system for Comet/Compound III also differs from previous versions of the protocol and other money markets like Aave since undercollateralized accounts are absorbed by the protocol, instead of by liquidators. In Comet, borrowers are repaid using the protocol’s reserves. The benefit of this system is that it allows the protocol to avoid bad debt at times where there is little incentive for liquidators to perform liquidations.

Source: Instadapp

Like AAVE, COMP can be used in governance to contribute to the future direction of the protocol and can also be earned by depositors and borrowers. As well as being an ERC-20 token, COMP holders can also delegate their voting rights to other addresses. Any address with at least 1% of the COMP supply can propose new governance actions.


The third and final DeFi money market we’ll cover is FraxLend, which was launched in September 2022 by Frax Finance to complement their ecosystem and drive more demand for the FRAX stablecoin.

At the time of writing, FraxLend is the 8th largest lending protocol by TVL with just over $155 million in assets and is only available on Ethereum’s mainnet. Currently, the FRAX stablecoin can be borrowed against 8 different ERC-20s as collateral, including WETH, WBTC and the project’s native governance token FXS. The maximum LTV is 75% for all pairs, except for FRAX-FPI, which has a maximum LTV of 95%.

Each lending pair is an isolated market so that anyone can participate in lending and borrowing activities. The isolated pairs also means liquidity providers can clearly assess the risk because the amount of variables is contained. There’s also reduced risk as compared to a pooled model from a development bug perspective.

Borrowers can deposit their selected ERC-20 token as collateral (say WETH) and borrow FRAX, paying an interest rate to the lenders. If a borrower exceeds their maximum LTV, then they risk their borrowing position being closed by a liquidator.

Similar to Aave’s aTokens, when a deposit is made into a FraxLend pair, a user receives yield-bearing fTokens. As a lender earns interest payments, these fTokens can be redeemed for a greater amount of the deposited asset. The diagram below shows how FraxLend functions from the perspective of different participants.

Source: Frax Finance

To combat bad debt, FraxLend implements something called dynamic debt restructuring. In the event of extreme volatility, liquidators can repay the maximum amount of the borrower's position covered by the borrower's collateral and the remaining debt is reduced from the total claims that all lenders have on underlying capital. This mechanism helps the lender of last resort to avoid holding worthless fTokens and ensures a lending pair is resilient after adverse events.

One of the unique aspects of FraxLend is how interest rates are calculated. While interest rates are usually based on a pool’s utilization (the linear rate), for FraxLend, there’s also a time-weighted variable rate calculator (which was inspired by SushiSwap’s Kashi). Essentially, the interest rate is adjusted in perpetuity as a basis of utilization and means that the market ultimately decides what the proper interest rate curve looks like. The idea behind the time-weighted variable rate is that the pool deployer doesn't have to make an assessment of what they believe the proper interest rate curve is.

Unlike Aave and Compound, FraxLend is just one part of the Frax trinity, with the other two being stablecoins (notably FRAX and frxETH), as well as liquidity systems such as FraxSwap and FraxFerry.

In the near future, Frax’s money market is going to be deployed on Layer 2s such as Arbitrum, which will boost the liquidity of its stablecoin products, and begin to support Curve LP positions as collateral. Another update on the horizon to watch out for is a new DeFi primitive known as BAMM (Borrowed AMM), which can enable support for long-tail assets on FraxLend without the requirement of a price oracle.

Combining DeFi Money Markets with Perpetuals

DeFi money markets can be used for many reasons, such as earning interest and token incentives or enabling leveraged exposure through a folding strategy. Another potential use case is to borrow against an asset you don’t want to sell and think will appreciate in the future to go long or short another asset using perpetual futures.

Let’s say you hold 100 AAVE and you’re bullish on the token’s price. But you’re also bullish on OP and currently have zero exposure to this asset. However, you don’t want to sell AAVE to free up some funds to buy OP, as you may have to buy AAVE back at a higher price if the token appreciates in value.

In this case, 100 AAVE can be deposited into a lending protocol, borrow some USDC against it and then visit Perp and go long on OP-USD using USDC as collateral. You don’t have to sell your AAVE tokens and give up any gains, while also capitalizing on a potentially strong upward move in OP.

Once you’ve made some profits from the OP long, the perpetual swap position can be closed and the USDC that was borrowed can be repaid to get your AAVE tokens back. You’ll also still have some USDC left over, roughly equal to the profit made from the long OP trade.

However, there’s a risk that your trade doesn’t go to plan, where you’ll end up with a loss and cannot pay back the entire debt to retrieve all of your AAVE tokens. Make sure your LTV is not too high, as your supplied tokens could be liquidated if the debt isn’t repaid when the LTV reaches the liquidation point.

For example, if 100 AAVE is worth $8,000, and you’ve borrowed $4,000 in USDC to go long on OP, then your LTV equals 50%. But if the price of the AAVE token falls 33%, then you’d risk facing liquidation.

It’s recommended to keep your LTV as low as possible, so in the event of an extreme market downturn, the value of your collateral is more than enough to ensure your assets do not get liquidated and you’ll still have the flexibility to pay back the loan when you can.

Money Markets of the Future

DeFi lending protocols like the ones mentioned above are the money markets of the future, allowing anyone to easily access borrowing and lending services without any restrictions.

This article has briefly covered Aave, Compound and FraxLend, but there are many other DeFi projects in this space doing innovative things. For example, Alchemix allows cryptocurrency users to take out self-repaying loans, Liquity enables ETH holders to obtain interest-free loans on their holdings and the rise of NFTs has spawned numerous lending protocols for these non-fungible assets.

There’s no doubt we’ll see more innovation in the area of DeFi lending as time goes on, and as these protocols become more battle-hardened, they are set for greater adoption in the near future.

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