This article was first published on Chainlink
One of the most fundamental mechanisms of a healthy economy is the ability to put idle capital to work, enabling people to borrow money to grow their businesses and pay for expenses, and enabling others to lend assets to earn yield and grow their savings. In order to meet these needs, money markets—venues that connect borrowers and lenders—were created to meet this demand and over the centuries have generated significant economic activity.
While money markets have changed over time, their purpose and fundamental design remains largely the same. Borrowers use money markets to take out a short term loan (typically under a year) in order to borrow one currency (e.g. dollars), while putting up another currency (e.g. Euros) or an asset (e.g. real estate) as collateral. This collateral is required in the event the borrower fails to pay back their debts, in which case the collateral is sold to make the lender whole. Otherwise the collateral is returned when the loan is paid off by the borrower.
In exchange for the ability to borrow working capital from lenders, borrowers are required to pay a fee, usually in the form of an annual interest rate (e.g. 7% a year), which generates yield for lenders and incentives deposits. This interest rate is typically a function of supply and demand to ensure sufficient liquidity is available to both borrowers and lenders. A high supply and low demand of an asset leads to lower interest rates, while low supply and high demand of an asset leads to a higher interest rate. Various money markets compete based on the interest rates they offer, as well as other parameters such as how much collateral is required for loans.
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