Modular lending: more than just a meme? - ChainCatcher

Original title: “Modular lending: More than a meme?” Original author: Chris Powers Original translation: Luccy, BlockBeats

Editor’s Note: DeFi researcher Chris Powers explores a new trend in the lending field - modular lending, and illustrates the potential of modular lending in addressing market challenges and providing better services.

Chris Powers compared traditional DeFi lending leaders such as MakerDAO, Aave, and Compound, as well as several major modular lending projects including Morpho, Euler, and Gearbox, pointing out the prevalence of modular lending in the DeFi world and emphasizing its positive impact on risk management and value flow.

In the business and technology fields, there is an ancient concept: ‘There are only two ways to make money in business: bundling and unbundling.’ This holds true not only in traditional industries, but also in the world of cryptocurrencies and DeFi, where the nature of being permissionless is more apparent. In this article, we will explore the rising trend of modular lending (and the enlightened ones who have already entered the post-modular era) and how it disrupts the mainstream of DeFi lending. With the emergence of unbundling, a new market structure has formed and new value flows - who will benefit the most?

—— Chris

A major unbundling has occurred at the core layer, where Ethereum previously had only one solution for execution, settlement, and data availability. However, it has now adopted a more modular approach, providing specialized solutions for each core element of the blockchain.

The same plot is also unfolding in the DeFi lending sector. The initially successful products are those that have everything, although the initial three DeFi lending platforms—MakerDAO, Aave, and Compound—have many active parts, they all operate within the predefined structures set by their respective core teams. However, today, the growth of DeFi lending comes from a new batch of projects that are splitting the core functions of lending protocols.

These projects are creating independent markets, minimizing governance, separating risk management, relaxing oracle responsibilities, and eliminating other single dependencies. Other projects are creating user-friendly bundled products that combine multiple DeFi building blocks to provide more comprehensive lending products.

This new push for unbinding DeFi lending has become a meme for modular lending. We at Dose of DeFi love memes, but we also see new projects (and their investors) trying to hype up market new issues, not because of potential innovation (look at DeFi 2.0).

Our view: speculation is not fictional. DeFi lending will undergo a similar revolution to the core technology layer - just like Ethereum, new modular protocols emerge, such as Celestia, while existing leading enterprises have adjusted their roadmaps to become more modular.

In the short term, major competitors are exploring different paths. New modular lending projects such as Morpho, Euler, Ajna, and Credit Guild have been successful, while MakerDAO is moving towards a more decentralized SubDAO model. In addition, the recently announced Aave v4 is also evolving towards a modular direction, echoing the architectural transformation of Ethereum. These paths being explored may determine the long-term value accumulation in the DeFi lending stack.

According to Token Terminal’s data, there has always been a question about whether MakerDAO belongs to the encrypted DeFi lending market share or the stablecoin market. However, with the success of Spark Protocol and the growth of MakerDAO’s RWA (Real World Assets), this will no longer be a problem in the future.

Why choose modularization?

There are typically two approaches to building complex systems. One strategy is to focus on the end user experience, ensuring that complexity does not impact usability. This means controlling the entire technology stack (like Apple does through the integration of hardware and software).

Another strategy is to let multiple participants build the various components of the system. In this approach, the central designer of the complex system focuses on creating interoperable core standards while relying on the market for innovation. This can be seen in the core internet protocols, which have remained unchanged while applications and businesses based on TCP/IP have driven innovation on the internet.

This analogy can also be applied to economies, where the government is seen as the foundational layer, similar to TCP/IP, ensuring interoperability through the rule of law and social cohesion, while economic development occurs in the private sector built upon the governance layer. These two approaches are not always applicable, and many companies, protocols, and economies operate somewhere in between.

Disassembly Analysis

Supporters of modular lending theory believe that the innovation of DeFi will be driven by achieving specialization in every part of the lending stack, rather than just focusing on the end user experience.

A key reason is to eliminate single dependencies. Lending protocol requires close risk monitoring, and a small problem can lead to catastrophic losses, so establishing redundancy mechanisms is key. Single-structure lending protocol typically introduce long Oracle Machine to prevent one from failing, but modular lending applies this Hedging approach to every layer of the lending stack.

For each DeFi loan, we can identify five key components that are necessary but adjustable:

· Loan assets

· Collateral assets

· Oracle Machine

· Maximum Loan-to-Value (LTV)

· Interest Rate Model

These components must be closely monitored to ensure the platform’s solvency and prevent the accumulation of bad debts due to rapid price changes (we can also add a clearing system to the above five components).

For Aave, Maker, and Compound, token governance mechanisms make decisions for all assets and users. Initially, all assets were pooled together, sharing the risks of the entire system. However, even single-structure lending protocols quickly began creating separate markets for each asset to isolate risk.

Understanding the main modular participants

Isolating the market is not the only way to make your lending protocol more modular. True innovation is happening in new protocols that rethink the necessary elements of the lending stack.

The largest players in the modular world are Morpho, Euler, and Gearbox:

Morpho is currently the clear leader in modular lending, although it seems to have recently become uncomfortable with the label, trying to become “non-modular, not monolithic, but aggregated”. With a total Lock-up Position (TVL) of $1.8 billion, it’s undoubtedly already at the top of the Decentralized Finance lending industry, but its ambition is to become the biggest. Morpho Blue is its main lending stack, where it is possible to create a vault that is tuned to the required parameters without permission. Governance only allows modification of a few components – currently five different components – without dictating what those components should be. This is configured by the vault owner (usually the Decentralized Finance Risk Management). Another major layer of Morpho is Meta Morpho, which attempts to be an aggregated liquidity layer for passive borrowers. This is a section that is particularly focused on the end-user experience. It is similar to Uniswap’s DE X on Ethereum, while also having Uniswap X for efficient transaction routing.

Euler launched its v1 version in 2022, generating over 200 million USD in outstanding contracts, but a hacker attack almost depleted all protocol funds (although later returned). Now, it is preparing to launch v2 and re-enter the mature modular lending ecosystem as a major participant. Euler v2 has two key components. One is the Euler Vault Kit (EVK), which is a framework for creating vaults compatible with ERC4626, with additional lending functionality, making it able to act as a passive lending pool. The other is the Ethereum Vault Connector (EVC), which is an EVM primitive, primarily implementing multi-vault collateral, i.e., multiple vaults can use collateral provided by one vault. v2 is planned to be launched in the second or third quarter.

Gearbox provides a user-centric and explicit framework where users can easily set positions without excessive supervision, regardless of their skills or knowledge level. Its main innovation is the ‘credit account’, a list that allows the operation and allowlist of assets valued in borrowed assets. It is essentially an independent lending pool, similar to Euler’s treasury, with the difference that Gearbox’s credit account combines users’ collateral and borrowed funds in one place. Like MetaMorpho, Gearbox demonstrates that there can be a layer focused on bundling for end users in a modular world.

Unbind, and then rebind

In the specialization of the lending stack, opportunities are provided to build alternative systems that may target specific niche markets or future growth drivers. Some leading proponents of this approach are as follows:

Credit Guild plans to enter the established pooled lending market through a trust-minimized governance model. Existing participants, such as Aave, have very strict governance parameters, which often result in apathy from small token holders as their votes seem to have little impact. As a result, a honest minority who controls the majority of tokens is responsible for most of the changes. Credit Guild disrupts this dynamic by introducing an optimistic, veto-based governance framework that stipulates various statutory thresholds and delays for different parameter changes, while incorporating a risk mitigation approach to handle unforeseen consequences.

Starport’s goal is cross-chain development. It has implemented a basic framework for integrating different types of EVM-compatible lending protocols. It handles data availability and terms execution through the following two core components:

· Starport contract, responsible for loan initiation (term definition) and refinancing (term update). It stores data for protocols built on top of the Starport core and provides this data when needed.

· Custody contract, mainly holding the collateral that the borrower initiates the protocol on Starport, and ensuring the debt settlement and closure are carried out according to the terms defined in the initiated protocol, and stored in the Starport contract.

Ajna has a truly permissionless, non-oracle pooled lending model with no governance at any level. It sets specific pairs of quote/collateral assets provided by the lender/borrower, allowing users to assess asset demand and allocate capital. Ajna’s non-oracle design allows lenders to determine borrowing rates by specifying the amount of collateral assets each borrower’s quoted token should be backed by. This is particularly attractive for long-tail assets, much like what Uniswap v2 did for small tokens.

If you can’t beat them, join them

The lending sector has attracted a large number of newcomers and has also rekindled the motivation for the largest DeFi protocol to launch new lending products:

Aave v4, announced just last month, is very similar to Euler v2. Previously, Marc ‘Chainsaw’ Zeller, a fervent supporter of Aave, stated that due to the modular nature of Aave v3, it would be the final version of Aave. Its soft liquidation mechanism was pioneered by Llammalend (see below); its unified liquidity layer is also similar to Euler v2’s EVC. While most upcoming upgrades are not novel, they have yet to be extensively tested in a highly liquid protocol (unlike Aave). Aave’s incredible success in capturing market share on every chain is remarkable. Its moat may not be deep, but it is wide, giving Aave a very strong tailwind.

Its most interesting feature is its Risk Management and Clearing logic, which is a Curve-based LLAMMA system that enables “soft liquidation”.

LLAMMA is implemented as a liquidity contract that encourages arbitrage between isolated lending market assets and external markets.

Just like centralized liquidity automated market makers (clAMM, such as Uniswap v3), LLAMMA evenly deposits borrowers’ collateral within a user-specified price range called an interval, which deviates significantly from the oracle machine price to ensure that there is always an incentive for arbitrage.

In this way, when the price of the collateral assets drops below the range, the system can automatically convert some of the collateral assets into crvUSD (soft liquidation). Although this approach may drop the overall loan health, it is much better than full liquidation, especially considering the explicit support for long-tail assets.

Since 2019, Curve founder Michael Egorov has invalidated the criticism of over-design.

Curve and Aave both attach great importance to the development of their respective stablecoins. This is a very effective strategy in the long run and can bring considerable income. Both of them are imitating MakerDAO’s approach. MakerDAO has not given up on DeFi lending and has also launched the independent brand Spark. Despite no native token incentives (yet), Spark has performed exceptionally well in the past year. Stablecoins and the enormous money creation capability (credit is indeed a powerful drug) present a huge long-term opportunity. However, unlike lending, stablecoins require on-chain governance or off-chain centralized entities. For Curve and Aave, this approach is reasonable because they have some of the oldest and most active token governance (of course, second only to MakerDAO).

What Compound is doing right now is something we cannot answer. It used to be a leader in the DeFi field, kickstarting the DeFi summer and establishing the concept of yield farming. Clearly, regulatory issues have limited the activity of its core team and investors, which is why its market share has declined. However, just like Aave’s broad and shallow moat, Compound still has $1 billion in outstanding loans and widespread governance distribution. Recently, some people have started developing Compound outside of the Compound Labs team. We are unsure what markets it should focus on - perhaps large-cap markets, especially if it can gain some regulatory advantages.

Accrued Value

The top three in DeFi lending (Maker, Aave, Compound) are all adjusting their strategies to cope with the transition to a modular lending architecture. Lending against cryptocurrency collateral used to be a good business, but when your collateral is on-chain, the market becomes more efficient and profits are squeezed.

This does not mean that there are no opportunities in an efficient market structure, just that no one can monopolize their position and extract rent.

The new modular market structure provides risk managers and private enterprises such as risk investors with more opportunities to acquire value without permission. This makes risk management more meaningful and directly translates into better opportunities, as economic losses can seriously affect the reputation of repository administrators.

The recent Gauntlet — Morpho incident is a good example, which occurred during the depegging of ezETH.

During the depegging period, the mature risk manager Gauntlet operated an ezETH vault and suffered losses. However, due to clearer and more isolated risks, most users of other metamorpho vaults were unaffected, and Gauntlet needs to provide a post-assessment and take responsibility.

Gauntlet first launched the repository because it saw a more promising future on Morpho and could charge a fee instead of providing Risk Management consulting services to Aave governance (which was more focused on politics than risk analysis — you try tasting or drinking a “chainsaw”).

Just this week, Morpho founder Paul Frambot revealed that a small risk management company, Re7 Capital, which also has excellent research news briefings, has achieved an annualized on-chain income of $500,000 as the manager of the Morpho repository. While not huge, this shows that you can build a financial company on DeFi (not just a wild yield farm). This does raise some long-term regulatory issues, but it is commonplace in today’s cryptocurrency world. Additionally, this will not prevent risk managers from becoming one of the biggest beneficiaries of future modular lending.