DeFi researcher Chris Powers explores the new trend in the lending sector, “modular lending,” and illustrates the potential of modular lending in addressing market challenges and providing better services. This article is based on an article by Chris Powers, compiled, translated, and written by BlockBeats.
In the article, Chris Powers compares traditional DeFi lending leaders (MakerDAO, Aave, and Compound) with several major modular lending projects, including Morpho, Euler, and Gearbox, pointing out that modular lending in the DeFi world generally emphasizes 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 is not only established in traditional industries but is more apparent in the world of cryptocurrencies and DeFi due to its permissionless nature.
In this article, we will discuss the rising trend of modular lending (and the enlightened individuals who have already entered the post-modular era) and how it is disrupting the mainstream of DeFi lending. With the emergence of unbundling, new market structures have formed new value flows. Who will benefit the most?
A significant unbundling has already occurred in the core infrastructure 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 every core element of the blockchain.
The DeFi lending sector is also witnessing a similar storyline. Initially successful products were those that were all-encompassing, although the first three DeFi lending platforms—MakerDAO, Aave, and Compound—had many active parts, they operated under predefined structures set by their 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 establishing independent markets, minimizing governance, separating risk management, loosening oracle responsibilities, and eliminating other single dependencies. Other projects are building user-friendly bundled products, combining multiple DeFi building blocks to offer more comprehensive lending products.
This new drive towards unbundled DeFi lending has become a meme of modular lending. We at Dose of DeFi love memes, but also see new projects (and their investors) trying to hype market new topics rather than for potential innovation (look at DeFi 2.0).
Our view: hype is not fictional. DeFi lending will undergo a transformation similar to the core technical layer, like Ethereum, with new modular protocols emerging, such as Celestia, while existing leaders adjust their roadmaps to become more modular.
In the short term, major competitors are paving different paths. New modular lending projects such as Morpho, Euler, Ajna, Credit Guild, have been successful, while MakerDAO is moving towards a more decentralized SubDAO model. Additionally, the recently announced Aave v4 is also evolving towards a modular direction, echoing Ethereum’s architectural shift. The paths currently being paved may determine the accumulation of value in the DeFi lending stack in the long term.
According to data from Token Terminal, 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 question in the future.
Building complex systems usually has two methods. One strategy is to focus on the end-user experience, ensuring that complexity does not affect usability. This means controlling the entire tech stack (like Apple achieves through hardware and software integration).
Another strategy is to have multiple participants build the various components of the system. In this approach, the central designers of the complex system focus on creating interoperable core standards while relying on the market for innovation. This can be seen in core internet protocols, where these protocols remain unchanged, and innovations are driven by applications and businesses based on TCP/IP.
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 on top of governance. These two approaches are not always applicable, and many companies, protocols, and economies operate somewhere between the two.
Supporters of modular lending theory believe that DeFi innovation will be driven by specializing in every part of the lending stack rather than just focusing on the end-user experience.
One key reason is to eliminate single dependencies. Lending protocols require close risk monitoring, as a small issue could lead to catastrophic losses, so building redundant mechanisms is crucial. Single-architecture lending protocols typically introduce multiple oracles to prevent failure of one, but modular lending applies this hedging method 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
Oracles
Loan-to-Value ratio (LTV)
Interest rate model
These components must be closely monitored to ensure the platform’s solvency and prevent bad debt accumulation due to rapid price changes (we can add a liquidation system to the above five components).
For Aave, Maker, and Compound, the token governance mechanism makes decisions for all assets and users. Initially, all assets were merged together, sharing the risks of the entire system. However, even single-architecture lending protocols quickly began creating separate markets for each asset to isolate risks.
Isolating markets is not the only way to make your lending protocol more modular. True innovation is happening in new protocols that reimagine the essential components of the lending stack. The biggest 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 felt uncomfortable with this label, trying to become “non-modular, non-single-structured, but aggregated.” Its total locked value (TVL) is 1.8 billion, undoubtedly ranking it among the top players in the DeFi lending industry, but its ambition is to become the largest.
Morpho Blue is its main lending stack, where vaults can be built permissionlessly based on tuned parameters. Governance only allows modifications to a few components, currently five different components, without specifying what these components should be.
This is configured by the vault owner (usually a DeFi risk manager). Another major layer of Morpho is MetaMorpho, attempting to become an aggregated liquidity layer for passive lenders. This is a section specifically focused on the end-user experience. It is similar to Uniswap in the Ethereum DEX, and also has Uniswap X for efficient trade routing.
Euler launched its v1 version in 2022, generating over 200 million in open 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 building vaults compatible with ERC4626, with additional lending features to serve as a passive lending pool, and the Ethereum Vault Connector (EVC), which is an EVM primitive, mainly implementing multi-vault collateral, where multiple vaults can use collateral provided by one vault. The v2 plan is set to launch in the second or third quarter.
Gearbox offers a user-centric clear framework where users can easily set positions without much oversight, regardless of their skills or knowledge level.
Its main innovation is the “Credit Guild,” which is a list that allows operations and whitelists of assets to be priced in borrowed assets. It is essentially an independent lending pool.Similar to Euler’s vault, the difference is that Gearbox’s credit account consolidates users’ collateral and borrowed funds in one place. Like MetaMorpho, Gearbox demonstrates a focused layer in the modular world that bundles for end-users.
Specialization in the lending stack offers opportunities to build alternative systems tailored to specific niche markets or future growth drivers. Some leading proponents of this approach include:
Credit Guild intends to enter the established pooled lending market through a trust-minimized governance model. Existing participants like Aave have very strict governance parameters, often leading to apathy among small token holders as their votes seem to have little impact. Therefore, a honest minority controlling the majority of tokens is responsible for most changes. Credit Guild disrupts this dynamic by introducing an optimistic, veto-based governance framework that specifies various statutory quorum thresholds and delays in parameter changes, while combining a risk response method to handle unforeseen consequences.
Starport aims for cross-chain development. It establishes a basic framework for integrating different types of EVM-compatible lending protocols. It manages data availability and term execution through two core components:
Starport contract, responsible for loan origination (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, primarily holding collateral initiated by borrowers on Starport and ensuring debt settlement and closure according to the terms defined in the initiated agreement, stored in the Starport contract.
Ajna possesses a truly permissionless, non-oracle pooled lending model with no governance at any level. Pools are established based on specific pairs of assets provided by lenders/borrowers, allowing users to assess asset demand and allocate capital. Ajna’s non-oracle design stems from lenders being able to determine loan prices by specifying the amount of collateral each borrower’s quoted token should be staked. This is particularly attractive for long-tail assets, much like what Uniswap v2 did for small tokens.
The lending space has attracted a large number of newcomers and reignited the drive for the largest DeFi protocols to introduce new lending products:
Aave v4, which was just announced last month, is very similar to Euler v2. Prior to this, Aave’s ardent supporter Marc “Chainsaw” Zeller had mentioned 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 not been widely tested in a highly liquid protocol (unlike Aave). Aave’s success in gaining market share on every chain is incredible. Its moat may not be deep, but it’s wide, giving Aave a very strong tailwind.
Curve, or more colloquially known as Llammalend, consists of isolated, unidirectional (non-borrowable collateral) lending markets, where crvUSD (already minted), Curve’s native stablecoin, is used as collateral or debt asset. This allows it to leverage Curve’s expertise in automated market maker (AMM) design, offering unique lending market opportunities. Curve has operated in a unique way in the DeFi space, but it has been effective for them. In addition to the giant Uniswap, Curve has also opened up an important niche market in the decentralized exchange (DEX) market and made people rethink their token economics through the successful veCRV model. Llammalend seems to be another chapter in the Curve story:
Its most interesting feature is its risk management and liquidation logic, based on Curve’s LLAMMA system, which can achieve “soft liquidations”.
LLAMMA is implemented as a market-making contract that encourages arbitrage between assets in isolated lending markets and external markets. Like centralized automated market makers (clAMM, such as Uniswap v3), LLAMMA evenly deposits collateral from borrowers within a specified price range (called a band), where prices deviate significantly from oracle prices to ensure continuous arbitrage incentives.
Through this method, when the price of collateral assets falls below the band, the system can automatically convert some collateral assets into crvUSD (soft liquidation). While this method may lower the overall health of the loans, it is much better than complete liquidation, especially considering the explicit support for long-tail assets.
Since 2019, Curve founder Michael Egorov has invalidated criticisms of over-design.
Curve and Aave both place significant emphasis on the development of their respective stablecoins. This is a very effective long-term strategy that can generate significant revenue. Both are emulating MakerDAO’s approach. MakerDAO has not abandoned DeFi lending and has also launched the independent brand Spark.
Although there are no native token incentives yet, Spark has performed very well over the past year. Stablecoins and massive currency-creating capabilities (credit is a powerful drug) represent huge long-term opportunities. However, unlike lending, stablecoins require on-chain governance or centralized entities off-chain. For Curve and Aave, this path makes sense, as they have some of the oldest and most active token governance (second only to MakerDAO).
The question remains: what is Compound doing? It used to be a leader in the DeFi space, kicking off DeFi summer and establishing the concept of yield farming. Apparently, regulatory issues have limited the activity of its core team and investors, leading to a decline in market share.
However, like Aave’s broad and shallow moat, Compound still has $1 billion in outstanding loans and widespread governance distribution. Recently, development has continued outside the Compound Labs team. It remains uncertain which markets it should focus on — perhaps large blue-chip markets, especially if it can gain some regulatory advantages.
The top three in DeFi lending (Maker, Aave, Compound) are adjusting their strategies to adapt to the shift towards modular lending architectures. 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 there are no opportunities in an efficient market structure, it just means no one can monopolize their position and extract rent.
The new modular market structure offers more permissionless opportunities for private entities like risk managers and investors to capture value. This makes risk management more practical and directly translates into better opportunities, as economic losses can severely impact custodians’ reputations.
The recent Gauntlet-Morpho incident is a good example, which occurred during the ezETH unpegging process.
During the unpegging, the mature risk manager Gauntlet operated an ezETH vault and incurred losses. However, due to clearer and more isolated risks, most users of other metamorpho vaults were largely unaffected, while Gauntlet needed to provide post-assessment and take responsibility.
Gauntlet initially launched the vault because it believed its future prospects on Morpho were more promising, allowing for direct fee collection, rather than providing risk management advisory services to Aave governance (the latter focuses more on politics than risk analysis, try tasting or drinking “Chainsaw”).
Just this week, Morpho founder Paul Frambot revealed that a smaller risk management company, Re7Capital, also a company with excellent research newsletters, as the manager of the Morpho vault, achieved an on-chain annualized income of $500,000. While not huge, this shows that you can build financial companies on DeFi (not just wild yield farms).
This indeed raises some long-term regulatory issues, but this is commonplace in today’s cryptocurrency world. Furthermore, this will not prevent risk managers from becoming one of the biggest beneficiaries of future modular lending.
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