Modular lending: Greater than a meme?

There’s an previous trope in enterprise and know-how: “there are solely two methods to earn cash in enterprise: one is to bundle; the opposite is unbundle.” That is true in conventional industries however much more true on this planet of crypto and DeFi, given its permissionless nature. On this piece, we’ll have a look at the surging reputation of modular lending (and people enlightened of us which can be already post-modular), and look at the way it’s upending the DeFi lending stalwarts. With unbundling, a brand new market construction emerges with new worth flows – who will profit most?

– Chris  

There’s already been a fantastic unbundling on the core base layer, the place Ethereum used to have a single answer for execution, settlement and knowledge availability. Nonetheless, it has since moved towards a extra modular strategy, with specialised options for every core factor of the blockchain. 

This similar sample is taking part in out within the DeFi lending area. The primary profitable merchandise have been these with every little thing self-contained. Whereas the unique three DeFi lenders – MakerDAO, Aave, and Compound – had many shifting elements, all of them operated in a pre-defined construction set by their respective core groups. Today, nevertheless, progress in DeFi lending has come from a brand new crop of initiatives that break up up the core capabilities of a lending protocol. 

These initiatives are creating remoted markets, minimizing governance, separating danger administration, liberalizing oracle duties, and eradicating different single dependencies. Others are creating easy-to-use bundled merchandise that put a number of DeFi legos collectively to supply a extra all-encompassing lending product.

This new push to unbundle DeFi borrowing has been memed into Modular Lending. We’re massive followers of memes right here at Dose of DeFi, however have additionally seen new initiatives (and their buyers) attempt to hype new narratives available on the market extra for his or her luggage than as a result of there’s some underlying innovation (taking a look at you, DeFi 2.0).

Our take: the hype is actual. DeFi lending will undergo the same metamorphosis because the core base layer – the place new modular protocols emerged like Celestia whereas current incumbents shifted their roadmaps to grow to be extra modular – as Ethereum has completed because it continues to unbundle itself.

Within the fast time period, the important thing rivals are forging totally different paths. Morpho, Euler, Ajna, Credit score Guild and others are seeing success as new modular lending initiatives, whereas MakerDAO strikes towards a much less concentrated SubDAO mannequin. Then you could have the just lately introduced Aave v4, which is shifting within the modular path, mirroring Ethereum’s structure shift. These paths being carved-out now may properly decide the place the worth accrues within the DeFi lending stack over the long run.

There are usually two approaches to constructing complicated techniques. One technique is to deal with the end-user expertise and make sure the complexity doesn’t hinder usability. This implies controlling the complete stack (as Apple does with its {hardware} and software program integration). 

The opposite technique focuses on enabling a number of events to construct particular person elements of a system. Right here, the centralized designers of the complicated system deal with core requirements that create interoperability, whereas counting on the market to do the innovation. That is seen with the core web protocols, which haven’t modified, whereas the purposes and companies which have constructed on high of TCP/IP have pushed innovation on the web.

This analogy is also utilized to economies, the place a authorities is seen as the bottom layer, a la TCP/IP, making certain interoperability by way of the rule of legislation and social cohesion, the place financial improvement then happens within the non-public sector constructed on high of the governance layer. Neither of those approaches work on a regular basis; many corporations, protocols, and economies function someplace on the spectrum. 

People who help the modular lending thesis imagine that innovation in DeFi can be pushed by specialization in every a part of the lending stack, slightly than specializing in simply the end-user expertise. 

A key purpose for that is the will to remove single dependencies. Lending protocols require shut danger monitoring and a small subject can result in catastrophic loss, so constructing redundancy is vital. Monolithic lending protocols have launched a number of oracles in case one fails, however modular lending takes this hedging strategy and applies it to each layer of the lending stack.

For each DeFi mortgage, we will determine 5 key elements which can be wanted – however might be modified:

1. A mortgage asset 

2. A collateral asset 

3. Oracle

4. Max loan-to-value (LTV) 

5. Rate of interest mannequin. 

These elements should be intently monitored to make sure a platform’s solvency and stop unhealthy debt accruing due to speedy worth adjustments (we may additionally add the liquidation system to the 5 elements above). 

For Aave, Maker, and Compound, token governance makes selections for all property and customers. Initially, all property have been pooled collectively and shared the danger of the entire system. However even the monolithic lending protocols have moved shortly into creating remoted markets for every asset, to compartmentalize the danger. 

Isolating markets is just not the one factor you are able to do to make your lending protocol extra modular. The actual innovation is going on in new protocols which can be reimagining what’s obligatory in a lending stack.

The most important gamers within the modular world are Morpho, Euler and Gearbox: 

• Morpho is the clear chief of modular lending in the intervening time, though it appears just lately uncomfortable with the meme, making an attempt to morph into “not modular, not monolithic, however aggregated”. With $1.8 billion in TVL, it’s arguably already within the high tier of the DeFi lending business as an entire, however its ambitions are to be the biggest. Morpho Blue is its main lending stack, on which it’s permissionless to create a vault tuned to no matter parameters it needs. Governance solely allows what might be modified – presently 5 totally different elements – not what these elements needs to be. That’s configured by the vault proprietor, sometimes a DeFi danger supervisor. The opposite main layer of Morpho is MetaMorpho, an try and be the aggregated liquidity layer for passive lenders. It is a explicit piece targeted on end-user expertise. It’s akin to Uniswap having the DEX on Ethereum and in addition Uniswap X for environment friendly commerce routing.

• Euler launched its v1 in 2022 and generated over $200 million in open curiosity earlier than a hack drained almost all protocol funds (though they have been later returned). Now, it’s making ready to launch its v2 and reenter a maturing modular lending ecosystem as a significant participant. Euler v2 has two key elements. One, the Euler Vault Equipment (EVK), which is a framework for creation of ERC4626 appropriate vaults with extra borrowing performance, enabling them to function passive lending swimming pools, and two, the Ethereum Vault Connector (EVC), which is an EVM primitive that primarily allows multi-vault collateralisation, i.e., a number of vaults can use collateral made accessible by one vault. V2 has a deliberate Q2/Q3 launch.

• Gearbox offers an opinionated framework that’s extra person centric, i.e. customers can simply arrange their positions with out an excessive amount of oversight, no matter their talent/data stage. Its main innovation is a “credit score account” which serves as a list of allowable actions and whitelisted property, denominated in a borrowed asset. It’s mainly an remoted lending pool, analogous to Euler’s vaults, besides that Gearbox’s credit score accounts maintain each person collateral and borrowed funds in a single place. Like MetaMorpho, Gearbox demonstrates {that a} modular world can have a layer that focuses on packaging for the top person.

Specialization in elements of the lending stack presents a chance to construct different techniques that will goal a particular area of interest or guess on a future progress driver. Some main movers with this strategy are listed right here:

• Credit score Guild intends to strategy the already-established pooled lending market with a trust-minimized governance mannequin. Present incumbents, resembling Aave, have very restrictive governance parameters, and as a rule this ends in apathy amongst smaller token holders since their votes seemingly do not change a lot. Thus, an sincere minority answerable for most tokens is accountable for most adjustments. Credit score Guild turns this dynamic on its head by introducing an optimistic, vetocracy-based governance framework, which stipulates varied quorum thresholds and latencies for various parameter adjustments, whereas integrating a risk-on strategy to cope with unexpected fallouts.

• Starport’s ambitions are a guess on the cross-chain thesis. It has carried out a really primary framework for composing several types of EVM-compatible lending protocols. It’s designed to deal with knowledge availability and time period enforcement for the protocols constructed atop it through two core elements: 

  1. The Starport contract, which is accountable for mortgage originating (time period definition) and refinancing (time period renewal). It shops this knowledge for the protocols constructed atop the Starport kernel and makes it accessible when wanted. 

  2. The custodian contract, which primarily holds the collateral of debtors on originating protocols atop Starport, and ensures that debt settlements and closure proceed based on the phrases outlined by the originating protocols and saved within the Starport contract.

• Ajna boasts a really permissionless mannequin of oracleless pooled lending with no governance at any stage. Swimming pools are arrange in distinctive pairs of quote/collateral property offered by lenders/debtors, permitting customers to evaluate demand for both of the property and allocate their capital accordingly. Ajna’s oracle-less design is borne off lenders’ means to specify the worth at which they’re prepared to lend, by specifying the quantity of collateral a borrower ought to pledge per quote token they maintain (or vice versa). It will likely be particularly interesting to the lengthy tail of property (very similar to Uniswap v2 does for small-ish tokens).

The lending area has attracted a slew of latest entrants, which has additionally reinvigorated the biggest DeFi protocols to launch new lending merchandise:

• Aave v4, which was introduced final month, is awfully just like Euler v2. It comes after Aave zealot Marc “Chainsaw” Zeller mentioned that Aave v3 could be the top state of Aave due to its modularity. Its mushy liquidation mechanism was pioneered by Llammalend (explainer beneath); its unified liquidity layer can also be just like Euler v2’s EVC. Whereas many of the impending upgrades aren’t novel, they’re additionally but to be extensively examined in a extremely liquid protocol (which Aave already is). It’s loopy how profitable Aave has been at profitable market share on EVERY chain. Its moat could also be shallow, but it surely’s broad, and offers Aave a extraordinarily robust tailwind.

• Curve, or extra informally Llammalend, is a sequence of remoted and one-way (non-borrowable collateral) lending markets during which crvUSD (already minted), Curve’s native stablecoin, is used as both the collateral or debt asset. This permits it to mix Curve’s experience in AMM design and provide distinctive alternatives as a lending market. Curve has all the time pushed on the left facet of the highway in DeFi, but it surely’s labored out for them. It has as such carved out a important area of interest within the DEX market, apart from the Uniswap goliath, and is making everybody query their tokenomics skepticism with the success of the veCRV mannequin. Llamalend seems to be one other chapter within the Curve story:

  • Its most attention-grabbing function is its danger administration and liquidation logic, which is predicated on Curve’s LLAMMA system that permits ‘mushy liquidations’.

  • LLAMMA is carried out as a market making contract that encourages arbitrage between an remoted lending market’s property and exterior markets. 

  • Similar to a concentrated liquidity Automated Market Maker (clAMM eg. Uniswap v3), LLAMMA evenly deposits a borrower’s collateral throughout a spread of user-specified costs, known as bands, the place the provided costs are drastically skewed in relation to the oracle worth to be able to guarantee arbitrage is all the time incentivised.

  • On this means, the system can robotically promote (soft-liquidate) parts of the collateral asset into crvUSD as the previous’s worth decreases previous bands. This decreases the general mortgage well being, however is decidedly higher than outright liquidations, particularly contemplating the express help of long-tail property.

Whew. Curve founder Michael Egorov making over-engineered criticisms out of date since 2019. 

Each Curve and Aave are hyper targeted on the expansion of their respective stablecoins. It is a good long-term technique for fee-extraction (ahem, income) functionality. Each are following within the footsteps of MakerDAO, which has not given up on DeFi lending, spinning off Spark as an remoted model that has had a really profitable previous 12 months even with none native token incentives (but). However a stablecoin and the loopy means to print cash (credit score is a hell of a drug) are simply gigantic alternatives long run. Not like lending, nevertheless, stablecoins do require some onchain governance or offchain centralized entities. For Curve and Aave, which have a few of the oldest and most energetic token governance (behind MakerDAO after all), this route is sensible.

The query we will’t reply is what’s Compound doing? It was as soon as DeFi royalty, kickstarting DeFi summer time and actually establishing the yield farming meme. Clearly, regulatory issues have constricted its core crew and buyers from being extra energetic, which is why its market share has dwindled. Nonetheless, very similar to Aave’s broad, shallow moat, Compound nonetheless has $1 billion in open loans and a large governance distribution. Only in the near past, some have picked up the baton to develop Compound exterior the Compound Labs Workforce. It’s unclear to us what markets it ought to deal with – maybe giant, blue-chip markets, particularly if it may possibly acquire some regulatory benefit.

The DeFi lending authentic three (Maker, Aave, Compound) are all rejiggering their methods in response to the shift to a modular lending structure. Lending in opposition to crypto collateral was as soon as a superb enterprise, however when your collateral is onchain, your margins will compress as markets grow to be extra environment friendly. 

This doesn’t imply there aren’t any alternatives in an environment friendly market construction, simply that nobody can monopolize their place and extract hire.

The brand new modular market construction allows extra permissionless worth seize for proprietary our bodies resembling danger managers and enterprise capitalists. This permits a extra skin-in-the-game strategy to danger administration, and immediately interprets to raised alternatives for finish customers, since financial losses will trigger a lot hurt to a vault supervisor’s repute. 

A terrific instance of that is the latest Gauntlet-Morpho drama in the course of the ezETH depeg.

Gauntlet, a longtime danger supervisor, ran an ezETH vault which suffered losses in the course of the depeg. Nonetheless, because the danger was extra outlined and remoted, customers throughout different metamorpho vaults have been principally insulated from the fallout, whereas Gauntlet had to supply autopsy evaluations and take accountability.

The explanation Gauntlet launched the vault within the first place was as a result of it felt its future prospects have been extra promising on Morpho, the place it may cost a direct price, versus offering danger administration advisory companies to Aave governance (which tends to focus extra on politiking than danger evaluation – you strive wining and eating a chainsaw).

Simply this week, Morpho founder, Paul Frambot, revealed {that a} smaller danger supervisor, Re7Capital, which additionally has a fantastic analysis e-newsletter, was incomes $500,000 in annualized onchain income as a supervisor of Morpho vaults. Whereas not large, this demonstrates how one can construct monetary corporations (and never simply degen yield farming) on high of DeFi. It does elevate some long-term regulatory questions, however that’s par for the course in crypto today. And furthermore, this would possibly not cease danger managers from topping the ‘who’s set to achieve probably the most’ record for the way forward for modular lending.

• U.S. Home Approves Crypto FIT21 Invoice With Wave of Democratic Assist Hyperlink

• Block Analitica proposes new rate of interest framework for MakerDAO Hyperlink

• DOJ expenses two brothers with fraud for baiting MEV bots Hyperlink

• Maker founder Rune proposes ‘PureDai’ made up of solely crypto collateral Hyperlink

• EIP-7706 would add a brand new gasoline sort particular for calldata Hyperlink

• ENS goals to launch personal L2, doubtless with zkSync Hyperlink

• Token circulate regulatory chart in gentle of latest US progress Hyperlink

That’s it! Suggestions appreciated. Simply hit reply. Due to Zhev for main assistance on breaking down the foremost modular gamers. A lot inexperienced in Tennessee within the spring.

Dose of DeFi is written by Chris Powers, with assist from Denis Suslov and Monetary Content material Lab. I spend most of my time contributing to Powerhouse, an ecosystem actor for MakerDAO. A few of my compensation comes from MKR, so I’m financially incentivized for its success. All content material is for informational functions and isn’t supposed as funding recommendation.