Modular lending: Greater than a meme?

There’s an outdated trope in enterprise and expertise: “there are solely two methods to generate income in enterprise: one is to bundle; the opposite is unbundle.” That is true in conventional industries however much more true on the planet of crypto and DeFi, given its permissionless nature. On this piece, we’ll take a look at the surging recognition of modular lending (and people enlightened of us which can be already post-modular), and study 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 terrific unbundling on the core base layer, the place Ethereum used to have a single resolution for execution, settlement and information availability. Nevertheless, it has since moved towards a extra modular method, with specialised options for every core factor of the blockchain. 

This identical sample is enjoying out within the DeFi lending house. The primary profitable merchandise have been these with every 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. Nowadays, nonetheless, development in DeFi lending has come from a brand new crop of initiatives that break up up the core features of a lending protocol. 

These initiatives are creating remoted markets, minimizing governance, separating danger administration, liberalizing oracle obligations, 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 huge followers of memes right here at Dose of DeFi, however have additionally seen new initiatives (and their buyers) attempt to hype new narratives in the marketplace 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 an analogous metamorphosis because the core base layer – the place new modular protocols emerged like Celestia whereas present incumbents shifted their roadmaps to turn out to be extra modular – as Ethereum has executed because it continues to unbundle itself.

Within the speedy time period, the important thing opponents 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’ve got the just lately introduced Aave v4, which is shifting within the modular course, mirroring Ethereum’s structure shift. These paths being carved-out now might properly decide the place the worth accrues within the DeFi lending stack over the long run.

There are typically two approaches to constructing complicated programs. 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 functions and companies which have constructed on prime of TCP/IP have pushed innovation on the web.

This analogy may be utilized to economies, the place a authorities is seen as the bottom layer, a la TCP/IP, guaranteeing interoperability via the rule of legislation and social cohesion, the place financial improvement then happens within the non-public sector constructed on prime of the governance layer. Neither of those approaches work on a regular basis; many firms, protocols, and economies function someplace on the spectrum. 

People who assist the modular lending thesis consider that innovation in DeFi might be pushed by specialization in every a part of the lending stack, relatively than specializing in simply the end-user expertise. 

A key motive for that is the need to remove single dependencies. Lending protocols require shut danger monitoring and a small difficulty 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 method and applies it to each layer of the lending stack.

For each DeFi mortgage, we are able to determine 5 key elements which can be wanted – however could 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 have to be carefully monitored to make sure a platform’s solvency and stop dangerous debt accruing due to speedy worth modifications (we might 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 rapidly into creating remoted markets for every asset, to compartmentalize the danger. 

Isolating markets isn’t the one factor you are able to do to make your lending protocol extra modular. The true innovation is occurring in new protocols which can be reimagining what’s crucial 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 for the time being, 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 prime 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 wishes. Governance solely permits what could be modified – at present 5 totally different elements – not what these elements ought to be. That’s configured by the vault proprietor, usually a DeFi danger supervisor. The opposite main layer of Morpho is MetaMorpho, an try and be the aggregated liquidity layer for passive lenders. This can be a specific 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 serious participant. Euler v2 has two key elements. One, the Euler Vault Package (EVK), which is a framework for creation of ERC4626 suitable vaults with further borrowing performance, enabling them to function passive lending swimming pools, and two, the Ethereum Vault Connector (EVC), which is an EVM primitive that primarily permits multi-vault collateralisation, i.e., a number of vaults can use collateral made out there by one vault. V2 has a deliberate Q2/Q3 launch.

• Gearbox gives 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 degree. Its main innovation is a “credit score account” which serves as a listing of allowable actions and whitelisted property, denominated in a borrowed asset. It’s principally 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 makes a speciality of packaging for the tip person.

Specialization in elements of the lending stack presents a chance to construct different programs which will goal a selected area of interest or guess on a future development driver. Some main movers with this method are listed right here:

• Credit score Guild intends to method the already-established pooled lending market with a trust-minimized governance mannequin. Current incumbents, comparable to Aave, have very restrictive governance parameters, and most of the time this ends in apathy amongst smaller token holders since their votes seemingly do not change a lot. Thus, an trustworthy minority accountable for most tokens is liable for most modifications. 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 modifications, whereas integrating a risk-on method 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 information availability and time period enforcement for the protocols constructed atop it through two core elements: 

  1. The Starport contract, which is liable for mortgage originating (time period definition) and refinancing (time period renewal). It shops this information for the protocols constructed atop the Starport kernel and makes it out there 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 in response to the phrases outlined by the originating protocols and saved within the Starport contract.

• Ajna boasts a very permissionless mannequin of oracleless pooled lending with no governance at any degree. Swimming pools are arrange in distinctive pairs of quote/collateral property supplied 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’ skill 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 house has attracted a slew of recent 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 stated that Aave v3 could be the tip state of Aave due to its modularity. Its gentle liquidation mechanism was pioneered by Llammalend (explainer beneath); its unified liquidity layer can 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 successful market share on EVERY chain. Its moat could also be shallow, but it surely’s large, and provides 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 allows 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 aspect of the street 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, other than 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 fascinating characteristic is its danger administration and liquidation logic, which relies on Curve’s LLAMMA system that permits ‘gentle liquidations’.

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

  • Identical 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 supplied costs are tremendously skewed in relation to the oracle worth in an effort to guarantee arbitrage is all the time incentivised.

  • On this manner, the system can mechanically 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 assist 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. This can be 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 skill to print cash (credit score is a hell of a drug) are simply gigantic alternatives long run. In contrast to lending, nonetheless, stablecoins do require some onchain governance or offchain centralized entities. For Curve and Aave, which have among the oldest and most lively token governance (behind MakerDAO in fact), this route is smart.

The query we are able to’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 considerations have constricted its core group and buyers from being extra lively, which is why its market share has dwindled. Nonetheless, very similar to Aave’s large, 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 outdoors the Compound Labs Group. It’s unclear to us what markets it ought to deal with – maybe massive, blue-chip markets, particularly if it could actually 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 great enterprise, however when your collateral is onchain, your margins will compress as markets turn out 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 lease.

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

An excellent instance of that is the latest Gauntlet-Morpho drama throughout the ezETH depeg.

Gauntlet, a longtime danger supervisor, ran an ezETH vault which suffered losses throughout the depeg. Nevertheless, for the reason that danger was extra outlined and remoted, customers throughout different metamorpho vaults have been largely insulated from the fallout, whereas Gauntlet had to supply autopsy evaluations and take duty.

The rationale 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 might 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 terrific analysis publication, was incomes $500,000 in annualized onchain income as a supervisor of Morpho vaults. Whereas not large, this demonstrates how one can construct monetary firms (and never simply degen yield farming) on prime of DeFi. It does increase some long-term regulatory questions, however that’s par for the course in crypto lately. And furthermore, this may not cease danger managers from topping the ‘who’s set to realize 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 prices 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 fuel sort particular for calldata Hyperlink

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

• Token move 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.