Modular lending: more than just a meme?

Original title: "Modular lending: More than a meme?"
Original author: Chris Powers
Original translation: Lucy, BlockBeats

Editor's note:
DeFi researcher Chris Powers discussed the new trend in the lending field - modular lending, and gave examples of the potential of modular lending in addressing market challenges and providing better services.

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

In the business and technology fields, there is an old idea: "There are only two ways to make money in business: bundle and unbundle." This is not only true in traditional industries, but also more obvious in the world of cryptocurrency and DeFi because of its permissionless nature. In this article, we’ll explore the surge in modular lending (and those who have made the leap into the post-modular world), and explore how it’s disrupting the mainstream of DeFi lending. With unbundling, new market structures are forming new value flows — who will benefit the most?

—Chris

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

The same story is playing out in the DeFi lending space. The initial successful products were those that had everything in one package, and while the original three DeFi lending platforms — MakerDAO, Aave, and Compound — had many moving parts, they all operated under a predefined structure set by their respective core teams. Today, however, the growth in DeFi lending is coming from a new crop of projects that are unbundling the core functionality 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 easy-to-use bundled products that combine multiple DeFi building blocks to provide more comprehensive lending products.

This new push for unbundling DeFi lending has become the meme for modular lending. We at Dose of DeFi love memes, but have also seen new projects (and their investors) trying to hype up new market topics more than potential innovation (see DeFi 2.0).

Our take: The hype is not fiction. DeFi lending will go through a similar evolution to the core technology layer - just like Ethereum, new modular protocols emerge like Celestia, while existing leaders adjust their roadmaps to become more modular.

In the short term, the main players are forging different paths. New modular lending projects such as Morpho, Euler, Ajna, Credit Guild have achieved success, while MakerDAO is moving towards a more decentralized SubDAO model. In addition, the recently announced Aave v4 is also moving in a modular direction, echoing Ethereum's architectural shift. These paths currently being blazed may determine the accumulation of value in the DeFi lending stack in the medium to long term.

According to data from Token Terminal, there is always a question about whether MakerDAO belongs in the crypto 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 an issue in the future.

Why modularity?

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

The other strategy is to have multiple participants build the individual components of the system. In this approach, the central designer of the complex system focuses on creating core standards for interoperability while relying on the market to innovate. This can be seen in the core Internet protocols, which have not changed, while the applications and businesses built on top of TCP/IP drive innovation on the Internet.

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

Disassembly Analysis

Those who support the modular lending theory believe that innovation in DeFi will be driven by specialization in each part of the lending stack, rather than just focusing on the end-user experience.

A key reason is to eliminate single reliance. Lending protocols require close risk monitoring, and a small problem can lead to catastrophic losses, so establishing a redundant mechanism is key. Single-structured lending protocols usually introduce multiple oracles to prevent one of them from failing, but modular lending applies this hedging method to every layer of the lending stack.

For every DeFi loan, we can identify five key components that are required but adjustable:

· Loan Asset

· Collateral Asset

· Oracle

· Maximum Loan-to-Value Ratio (LTV)

· Interest Rate Model

These components must be closely monitored to ensure the solvency of the platform and prevent bad debt accumulation due to rapid price changes (we can also add liquidation systems 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 and shared the risk of the entire system. But even single-structured lending protocols quickly began to create independent markets for each asset to isolate risks.

Understanding the main modular players

Isolating markets is not the only way to make your lending protocol more modular. The real innovation is happening in new protocols that are reimagining what is necessary in 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 be uncomfortable with this label recently, trying to become "not modular, not monolithic, but aggregated." With a total value locked (TVL) of 1.8 billion, it is undoubtedly already at the top of the DeFi lending industry, but its ambition is to become the largest. Morpho Blue is its main lending stack, where a vault can be created without permission and tuned to the desired parameters. Governance only allows modification of some components - currently five different components - without dictating what these components should be. This is configured by the vault owner (usually a DeFi risk manager).The other main layer of Morpho is MetaMorpho, which attempts to be an aggregated liquidity layer for passive borrowers. This is a part that is particularly focused on the end-user experience. It is similar to Uniswap's DEX on Ethereum, but there is also Uniswap X for efficient trade routing.

Euler launched its v1 version in 2022, generating more than $200 million in open interest, but a hacker attack almost drained all the protocol funds (although it was later returned). Now, it is preparing to launch v2 and re-enter the mature modular lending ecosystem as a major player. Euler v2 has two key components. One is the Euler Treasury Kit (EVK), a framework for creating ERC4626-compatible vaults with additional lending functions that enable it to act as a passive lending pool, and the other is the Ethereum Treasury Connector (EVC), an EVM primitive that mainly implements multi-vault collateralization, that is, multiple vaults can use the collateral provided by one vault. v2 is scheduled to be launched in the second or third quarter.

Gearbox provides a clear user-centric framework, that is, users can easily set up positions without too much supervision, regardless of their skill or knowledge level. Its main innovation is the "credit account", a list of allowed operations and whitelisted assets, denominated in borrowed assets. It is basically a standalone lending pool, similar to Euler’s vault, except that Gearbox’s Credit Account holds a user’s collateral and borrowed funds in one place. Like MetaMorpho, Gearbox shows that there can be a layer in the modular world that focuses on bundling for the end user.

Unbundle, then rebundle

Specializing in parts of the lending stack offers the opportunity to build alternative systems that may target specific market segments or future growth drivers. Some of the leading movers in this approach are as follows:

Credit Guild intends to enter the already established pooled lending market with a trust-minimized governance model. Existing players, such as Aave, have very strict governance parameters, which often leads to apathy from small token holders, as their votes don’t seem to make much of a difference. Therefore, the honest minority that controls the majority of tokens is responsible for most of the changes. Credit Guild flips this dynamic by introducing an optimistic, veto-based governance framework that provides for various quorum thresholds and delays for different parameter changes, combined with a risk-based approach to deal with unforeseen consequences.

Starport aims to be cross-chain. It implements a basic framework for integrating different types of EVM-compatible lending protocols. It handles data availability and terms execution through two core components:

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

· Custodian contracts, which primarily hold the collateral that borrowers have put up to initiate protocols on Starport, and ensure that debt settlement and closure occurs in accordance with the terms defined in the initiating protocol and stored in the Starport contract.

Ajna has a truly permissionless, oracle-free pooled lending model with no governance at any level. Pools are set up with specific pairs of quote/collateral assets provided by lenders/borrowers, allowing users to assess asset demand and allocate capital. Ajna’s oracle-free design stems from lenders being able to determine the borrowing price by specifying the amount of asset that a borrower should collateralize per quote token held. This is particularly attractive for long-tail assets, much like Uniswap v2 did for small tokens.

If you can’t beat it, join it

The lending space has attracted a large number of new entrants, and has also reignited the momentum for the largest DeFi protocols to launch new lending products:

Aave v4, just announced last month, is very similar to Euler v2. Previously, Marc "Chainsaw" Zeller, an avid supporter of Aave, said that Aave v3 will be the final version of Aave due to its modular nature. Its soft liquidation mechanism was pioneered by Llammalend (see below); its unified liquidity layer is also similar to Euler v2's EVC. While most of the upcoming upgrades are not new, they have not yet been widely tested in a highly liquid protocol (and Aave is already such a protocol). Aave's success in winning market share on each chain is incredible. Its moat may not be deep, but it is wide, giving Aave a very strong tailwind.

Curve, or more colloquially known as Llammalend, is a series of isolated, one-way (non-borrowable collateral) lending markets, where crvUSD (already minted), Curve's native stablecoin, is used as collateral or debt assets. This allows it to combine Curve's expertise in automated market maker (AMM) design to provide unique lending market opportunities. Curve has always operated in a unique way in the DeFi space, but it works for them. In addition to the giant Uniswap, Curve has also carved out an important niche in the decentralized exchange (DEX) market and made people rethink their token economics through the success of the veCRV model. Llammalend seems to be another chapter in the Curve story:

Its most interesting feature is its risk management and liquidation logic, which is based on Curve's LLAMMA system and enables "soft liquidation".

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

Like a pooled liquidity automated market maker (clAMM, such as Uniswap v3), LLAMMA deposits borrowers’ collateral evenly within a user-specified price range (called a band) that deviates significantly from the oracle price to ensure that arbitrage is always incentivized.

In this way, when the price of the collateral asset drops beyond the band, the system can automatically convert part of the collateral asset to crvUSD (soft liquidation). Although this approach will reduce overall loan health, it is much better than full liquidation, especially given the explicit support for long-tail assets.

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

Both Curve and Aave are very focused on the development of their respective stablecoins. This is a very effective strategy in the long run and can bring significant revenue. Both are following MakerDAO’s lead. MakerDAO has not given up on DeFi lending, and has launched a standalone brand, Spark. Spark has performed very well over the past year despite not having any native token incentives (yet). Stablecoins and huge money creation capabilities (credit is really a powerful drug) are huge opportunities in the long term. However, unlike lending, stablecoins require either on-chain governance or a centralized entity off-chain. This route makes sense for Curve and Aave, as they have some of the oldest and most active token governance (next to MakerDAO, of course).

What we can’t answer at the moment is what Compound is doing? It used to be the leader in the DeFi space, kicking off 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, like Aave’s wide and shallow moat, Compound still has $1 billion in outstanding loans and a wide distribution of governance. Recently, someone has begun to continue developing Compound outside of the Compound Labs team. We’re not sure which markets it should focus on — maybe large blue-chip markets, especially if it can gain some regulatory advantage.

Accumulated Value

The top three DeFi lenders (Maker, Aave, Compound) are all adjusting their strategies to cope with the shift to modular lending architectures. Lending against crypto collateral used to be a good business, but when your collateral is on-chain, the market becomes more efficient and margins get squeezed.

This doesn’t mean there aren’t opportunities in an efficient market structure, just that no one can monopolize their position and extract rents.

The new modular market structure provides more permissionless value capture opportunities for private players such as risk managers and venture capitalists. This makes risk management more practical and directly translates into better opportunities, as financial losses can have a significant impact on the reputation of repository administrators.

The recent Gauntlet-Morpho incident, which occurred during the ezETH decoupling, is a good example.

During the decoupling, Gauntlet, a sophisticated risk manager, operated an ezETH repository and suffered losses. However, because the risk was more clear and isolated, users of other metamorpho repositories were mostly unaffected, while Gauntlet was required to provide a post-mortem assessment and take responsibility.

Gauntlet first launched the repository because it sees a more promising future on Morpho, charging fees directly, rather than providing risk management consulting services to Aave governance (the latter is more political than risk analysis - try tasting or drinking "chainsaw").

Just this week, Morpho founder Paul Frambot revealed that a smaller risk management firm, Re7Capital, also a company with an excellent research newsletter, has made $500,000 in annualized on-chain revenue as a manager of the Morpho repository. While not huge, it shows that you can build financial companies on DeFi (not just wild yield farms). This does raise some long-term regulatory questions, but that's par for the course in today's crypto world. Also, it won't stop risk managers from being one of the biggest beneficiaries of modular lending in the future.

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