DeFi researcher Chris Powers discusses the new trend in lending sector, “modular lending,” and provides examples of how modular lending has the potential to address market challenges and offer better services. This article is sourced from an article by Chris Powers, compiled, translated, and written by BlockBeats.
Table of Contents
Modular Lending Projects
Why Choose Modular?
Breakdown Analysis
Understanding Key Modular Participants
Morpho
Euler
Gearbox
Unbundle and Rebundle
Credit Guild
Starport
Ajna
If You Can’t Beat Them, Join Them
Accrued Value
Chris Powers compares traditional DeFi lending pioneers (MakerDAO, Aave, and Compound) with several key modular lending projects, including Morpho, Euler, and Gearbox, pointing out that modular lending in the DeFi world emphasizes its positive impact on risk management and value flow.
In business and technology, there is an ancient concept: “There are only two ways to make money in business: bundling and unbundling.” This is not only true in traditional industries but is even more pronounced in the world of cryptocurrencies and DeFi due to their permissionless nature.
In this article, we will explore the rising trend of modular lending (and those 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 each core element of the blockchain.
The DeFi lending sector is also witnessing a similar storyline. Initially successful products were those that were all-encompassing, and although the initial three DeFi lending platforms—MakerDAO, Aave, and Compound—had many moving parts, they all operated under predefined structures set by their respective core teams. However, the growth of DeFi lending now 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, relaxing oracle responsibilities, and eliminating other single dependencies. Other projects are building user-friendly bundling products, combining multiple DeFi building blocks to offer more comprehensive lending products.
This new push for unbundling in DeFi lending has become a meme of 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 rather than because of potential innovation (look at DeFi 2.0).
Our perspective: Hype is not fiction. DeFi lending will undergo a transformation similar to the core technical layer, as new modular protocols emerge, such as Celestia, while existing industry leaders adjust their roadmaps to become more modular.
In the short term, major competitors are charting different paths. New modular lending projects like Morpho, Euler, Ajna, Credit Guild, among others, have found success, while MakerDAO is moving towards a more decentralized SubDAO model. Additionally, the recently announced Aave v4 is also evolving towards modularity, echoing Ethereum’s architectural transformation. The paths being charted now 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 typically involves two approaches. One strategy is to focus on the end-user experience, ensuring that complexity does not affect usability. This means controlling the entire tech stack (similar to how Apple achieves integration through hardware and software).
The other strategy is to have multiple participants build various components of the system. In this approach, the central designer of the complex system focuses on establishing interoperable core standards while relying on the market for innovation. This can be seen in core internet protocols, where these protocols remain unchanged, while applications and businesses based on TCP/IP drive innovation on the internet.
This analogy can also be applied to economies, where the government is seen as the foundation 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 the governance layer. These two approaches are not always applicable, and many companies, protocols, and economies operate somewhere between the two.
Supporters of the modular lending theory believe that DeFi innovation will be driven by specialization in every part of the lending stack, rather than just focusing on the end-user experience.
One key reason for this is to eliminate single dependencies. Lending protocols require close risk monitoring, as a small issue can lead to catastrophic losses, so building redundant mechanisms is crucial. Single-structured lending protocols typically introduce multiple oracles to prevent failure of one, 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
Oracles
Maximum loan-to-value ratio (LTV)
Interest rate model
These components must be closely monitored to ensure platform solvency and prevent bad debt accumulation due to rapid price changes (we can also add a liquidation 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 merged together, sharing the risks of the entire system. However, even single-structured lending protocols quickly began to establish 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 rethink the necessary elements of the lending stack. The biggest players in the modular world are Morpho, Euler, and Gearbox:
Morpho is currently a 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 placing it at the forefront 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 built permissionlessly tuned to desired parameters. Governance only allows modifications to some 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, which aims to be an aggregated liquidity layer for passive lenders. This is a section that focuses specifically on the end-user experience. It is similar to Uniswap on Ethereum for DEX, and also has Uniswap X for efficient trading routing.
Euler launched its v1 in 2022, generating over $200 million in open contracts, but a hack almost depleted all protocol funds (though 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), a framework for building vaults compatible with ERC4626, with additional lending features to serve as a passive lending pool. The other is the Ethereum Vault Connector (EVC), an EVM primitive that implements multi-vault collateral, allowing multiple vaults to use collateral provided by a single vault. The v2 is planned to be launched in the second or third quarter.
Gearbox provides a user-centric framework that allows users to easily set positions without much supervision, regardless of their skills or knowledge level.
Its main innovation is the “credit account,” a list that allows assets to be operated and whitelisted for asset borrowing. It is essentially an independent lending pool.Similar to Euler’s vault, the difference with Gearbox is that the credit accounts of Gearbox will keep users’ collateral and borrowed funds in one place. Like MetaMorpho, Gearbox showcases a layer in the modular world that can focus on bundling for end users.
Specializing in the lending stack offers an opportunity to build alternative systems that may cater to specific niche markets or future growth drivers. Some leading proponents adopting this approach are as follows:
Credit Guild intends to enter the established pooled lending market through a trust-minimized governance model. Existing participants, like Aave, have very stringent governance parameters, which often result in apathy from small token holders, as their votes seem to have little impact.
Therefore, a honest minority controlling the majority 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 different parameter changes, while incorporating a risk mitigation approach to handle unforeseen consequences.
Starport aims for cross-chain development. It implements a foundational framework for integrating different types of EVM-compatible lending protocols. It handles data availability and terms execution through the following two core components:
Starport contracts, responsible for loan initiation (term definition) and refinancing (term updates). It stores data for protocols built on top of the Starport core and provides this data when needed.
Custody contracts, primarily holding the collateral initiated by borrowers on Starport and ensuring debt settlement and closure according to the terms defined in the initiated protocols, stored in the Starport contracts.
Ajna features a truly permissionless, non-oracle pooled lending model with no governance at any level. The pools are set up with specific pairs of quoted/collateral 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 assets each borrower’s quoted token should be backed by. This is particularly attractive for long-tail assets, similar to what Uniswap v2 did for small tokens.
The lending space has attracted a large number of newcomers and has reinvigorated the motivation for major DeFi protocols to launch new lending products:
Aave v4, announced 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 widely tested in a highly liquid protocol (Aave already being one). Aave’s success in capturing market share on every 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 asset. This enables it to leverage Curve’s expertise in automated market maker (AMM) design, providing unique lending market opportunities. Curve has always operated in a unique way within DeFi, but it has been effective for them. Besides the giant Uniswap, Curve has carved out an important niche in the decentralized exchange (DEX) market and has 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, based on Curve’s LLAMMA system, which can achieve “soft liquidation.”
LLAMMA is implemented as a market contract that encourages arbitrage between isolated lending market assets and external markets. Like centralized liquidity automated market makers (clAMMs, such as Uniswap v3), LLAMMA evenly deposits collateral from borrowers within a user-specified price range (referred to as a range) to ensure arbitrage is always incentivized when prices deviate significantly from oracle prices.
In this way, when the price of collateral assets falls beyond the range, the system can automatically convert some collateral assets into crvUSD (soft liquidation). While this approach may reduce 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 criticisms of over-engineering.
Both Curve and Aave place a strong emphasis on the development of their respective stablecoins. This is a very effective long-term strategy that can generate substantial revenue. Both are following in the footsteps of MakerDAO. MakerDAO has not abandoned DeFi lending and has even launched an independent brand, Spark.
Although there are no native token incentives yet, Spark has performed exceptionally well over the past year. Stablecoins and the massive money creation capacity (credit is indeed a powerful drug) present significant 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 big question now is, what is Compound doing? It was once a leader in the DeFi space, ushering in 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 decrease in market share.
However, like Aave’s broad and shallow moat, Compound still has $1 billion in outstanding loans and extensive governance distribution. Recently, development has begun outside the Compound Labs team to continue building on Compound. We are unsure 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. Leveraging cryptocurrency collateral for lending used to be a good business, but as your collateral is on-chain, the market becomes more efficient, squeezing profits.
This does not mean there are no 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 opportunities for value extraction for risk managers, investors, and other private enterprises. This makes risk management more practical and translates directly into better opportunities, as economic losses can severely impact the reputations of custodians.
The recent Gauntlet-Morpho incident is a good example, where this occurred during the uncoupling process of ezETH.
During the uncoupling, 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, while Gauntlet needed to provide post-assessment and take responsibility.
Gauntlet first launched the vault because it believed its future prospects on Morpho were more promising, enabling it to charge fees directly rather than provide risk management consulting services to Aave governance (the latter focusing more on politics than risk analysis, try tasting or drinking “Chain Saw”).
Just this week, Morpho founder Paul Frambot revealed that a smaller risk management company, Re7Capital, also a company with outstanding research newsletters, as the vault manager for Morpho, achieved an annualized on-chain income of $500,000. While not massive, this demonstrates that you can build financial companies on DeFi (not just wild yield farms).
This does indeed raise some long-term regulatory issues, but these are common in today’s cryptocurrency world. Additionally, this will not prevent risk managers from becoming one of the biggest beneficiaries of future modular lending.
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