Author: Alex Xu
introduction
After experiencing the bull-bear cycle of 2020-2023, we found that: in the application layer of the Web3 business world, the only truly established business model is still DeFi, and Dex, lending, and stablecoins are still the three cornerstones of DeFi (the derivatives track has also made great progress in recent years). Even in a bear market, their businesses remain strong.
Mint Ventures has written a large number of research reports and analysis articles on Dex and stablecoins in the past. Dex includes many ve (3,3) projects such as Curve, Trader Joe, Syncswap, Izumi and Velodrome, and stablecoin projects include MakerDao, Frax, Terra, Liquity, Angle, Celo, etc. This issue of Clips will return to the lending track and focus on Morpho, a new force with rapid growth in business data in the past year.
In this article, I will review Morpho’s existing business and the recently announced lending infrastructure service Morpho Blue, and try to answer the following questions:
What is the current market structure of the lending sector?
What services does Morpho include? What problems does it try to solve? How is the business development going at present?
What is the prospect of the newly launched Morpho Blue business? Will it impact the leading position of Aave and Compound? What other potential impacts are there?
The following article represents the author’s interim views at the time of publication. It may contain errors and biases in facts and opinions. It is for discussion purposes only, and we look forward to corrections from other investment research colleagues.
Decentralized lending market structure
Organic demand becomes the mainstream of the market, and the Ponzi scheme fades away
The capital capacity of decentralized lending has always been among the highest. Currently, TVL has surpassed Dex and has become the track with the largest capital capacity in the Defi field.
Source: https://defillama.com/categories
Decentralized lending is also a rare business category in the Web3 field that has achieved "PMF" (product need fit). Although many projects have provided high subsidies for lending activities through tokens during the DeFi summer wave of 2020-2021, this phenomenon has been greatly reduced after entering the bear market.
As shown in the figure below, the protocol revenue of Aave, a leading project in the lending field, has exceeded the incentive withdrawal of its tokens since December 2022, and has far exceeded the incentive withdrawal of tokens so far (the protocol revenue in September was 1.6 million US dollars, and the Aave token incentive withdrawal was 230,000 US dollars). In addition, Aave's token incentives are mainly used to guide token holders to pledge Aave to ensure that the protocol has bad debts and the treasury is insufficient to pay for repayment, rather than to incentivize users' deposit and borrowing behavior. Therefore, Aave's current deposit and borrowing behavior is completely "organic", rather than a Ponzi structure supported by liquidity mining.
Monthly comparison of Aave’s incentives and protocol revenue
In addition, Venus, the leading lending protocol on BNBchain, has also achieved a virtuous cycle in which protocol revenue has surpassed incentives since March 2023, and currently no longer subsidizes deposit and borrowing activities.
Monthly comparison of Venus incentives and agreement income
However, there are still high token subsidies behind the supply and demand of many lending protocols, and the value of the subsidies for lending activities by the protocols is far greater than the income that can be obtained from them.
For example, Compound V3 still provides Comp token subsidies for deposits and borrowing activities.
Nearly half of the USDC deposit rate on Compound V3 Ethereum mainnet is provided by token subsidies
84% of USDC deposit interest on Compound V3 Base mainnet is provided by token subsidies
If Compound maintains its market share through high token subsidies, then another protocol, Radiant, is a pure Ponzi structure.
On Radiant’s lending market page, we can see two unusual phenomena:
First, its asset lending rate is significantly higher than the market rate. The daily lending rate of stablecoins in the mainstream currency market is usually around 3-5%, while Radiant is as high as 14-15%. The lending rate of other assets is 8-10 times that of the mainstream currency market.
Second, it promotes revolving loans in the product interface, which encourages users to use the same asset as deposit collateral repeatedly: deposit-borrow operations, and amplify their "total deposit and borrowing amount" through revolving loans to maximize the mining income of the platform token Radiant. In essence, the Radiant project is selling the project token RDNT to users in disguise by charging users a loan fee.
But the problem is that the source of Radiant's fees - that is, the borrowing behavior of users - does not come from real organic borrowing demand, but to obtain RNDT tokens, which constitutes a "left foot on the right foot" Ponzi economic structure. In this process, there are no real "financial consumers" on the lending platform. Revolving loans are not a healthy lending model, because the depositors and borrowers of the same asset are the users themselves, and the economic source of RDNT dividends is also the users themselves. The only risk-free beneficiary is the platform project party that extracts profits from the fees (it charges 15% of interest income). Although the project party has delayed the short-term death spiral pressure brought about by the decline of RDNT tokens through the dLP pledge mechanism of RDNT, in the long run, unless Radiant can gradually shift its business from a Ponzi to a normal business model in the future, the death spiral will eventually come.
But in general, the leading projects in the decentralized lending market, represented by Aave, are gradually getting rid of their reliance on high subsidies to maintain operating income and returning to a healthy business model.
The figure below shows the changes in active loan volume in the web3 lending market from May 2019 to October 2023, from the initial hundreds of thousands of dollars to 22.5 billion U.S. dollars at the peak in November 2021, and then to 3.8 billion U.S. dollars at the lowest point in November 2022. Now it is 5 billion U.S. dollars. The business volume of the lending market is slowly bottoming out and recovering, and it still shows good business resilience in the bear market.
The moat is obvious and the market concentration is high
As DeFi infrastructure, compared with the fierce competition in the Dex market, the moat of the leading projects in the lending track is stronger, which is specifically reflected in:
1. Market share is more stable. The following figure shows the changes in the proportion of active lending volume of each project from May 2019 to October 2023. Since Aave started to make efforts in mid-2021, its market share has been stable in the range of 50-60%. Although the share of the second place Compound has been squeezed, its ranking is still relatively stable.
In contrast, the market share of the Dex track has changed more dramatically. After the leading project Uniswap quickly occupied nearly 90% of the transaction volume market share after its launch, its market share once fell to 37% due to the rapid growth of Sushiswap, Curve, and Pancakeswap, and has now returned to around 55%. In addition, the total number of projects in the Dex track is far greater than that in the lending track.
2. Lending projects are more profitable. As mentioned in the previous section, projects such as Aave have been able to achieve positive cash flow without subsidizing lending activities, with monthly operating income of about 1.5-2 million US dollars from interest spreads. Most Dex projects, such as Uniswap, have not yet started charging at the protocol level (only front-end charging is enabled), or the value of tokens emitted for liquidity incentives is far greater than the protocol's handling fee income, and are actually operating at a loss.
The source of the moat of the leading lending protocols can be generally summarized as the brand power of security, which can be specifically divided into the following two points:
Long history of safe operation: Since the DeFi Summer of 2020, there have been many Aave or Compound fork projects created on various chains, but most of them suffered from theft or large bad debt losses shortly after their establishment. Aave and Compound have not yet experienced serious theft or unbearable bad debt accidents. This long-term safe operation history in a real network environment is the most important security endorsement for depositors. New lending protocols may have more attractive concepts and higher short-term APY, but it is difficult to gain the trust of users, especially whale users, before they have been baptized by years.
More abundant security budget: The leading lending protocols have higher commercial income and more abundant treasury funds, which can provide sufficient budget for security audits and asset risk control. This is crucial for the development of new features and the introduction of new assets in the future.
Overall, lending is a market with proven organic demand, a healthy business model, and a relatively concentrated market share.
Morpho's business content and operating status
Business content: interest rate optimization
Morpho's currently launched business is a peer-to-peer lending protocol (or interest rate optimizer) built on Aave and Compound. Its function is to improve the problem of low capital efficiency caused by the incomplete matching of deposits and borrowings in peer-to-pool lending protocols such as Aave.
Its value proposition is simple and clear: provide better interest rates for both borrowers and lenders, that is, higher deposit returns and lower borrowing rates.
The reason why the peer-to-pool model of Aave and Compound has the problem of low capital efficiency is that its mechanism determines that the total scale of deposit funds (pool) is always greater than the total scale of lending funds (points). In most cases, the USDT money market has a total deposit of 1 billion, but only 600 million USDT is lent out.
For depositors, since the idle 400 million funds also have to share the interest generated by the 600 million loans, each person can get less interest; for borrowers, although they only borrowed a part of the fund pool, they actually have to pay interest for the entire fund pool, so each person has to bear more interest. This is the problem caused by the mismatch between deposits and borrowings.
Let’s take the interest rate optimizer module on Aave V2, which currently has the largest deposit business volume of Morpho, as an example to see how Morpho’s interest rate optimization service solves this problem.
Deposit: Depositor BOB deposits 10,000 Dai into Morpho. Morpho will first deposit the funds into the Aave V2 money market, with a deposit rate of 3.67% of Aave’s market rate.
Borrowing collateral: Borrower ALICE first deposits 20 ETH as collateral into Morpho and requests to borrow 10,000 Dai. Morpho will deposit the collateral into the money market of Aave V2
Deposit-borrow matching: Morpho then takes back the 10,000 Dai that BOB had previously deposited into Aave, and directly matches and lends it to ALICE. Note that at this point, BOB's deposit and ALICE's loan are fully matched, and BOB's deposit is not idle but fully lent out; ALICE only pays interest for the 10,000 Dai it has lent out, not the entire pool of funds. Therefore, in this matching situation, BOB obtains a deposit rate that is 4.46%, which is higher than the 3.67% in the Aave peer-to-pool model; ALICE bears a lower loan interest rate of 4.46%, which is 6.17% lower than the Aave peer-to-pool model, and the interest rates of both parties have been optimized.
*Note: Whether the 4.46% P2P interest rate in the example is closer to the lower limit (deposit APY) or upper limit (borrowing APY) of the underlying protocol is determined by Morpho’s parameters, which are determined by governance.
Solve the mismatch: Assuming that BOB wants to get back the Dai he lent before, and ALICE has not repaid the money, then if there are no other lenders on Morpho, Morpho will use ALICE's 20 ETH as collateral to borrow 10,000+ Dai principal and interest from Aave and provide it to BOB to complete the redemption.
Matching order: Considering the Gas cost, the P2P matching of deposits and loans is "matching large funds first". The larger the deposit and loan amount, the higher the matching priority. In this way, the Gas consumption per unit of funds is low. When the Gas consumption value of matching is too large relative to the amount of matching funds, matching will not be performed to avoid excessive wear and tear.
Through the above explanation, we find that the essence of Morpho’s business is to use Aave and Compound as capital buffer pools to provide interest rate optimization services for depositors and borrowers through matching.
The cleverness of this design is that through the composability of the DeFi world, Morpho attracts users' funds in a way of making money out of nothing. For users, the attraction lies in:
1. At the very least, TA can get the same financial interest rate as Aave and Compound in Morpho, and when matching occurs, its benefit/cost will be greatly optimized.
2. Morpho’s products are mainly based on Aave and Compound, and the risk parameters are completely copied and executed. Its funds are also allocated in Aave and Compound, so it has inherited the brand reputation of the two old protocols to a great extent.
This clever design and clear value proposition has enabled Morpho to obtain nearly $1 billion in deposits just over a year after its launch, second only to Aave and Compound in terms of data.
Business data and token status
Business data
The figure below shows the business trends of Morpho’s total deposits (blue line), total loans (light brown line) and matching amount (dark brown).
Overall, the scale of Morpho's various businesses has continued to grow, with a deposit matching rate of 33.4% and a loan matching rate of 63.9%, which are quite impressive figures.
Token Status
Source: Official Documentation
The total number of Morpho tokens is 1 billion, of which 51% belongs to the community, 19% is sold to investors, the founder and the development company behind it, Morpho Labs, and the operating organization, Morpho Association, own 24%, and the rest is given to consultants and contributors.
It is worth mentioning that although Morpho tokens have been issued and used in voting decisions and project incentives, they are in a non-transferable state. Therefore, they do not have a secondary market price. Users and investors who receive tokens can participate in voting governance, but cannot sell them.
Unlike projects like Curve that hard-code future token output and incentives, Morpho's token incentives are determined in batches, quarterly or monthly, which allows the governance team to flexibly adjust the intensity and specific strategies of incentives based on market changes.
The author believes that this is a more pragmatic approach, and may become the mainstream model for token incentive distribution in Web3 business in the future.
In terms of the objects of incentives, Morpho provides incentives for both deposit and borrowing. However, the current amount of Morpho tokens allocated in incentives is not large. In the past year or so, only 30.8 million tokens have been allocated, accounting for 3.08% of the total. Moreover, judging from the incentive period and the corresponding token allocation in the figure below, the official token expenditure on incentives is decreasing rapidly, and the reduction in expenditure has not slowed down the growth rate of Morpho's business.
This is a good signal, indicating that Morpho's PMF is relatively sufficient and user demand is becoming more and more organic. The community token share is 51%, and there is currently nearly 48% left, which reserves ample budget space for business incentives for new sections in the future.
However, Morpho does not currently charge for its services.
Team and Funding
The core team of Morpho is from France, and most of its members are based in Paris. The core members of the team have real names. The three founders are from the telecommunications and computer industries and have backgrounds in blockchain entrepreneurship and development.
Morpho has completed two rounds of financing, including a US$1.3 million seed round in October 2021, and an 18 million Series A round led by A16z, Nascent and Variant in July 2022.
Source: Official website
If the above financing amount corresponds to the 19% investor share officially disclosed, then the corresponding comprehensive project valuation is approximately US$100 million.
Morpho Blue and its potential impact
What is Morpho Blue?
In short, Morpho Blue is a permissionless lending base layer. Compared with Aave and Compound, Morpho Blue opens up most of the lending dimensions, so anyone can build a lending market based on Morpho Blue. The dimensions that builders can choose include:
What is used as collateral?
What is used as the loan asset?
What oracle to use;
What are the loan-to-value ratio (LTV) and liquidation ratio (LLTV);
What is the Interest Rate Model (IRM)?
What value will this bring?
In the official article, the features of Morpho Blue are summarized as follows:
Trustless because:
Morpho Blue is not upgradeable, no one can change it, and follows the principle of minimal governance
Only 650 lines of Solidity code, simple and safe
Efficient because:
Users can choose higher LTV and more reasonable interest rates
The platform does not need to pay for third-party audit and risk management services
Singleton smart contract based on simple code (singleton smart contract refers to the protocol being executed by one contract rather than a combination of multiple contracts. Uniswap V4 also uses a singleton smart contract), which significantly reduces the gas cost by 70%
Flexible because:
Market construction and risk management (oracle, lending parameters) are permissionless and no longer use a unified model, that is, the entire platform follows a set of standards set by the DAO (the model of Aave and Compound)
Developer-friendly: Introducing a variety of modern smart contract models, account management implements GAS-free interaction and account abstraction, and free flash loans allow anyone to access assets in all markets at the same time through a single call, as long as they are repaid in the same transaction
Morpho Blue adopts a product concept similar to Uni V4, that is, it only provides a basic layer for large financial services, opens up all modules above the basic layer, and allows different people to come in and provide services.
The difference with Aave is that although Aave's fund deposits and borrowing are permissionless, what kind of assets can be deposited and borrowed in Aave, whether the risk control rules are conservative or aggressive, which oracle to use, how to set the interest rate and liquidation parameters are all formulated and managed by Aave DAO and the various service providers behind DAO, such as Gaunlet and Chaos, which monitor and manage more than 600 risk parameters on a daily basis.
Morpho Blue is like an open lending operating system. Anyone can build a lending portfolio that they think is optimal on Morpho Blue, just like Aave. Professional risk management institutions such as Gaunlet and Chaos can also seek partners in the market and sell their risk management services to obtain corresponding fees.
In my opinion, the core value proposition of Morpho Blue is not trustlessness, efficiency and flexibility, but providing a free lending market, which facilitates participants in all links of the lending market to collaborate here and provides customers in all links with more abundant market choices.
Is Morpho Blue a threat to Aave?
maybe.
Morpho is somewhat different from many previous Aave challengers. In the past year or so, it has accumulated some advantages:
1 billion in other funds under management, which is already on the same order of magnitude as Aave’s 7 billion. Although these funds are currently deposited in Morpho’s interest rate optimizer function, there are many ways to import them into new functions;
Morpho is the fastest growing lending protocol in the past year. Its tokens are not officially circulated, which leaves a lot of room for imagination. Its major new features can easily attract users to participate.
Morpho has sufficient and flexible token budget and is able to attract users through subsidies in the early stage;
Morpho's stable operation history and capital have enabled it to accumulate certain security brand reputation.
Of course, this does not mean that Aave will be at a disadvantage in future competitions, because most users may not have the ability and willingness to choose services from a variety of lending options. The lending products currently output under the unified management model of Aave DAO may still be the most popular in the end.
Secondly, the Morpho interest rate optimizer largely inherits the security credit of Aave and Compound, which makes more funds gradually feel at ease to use. However, Morpho Blue is a brand new product with a separate code, and whales must have a hesitation period before investing with confidence. After all, the theft incidents of the previous generation of unlicensed lending markets such as Euler are still fresh in our minds.
Furthermore, Aave is fully capable of building a set of functions similar to Morpho's interest rate optimizer on the existing solution to meet users' needs to improve fund matching efficiency and squeeze Morpho out of the P2P lending market. Although this possibility seems unlikely at present, Aave also issued Grants to NillaConnect, a P2P lending product similar to Morpho, in July this year instead of doing it itself.
Finally, the lending business model adopted by Morpho Blue is ultimately not fundamentally different from Aave's existing solution, and Aave is also capable of observing and imitating Morpho Blue's excellent lending model.
But in any case, after Morpho Blue goes online, it will provide a more open lending test field, offering the possibility of participation and combination in all aspects of lending. Will there emerge among these newly connected lending groups solutions that are capable of challenging Aave?
Let's wait and see.
