Author: Kevin, the Researcher from BlockBooster
The funding capacity ranking of lending protocols is first in the DeFi track, being the largest sector in terms of capital absorption in DeFi. Moreover, lending is a market that has already proven its demand, with a healthy business model and a relatively concentrated market share.
Source: defillama
The moat of the decentralized lending market is evident: Aave's market share has further increased, stabilizing at 50-60% in 2023, and currently rising to the range of 65-70%.
Source: https://tokenterminal.com/explorer/markets/lending
After years of accumulation, the token subsidy for Aave is gradually decreasing. However, apart from Aave, other lending protocols still require substantial additional token incentives, including Morpho. Observing Aave's development trajectory reveals its core advantages in achieving its current market share:
Long-term stable security performance: Aave has many fork projects, but they have all halted due to theft or bad debt events in a short time. In contrast, Aave has maintained a relatively good security record to this day, providing deposit users with an irreplaceable trust foundation. In comparison, some emerging lending protocols, although they may possess innovative concepts or higher short-term yields, often struggle to win user trust, especially from large fund users, without undergoing years of market testing.
More adequate security investment: Leading lending protocols can provide strong resource support for security audits and risk management due to higher revenues and ample treasury funds. This budget advantage not only ensures the safety of new feature development but also lays a solid foundation for introducing new assets, which is crucial for the long-term development of the protocol.
Since receiving funding from a16z in the second half of 2022, Morpho has achieved a significant leap in the lending track in just two years. As shown in the image below, Morpho's current lending volume has reached $1.432 billion, second only to Aave and Spark.
Source: https://tokenterminal.com/explorer/markets/lending
Morpho's success can generally be divided into two periods, and it is through the accumulation during these two periods that the leap is achieved, leading to a steady rise in Morpho's market share.
First Leap: Optimizing Aave and Compound for rapid growth.
Morpho's initial business model focuses on enhancing the capital utilization efficiency of lending protocols, particularly addressing the issue of mismatched fund deposits and borrowings in peer-to-pool models like Aave and Compound. By introducing a peer-to-peer matching mechanism, it offers users better interest rate options, which means higher deposit rates and lower borrowing rates.
The core limitation of the peer-to-pool model lies in the fact that the total deposits in the liquidity pool often far exceed the total amount borrowed, leading to efficiency issues: the interest of deposit users is diluted by idle funds, while borrowers need to bear the interest cost for the entire liquidity pool, rather than just paying interest on the portion they actually use.
Morpho's solution lies in introducing a new workflow: users' deposits and collaterals are allocated to Aave and Compound to ensure the acquisition of base interest rates. Meanwhile, Morpho prioritizes processing large orders through a peer-to-peer matching mechanism, directly allocating deposits to borrowers, thus reducing idle funds. This way, deposits can be fully utilized, while borrowers only pay interest on the funds they need, achieving interest rate optimization.
The biggest advantage of this matching mechanism is that it eliminates the efficiency bottleneck found in traditional models:
Deposit users enjoy higher yields, while borrowing users pay less interest, bringing the rates for both parties closer together, greatly enhancing the user experience.
Morpho operates based on Aave and Compound, utilizing their infrastructure as a capital buffer, thereby controlling risks at levels comparable to these mature protocols.
For users, this model is significantly attractive:
Regardless of successful matchmaking, users can at least obtain interest rates comparable to Aave and Compound, while successful matchmaking will further optimize returns or costs.
Morpho is built on mature protocols, with its risk control model and fund management completely following Aave and Compound, significantly reducing users' trust costs in emerging platforms.
Through innovative design, Morpho cleverly utilizes the composability of DeFi protocols to attract more user funds under low-risk conditions, achieving more efficient interest rate optimization services.
Second Leap: Transitioning from applications to decentralized infrastructure, separating risks and building an independent ecosystem.
As mentioned earlier, the Morpho optimizer only completed Morpho's first leap, allowing it to stand out among various lending protocols and become an undeniable platform in the market. However, both from the product and protocol positioning, as well as the openness of ecological development, the optimizer cannot bring broader imaginative space. This is because, firstly, the growth of the optimizer is limited by the current design of the underlying lending pools, which severely relies on its DAO and trusted contractors to monitor and update hundreds of risk parameters or upgrade large smart contracts daily. If it remains stagnant, Morpho cannot attract a broader range of developers and native protocols, and it can only be positioned as an ecosystem protocol of Aave and Compound in the market. Therefore, Morpho adopts a product approach similar to Uni V4, focusing on being a foundational layer for a type of large financial service while opening up all modules above the foundational layer, that is: minimizing the product, which the team refers to as 'primitive', allowing all lending parameters to be opened to individuals and ecological protocols without permission. By transferring risks from the platform to third parties, Morpho's ecological value will continue to rise.
Why does Morpho want to create minimal components and open risk parameters to third parties?
Risk isolation: The lending markets are independent of each other. Unlike multi-asset pools, the liquidation parameters for each market can be set without considering the highest-risk assets in the basket. Morpho's smart contracts consist of only 650 lines of Solidity code, are non-upgradable, simple, and secure.
Customizability of vaults: For instance, suppliers can lend at higher LLTV while bearing the same market risk as when supplying to a multi-asset pool with lower LLTV. They can also create any collateral and loan assets as well as any risk-parameterized markets.
Cost reduction: Morpho is completely independent, thus there is no need to introduce fees to pay for platform maintenance, risk managers, or code security experts. The singleton contract based on simple code significantly reduces gas costs by 70%.
Lego foundation: Third-party protocols or individuals are allowed to add more logical layers on Morpho. These layers can enhance core functionalities by handling risk management and compliance or simplifying the user experience for passive lenders. For example, risk experts can establish non-custodial curated vaults that allow lenders to passively earn returns. These vaults reconstruct the current multi-collateral loan pools.
Bad debt handling design: Morpho adopts a different strategy for dealing with bad debts compared to conventional lending protocols. Specifically, if an account still has outstanding debts after liquidation and no collateral is available for compensation, the loss will be jointly borne by all lenders according to a predetermined ratio. This way, Morpho will not go bankrupt due to bad debts. Even if there are bad debts, they will only affect specific independent markets; unless large-scale market issues arise, Morpho's ecological value will not be harmed.
Developer Friendly: Account management implements gasless interactions and account abstraction, while free flash loans allow anyone to access assets across all markets in a single call.
The Morpho platform provides users with a completely autonomous building space, where any individual or institution can design and implement their own lending risk management mechanisms. Professional financial institutions can also utilize this platform to collaborate with other market participants, earning fees by providing management services. Its permissionless nature allows users to flexibly set various parameters and autonomously create and deploy independent lending markets without relying on external governance to add assets or adjust market rules. This flexibility grants market creators significant freedom, enabling them to independently manage lending pool risks and returns based on their own risk assessments, thereby meeting diverse user needs in terms of risk preferences and use cases.
However, looking further, the trustless design is actually aimed at low-cost reputation and TVL accumulation. Currently, there are hundreds of Vaults on Morpho, but most of those listed on the Morpho Interface come from risk management experts. Morpho allows anyone to create Vaults, which can increase TVL without risk; even if most of these Vaults fail, it won’t have an impact. However, the well-performing Vaults will stand out, and their positioning will be elevated to the level of risk management experts, enjoying the user volume brought by the Morpho platform. Before this, individually created Vaults need to undergo a long operational process.
How does MorphoVault work?
Morpho Vault is a lending vault system built on the Morpho protocol, designed specifically for managing lent assets. Whether it's DAOs, protocols, individual investors, or hedge funds, anyone can freely create and manage vaults on Morpho Vault, with each vault focusing on a single loan asset and supporting customized risk exposure, allowing capital to be allocated to one or more Morpho markets.
Source: Morpho
This design greatly optimizes the lending process, enhances the overall user experience, and effectively aggregates market liquidity. Users can not only enter independent markets and lending pools to participate in transactions but also easily provide liquidity, thereby earning interest passively.
Another notable feature is that Morpho Vault provides highly flexible risk management and fee structures. Each vault can adjust risk exposure and performance fee settings flexibly based on demand. For example, a vault focused on LST assets will only involve related risk exposures, while a vault dedicated to RWA assets will focus on that asset class. This customizable feature allows users to choose the most suitable vault for investment based on their risk tolerance and investment goals.
Since late November, Morpho has passed the token transferability proposal. For the current model relying on subsidizing Morpho tokens to attract users, the ability to trade Morpho tokens can entice more participants. Since the launch on Base in June, various metrics have been rising continuously, making it a popular DeFi protocol within the Base ecosystem. Due to the potential staking possibilities of ETH ETFs, the discussion around RWA is also increasing. Morpho is launching the first Coinbase-certified RWA vault on the Base chain, with two vaults curated by SteakhouseFi and Re7Capital supporting various RWA collateral options, placing Morpho in a very special position within the Base ecosystem.
Looking back at Morpho's development history, other lending protocols may learn from Morpho's efforts in building its reputation, starting from the initial Morpho optimizer, using Aave and Compound as capital buffers, and relying on the historical security assumptions of the two to quickly establish its brand; when the timing is right to develop its own ecosystem and become an independent protocol, Morpho significantly reduces the risks it may face by opening up the lending dimension to third parties, and develops its ecosystem in a low-cost manner, creating native applications within its ecosystem. Morpho clearly understands that for lending protocols, a stable operational history is crucial for building a security brand, and this is also the foundation of Morpho.
