Modular Lending: Is it More Than Just a Meme?

Original Title: 《Modular lending: More than a meme?》
Original Author: Chris Powers
Original Translation: Luccy, BlockBeats

Editor's Note:
DeFi researcher Chris Powers explores the new trend in the lending space—modular lending—and illustrates its potential in addressing market challenges and providing better services.

Chris Powers compares traditional DeFi lending leaders (MakerDAO, Aave, and Compound) with several major modular lending projects, including Morpho, Euler, and Gearbox, pointing out the prevalence of modular lending in the DeFi world and emphasizing its positive impact on risk management and value flow.

In business and technology, there is an old adage: "There are only two ways to make money in business: bundling and unbundling." This holds true not only in traditional industries but is even more evident in the world of cryptocurrency and DeFi due to its permissionless nature. In this article, we will explore the surge in modular lending trends (and those who have already stepped into the post-modular era) and discuss how it may disrupt mainstream DeFi lending. With unbundling emerging, new market structures are forming new value flows—who will benefit the most?

------ Chris

A significant unbundling has already occurred at the core infrastructure layer. Previously, Ethereum had only one solution for execution, settlement, and data availability. However, it has adopted a more modular approach, providing specialized solutions for each core element of the blockchain.

The same narrative is playing out in the DeFi lending space. Initially successful products were those that offered everything, although the first three DeFi lending platforms—MakerDAO, Aave, and Compound—operated under predefined structures set by their respective core teams, despite having many moving parts. Today, however, the growth of DeFi lending comes from a new batch of projects that break down the core functionalities 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 user-friendly bundled products that combine multiple DeFi building blocks to offer more comprehensive lending solutions.

This new push towards unbundled 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 new market topics more than they are due to potential innovations (just look at DeFi 2.0).

Our view: hype is not fiction. DeFi lending will undergo transformations similar to those at the core technology layer—just as Ethereum has seen new modular protocols emerge, such as Celestia, existing leaders are adjusting their roadmaps to become more modular.

In the short term, major competitors are paving different paths. New modular lending projects like Morpho, Euler, Ajna, and Credit Guild have found success, while MakerDAO is adopting a more decentralized SubDAO model. Additionally, the recently announced Aave v4 is also moving towards modularity, echoing the architectural shift of Ethereum. The paths currently being paved may determine the accumulation of value in the DeFi lending stack in the long term.

According to data from Token Terminal, there is always a question about whether MakerDAO belongs to the crypto DeFi lending market share or the stablecoin market. However, with the success of the Spark Protocol and the growth of MakerDAO's RWA (real-world assets), this will no longer be an issue in the future.

Why Choose Modularization?

There are typically two approaches to building complex systems. One strategy is to focus on the end-user experience, ensuring that complexity does not affect usability. This means controlling the entire tech stack (as Apple does through the integration of hardware and software).

The other strategy is to allow multiple participants to build the various 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 for innovation. This can be seen in core internet protocols, which have remained unchanged while TCP/IP-based applications and businesses have driven innovation on the internet.

This analogy can also be applied to economies, where the government is seen as the foundational 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 the governance layer. These two approaches are not always applicable, as many companies, protocols, and economies operate somewhere between the two.

Disassembly Analysis

Proponents of modular lending theory argue that DeFi innovation 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 dependencies. Lending protocols require close risk monitoring, as a small issue can lead to catastrophic losses, making the establishment of redundancy mechanisms crucial. Single-structure lending protocols often introduce multiple oracles to prevent one from failing, 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 asset
• Collateral asset
• Oracle
• Maximum Loan-to-Value (LTV) ratio
• Interest rate model

These components must be closely monitored to ensure the platform's solvency and prevent the accumulation of bad debts due to rapid price changes (we can also add the liquidation system to the five components above).

For Aave, Maker, and Compound, the token governance mechanism makes decisions for all assets and users. Initially, all assets were pooled together, sharing the risks of the entire system. However, even single-structure lending protocols quickly began to create independent markets for each asset to isolate risk.

Understanding Key Modular Participants

Isolating markets is not the only way to make your lending protocol more modular. True innovation is happening in those new protocols that are rethinking the necessary components of 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 have recently felt uncomfortable with this label, trying to transform into "non-modular, non-single-structure, but rather aggregated." Its total value locked (TVL) is $1.8 billion, undoubtedly placing it among the top in 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 permissionlessly, optimized according to desired parameters. Governance only allows modifications to certain components—currently five different components—without specifying what those components should be. This is configured by the vault owner (often a DeFi risk manager). Another major layer of Morpho is Meta Morpho, which aims to be an aggregation liquidity layer for passive lenders. This is a part particularly focused on the end-user experience. It is similar to Uniswap's DEX on Ethereum, while also having Uniswap X for efficient trade routing.

Euler launched its v1 version in 2022, generating over $200 million in outstanding contracts, but a hack nearly drained all protocol funds (which were 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 Vault Kit (EVK), a framework for creating ERC4626-compatible vaults with additional lending features, allowing it to function as a passive lending pool. The other is the Ethereum Vault Connector (EVC), an EVM primitive primarily implementing multi-vault collateralization, meaning multiple vaults can use collateral provided by one vault. v2 is planned for launch in the second or third quarter.

Gearbox offers a user-centered clear framework, allowing users to easily set up positions with minimal oversight, regardless of their skill or knowledge level. Its main innovation is the "credit account," which is a list of assets that can be operated and whitelisted, priced in the borrowed assets. It is essentially an independent lending pool, similar to Euler's vault, with the difference being that Gearbox's credit account consolidates users' collateral and borrowed funds in one place. Like MetaMorpho, Gearbox demonstrates that there can be a layer focused on bundling for the end user in a modular world.

Unbundle, Then Re-bundle

Specializing in parts of the lending stack provides opportunities to build alternative systems that may target specific market segments or future growth drivers. Some leading proponents adopting this approach include:

Credit Guild intends to enter the already established pooled lending market with a trust-minimized governance model. Existing participants, like Aave, have very strict governance parameters, which often leads to apathy among small token holders, as their votes seem to make little difference. Thus, a small honest minority controlling the majority of tokens is responsible for most changes. Credit Guild disrupts this dynamic by introducing an optimistic, veto-based governance framework that stipulates various quorum thresholds and delays for different parameter changes, while combining a risk response approach to handle unforeseen consequences.

Starport aims for cross-chain development. 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 contracts, responsible for loan initiation (terms definition) and refinancing (terms updating). It stores data for protocols built on the Starport core and provides this data when needed.

• Custody contracts, primarily holding the collateral of borrowers initiating protocols on Starport and ensuring debt settlement and closure according to the terms defined in the initiating protocol, stored in the Starport contract.

Ajna boasts a truly permissionless, oracle-free pooled lending model with no governance at any level. Pools are set up with specific pairs of quotes/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 borrowing prices by specifying the amount of collateral that should be pledged for each quote token held by the borrower. This is particularly appealing for long-tail assets, much like what Uniswap v2 did for small tokens.

If You Can't Beat Them, Join Them

The lending space has attracted a plethora of newcomers and has reignited the motivation for the largest DeFi protocols to launch new lending products:

Aave v4, announced just last month, is very similar to Euler v2. Previously, Aave's fervent supporter Marc "Chainsaw" Zeller stated that due to the modular nature of Aave v3, it would become 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 of the upcoming upgrades are not novel, they have yet to be widely tested in a highly liquid protocol (and Aave is already such a protocol). Aave's success in gaining 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 asset. This allows it to leverage Curve's expertise in automated market maker (AMM) design to provide unique lending market opportunities. Curve has operated in a unique way in the DeFi space, but it has worked effectively for them. Besides the giant Uniswap, Curve has carved out a significant niche in the decentralized exchange (DEX) market and has rethought their tokenomics through the success of the veCRV model. Llammalend seems to be another chapter in Curve's story:

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

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

Like concentrated liquidity automated market makers (clAMM, such as Uniswap v3), LLAMMA deposits borrowers' collateral uniformly within a user-specified price range (called a band) that significantly deviates from oracle prices to ensure that arbitrage is always incentivized.

In this way, when the price of the collateral asset falls beyond the band, the system can automatically convert part of the collateral into crvUSD (soft liquidation). While this approach may reduce the overall health of the loan, it is much better than a complete liquidation, especially considering the explicit support for long-tail assets.

Since 2019, Curve founder Michael Egorov has rendered criticisms of over-engineering ineffective.

Both Curve and Aave place great importance on the development of their respective stablecoins. This is a very effective long-term strategy that can yield substantial revenue. Both are following in the footsteps of MakerDAO. MakerDAO has not abandoned DeFi lending and has also launched the independent brand Spark. Despite lacking any native token incentives (not yet), Spark has performed exceptionally well over the past year. Stablecoins and massive monetary creation capabilities (credit is indeed a powerful drug) present a significant long-term opportunity. However, unlike lending, stablecoins require on-chain governance or off-chain centralized entities. For Curve and Aave, this route makes sense as they have some of the oldest and most active token governance (certainly second only to MakerDAO).

What we currently cannot answer is what Compound is doing? It was once the leader in the DeFi space, kicking off 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 broad and shallow moat, Compound still has $1 billion in outstanding loans and widespread governance distribution. Recently, there have been efforts to continue developing Compound outside of the Compound Labs team. We are uncertain about which markets it should focus on—perhaps large blue-chip markets, especially if it can gain some regulatory advantages.

Accrued Value

The top three in DeFi lending (Maker, Aave, Compound) are all adjusting their strategies to respond to the shift towards a modular lending architecture. Lending against crypto collateral used to be a good business, but as your collateral is on-chain, the market becomes more efficient, and profits are squeezed.

This does not mean there are no opportunities in an efficient market structure; it just means no one can monopolize their position and extract rents.

The new modular market structure provides more permissionless value capture opportunities for private enterprises such as risk managers and venture investors. This makes risk management more practical and directly translates into better opportunities, as economic losses can severely impact the reputation of custodians.

The recent Gauntlet—Morpho incident is a great example, occurring during the decoupling of ezETH.

During the decoupling, 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 largely unaffected, while Gauntlet needed to provide post-event assessments and take responsibility.

Gauntlet initially launched the vault because it believed its future prospects on Morpho were more promising, allowing it to charge fees directly rather than providing risk management consulting services to Aave governance (the latter being more focused on politics than risk analysis—try tasting or drinking "Chainsaw").

Just this week, Morpho founder Paul Frambot revealed that a smaller risk management firm, Re7 Capital, which also has an excellent research newsletter, achieved an annual on-chain income of $500,000 as a manager of the Morpho vault. While not huge, this indicates that you can build financial companies on DeFi (not just wild yield farms). This indeed raises some long-term regulatory questions, but this is commonplace in today's cryptocurrency world. Moreover, this will not prevent risk managers from becoming one of the biggest beneficiaries of future modular lending.