TLDR

• The essence of modular lending is not just about cross-chain and aggregation, but both play important roles in modular lending.
• Modular lending leverages the security, consensus, and data availability provided by the base layer, focusing on functional modularization at the execution and application layers.
• Modular lending breaks down its processes into several independent modules, such as collateral management, interest rate calculation, risk assessment, and liquidation mechanisms, with each module communicating through standardized interfaces.
• Currently, the characteristics of modular DeFi protocols are similar to the logic of OP Stack’s one-click chain deployment, where deployment requires establishing module combinations on top of the protocol itself to create new financial products and services.

I. The Origin of Modularity

The concept of modular blockchain originates from two white papers. In 2018, Mustafa Albasan and Vitalik Buterin co-authored the paper “Data Availability Sampling and Fraud Proofs,” which proposed a system allowing light clients to receive and verify fraud proofs from full nodes. It designed a data availability sampling protocol to reduce the trade-off between on-chain capacity and security, addressing blockchain scalability issues without compromising security and decentralization.

Subsequently, in 2019, Mustafa Albasan detailed a new architecture in the “Lazy Ledger” white paper. This architecture uses the blockchain for ordering and ensuring transaction data availability without handling transaction execution and validation. This new architecture aimed to solve scalability issues in existing blockchain systems and was initially called a “smart contract client.” The execution of smart contracts was performed by another execution layer on this client, forming the prototype of Celestia, the first modular data availability layer project.

With the advent of Rollup technology, this concept became more concrete, following the logic of executing smart contracts off-chain and uploading the results as proofs to the “client’s” execution layer. Reflecting on blockchain architecture and new scaling technologies, Celestia emerged, defining a new paradigm of “modular blockchain.”

II. The Emergence of Modular Blockchain

Modular blockchains aim to solve the “impossible triangle” dilemma in the blockchain field through decoupling and restructuring. Simply put, it breaks down the main functions of a single chain into multiple layers, each focused on specific functions, thus achieving scalability. Generally, the basic functions of a monolithic chain can be divided into the following four layers:

1. Data Availability Layer: Ensures that data in the network can be accessed and verified, including data storage, transmission, and verification functions, maintaining blockchain network transparency and trust. Representative DA projects include Celestia, Avail, EigenDA, etc. Monolithic blockchains like Ethereum and Solana can also serve DA needs (Bitcoin, due to its non-Turing completeness, lacks good validation solutions for traditional Rollups, but its scaling capabilities are progressing rapidly).
2. Consensus Layer: Handles protocols among nodes to achieve data and transaction consistency in the network. Through consensus algorithms (like PoW or PoS), it verifies transactions and creates new blocks. Most DA projects also require their consensus layer, typically designed for low hardware requirements and simple verification light nodes.
3. Execution Layer: Processes transactions and executes smart contracts, including transaction verification, execution, and state updates. Layer2 projects (like Arbitrum, Optimism, ZKsync) function as execution layers of modular blockchains, validating transaction correctness through the main chain and inheriting the main chain’s security.
4. Settlement Layer: Finalizes transactions, ensuring asset transfers and permanent records on the blockchain. The modular settlement layer’s main role is to verify the Rollup validity proofs and state data, with notable projects like Dymension and Cevmos.

In early history, solutions around Bitcoin like the Lightning Network and sidechains can be considered “modular pioneers.” However, due to Bitcoin’s non-Turing completeness, these scaling solutions progressed slowly with various flaws and were not widely adopted. Traditional blockchains tried to solve the trilemma by reconstructing the underlying framework, but with limited success. To address this issue, Vitalik Buterin proposed improvements around Rollups. With the maturity of fraud proofs and zero-knowledge proofs, building execution layers on Ethereum through a Lego-like method became realistic. Ethereum has set its endgame as a layered scaling path centered around Rollups. This upgrade method, centered on Rollups, is expected to surpass previous scaling solutions and become the ultimate solution for blockchain expansion.

III. Modular Lending Evolution

Image Source: Legendary Quant

Modular DeFi lending leverages the security, consensus, and data availability provided by the foundational layer, focusing on functional modularization at the execution and application layers and running these modules on the blockchain. Key modular parts include:

• Collateral Management Module: Responsible for storing, managing, and processing users’ collateral, ensuring its safety and compliance.
• Interest Rate Calculation Module: Dynamically adjusts lending rates based on market supply and demand, user credit scores, and other factors.
• Risk Assessment Module: Evaluates borrowers’ credit risk to decide whether to approve loan requests and determine the required collateral amount.
• Liquidation Mechanism Module: Activates the liquidation process when borrowers fail to repay on time, protecting the interests of the platform and other users.

A modular lending system needs to obtain all necessary transaction and contract data from the data availability layer to enable interaction and verification between modules. The results of each module’s operations need to be confirmed and recorded by the consensus layer, ensuring the security and consistency of all module state changes. Most of the logic of modular lending runs on the execution layer, implementing the functionalities of each module through smart contracts. The final settlement and liquidation of lending transactions rely on the settlement layer, ensuring the finality of lending and liquidation transactions.

3.1 Core Concepts

• Modular Design: Breaking down the lending process into multiple independent modules, such as collateral management, interest rate calculation, risk assessment, and liquidation mechanisms. Each module can be developed, tested, and deployed independently.
• Interoperability: Standardized interfaces allow communication between modules, making it easy to combine different modules and even use certain modules across platforms.
• Upgradability: Since each module is independent, any module can be upgraded individually without affecting the entire system. This feature allows the system to respond quickly to market changes and technological advancements.
• Security: Modular design can isolate risks. For instance, if a security vulnerability occurs in one module, only that module needs to be fixed without impacting the entire system.

3.2 Key Components

• Collateral Management Module: Handles the deposit, withdrawal, and management of collateral, ensuring user collateral is secure and compliant.
• Interest Rate Calculation Module: Dynamically adjusts lending rates based on market supply and demand, borrower credit scores, and other factors.
• Risk Assessment Module: Assesses the risk of borrowers, deciding whether to approve loan requests and determining the required collateral amount.
• Liquidation Mechanism Module: Activates the liquidation process when borrowers fail to repay on time, ensuring the safety of funds on the lending platform.

3.3 Advantages

• Flexibility: Different modules can be combined as needed to meet diverse lending requirements.
• Efficiency: Optimizing the performance of each module improves the overall system’s efficiency.
• Innovation: Developers can innovate on specific problems by introducing new modules to enhance functionality.
• Transparency: Modular systems offer higher transparency, allowing each module’s operational logic and state to be audited and verified independently.

3.4 Role of Cross-Chain and Aggregation in Modular Lending

Image Source: Cross-Chain Bridges Explained

The essence of modular lending is not just about cross-chain and aggregation, although both play significant roles. The core idea of modular lending is to enhance system flexibility, scalability, security, and innovation by modularizing various functions of the lending process. Cross-chain and aggregation are parts of realizing this core idea but are not its entirety.

Cross-Chain (Interoperability):

• Cross-Chain Technology: Enables assets and functional modules on different blockchains to interoperate. This is crucial for modular lending as it allows users to transfer assets across blockchains and utilize various decentralized applications (dApps).
• Multi-Chain Support: By supporting multiple blockchains, lending platforms can enhance their usability and flexibility, attracting more users and assets.

Aggregation:

• Aggregation Protocols: Aggregate multiple lending protocols and liquidity pools, providing a unified interface and better user experience. For example, users can access multiple lending markets through one aggregation platform to get the best lending rates.
• Liquidity Aggregation: By aggregating multiple liquidity sources, it improves capital utilization efficiency and market liquidity.

3.5 Other Key Aspects of Modular Lending

Modular Design:

• Functional Modularization: Breaks down the lending process into independent functional modules (such as collateral management, interest rate calculation, risk assessment, and liquidation mechanisms). Each module can be developed, deployed, and upgraded independently.
• Standardized Interfaces: Modules communicate through standardized interfaces, ensuring compatibility and interoperability between modules.

Security and Risk Management:

• Risk Isolation: Modular design can isolate risks within specific modules. If an issue occurs in one module, it does not impact the entire system.
• Security Audits: Each module can be audited independently, enhancing the overall system’s security.

Flexibility and Scalability:

• Flexible Combination: Users and developers can flexibly combine different modules to meet diverse lending needs.
• Scalability: The system’s functionality and performance can be expanded by adding or replacing modules without needing to reconstruct the entire system.

Some established DeFi platforms, such as Aave, Compound, and MakerDAO, are also adopting modular design concepts. For instance, MakerDAO is moving towards a more decentralized SubDAO model, and Aave’s protocol consists of multiple smart contracts handling borrowing, collateral management, liquidation, etc. Developers and users can combine these contracts as needed and even develop new contracts to extend the platform’s functionality.

IV. Modular Lending Projects

4.1 Morpho Labs

Morpho Labs aims to enhance the efficiency and user experience of decentralized lending markets through technological innovation and optimization, promoting the growth of the DeFi ecosystem. With its modular design and frictionless trading mechanism, Morpho Labs seeks to attract more users and funds to the decentralized finance field. Key innovations include Morpho Blue and Meta Morpho, which enhance DeFi lending efficiency and interoperability.

Image Source: Morpho Labs Official

Morpho Blue

Morpho Blue is an advanced version of the lending protocol provided by Morpho Labs. It aims to minimize the deployment of encrypted assets (ERC20 and ERC4626 tokens) on the Ethereum Virtual Machine and create independent lending markets. Morpho Blue offers a trustless foundation layer for lenders, borrowers, and applications, operating under dual licenses (BUSL-1.1 and GPLv2). Once deployed, it will run permanently on the Ethereum blockchain.(1) Key features and components include:

• Collateral: Users must provide collateral supported by the protocol to borrow assets.
• Liquidation Loan-to-Value (LLTV): The protocol sets a minimum value requirement for collateral relative to the borrowed assets. For example, if the ratio is 90%, the value of the borrowed assets must not exceed 90% of the collateral value, or the position will be liquidated.
• Borrowing: Users initiate the borrowing process by interacting with the protocol. They specify the amount of assets they wish to borrow and provide the necessary collateral.
• Interest Rate: Borrowers pay interest on the borrowed amount based on the protocol’s interest rate model. Interest accrues over time and is paid upon loan repayment.
• Repayment: Borrowers can repay the borrowed assets and accrued interest at any time to close the loan. Once repayment is confirmed on-chain, borrowers can retrieve their collateral from the smart contract.
• Liquidation Mechanism: To mitigate default risk, the protocol includes a liquidation mechanism. If the value of the borrowed assets exceeds the LLTV due to market fluctuations or accrued interest, the position may be partially or fully liquidated to repay the loan and any outstanding interest.
• Lending: Users initiate the lending process by interacting with the protocol, specifying the amount of assets they want to lend, and transferring these assets to the smart contract.
• Withdrawal: Lenders can withdraw their loaned assets and accrued interest at any time, provided there is sufficient market liquidity.

A notable feature of Morpho Blue is the ability to create permissionless trading markets, allowing users to establish independent markets composed of loan assets, collateral assets, LLTV, oracles, and interest rate models (IRM). Each parameter is selected during market creation and is immutable, with LLTV and interest rate models chosen from a set of options approved by Morpho governance.

Meta Morpho

Meta Morpho is an independent meta-protocol designed to create MetaMorpho Vaults based on Morpho Blue, enabling seamless integration and interoperability across different DeFi platforms and protocols. Key features include:

• Cross-Platform Integration: Allows users to seamlessly transfer assets and strategies across different DeFi protocols.
• Enhanced Interoperability: Provides better interoperability through standardized interfaces and protocols, facilitating smoother collaboration between different DeFi protocols.
• Automated Management: Uses smart contracts and automation tools to enhance the efficiency and reliability of asset management and strategy execution.
• Liquidity Aggregation: Aggregates liquidity from different platforms, improving overall market liquidity and efficiency.

4.2 Euler Finance

Image Source: Euler Finance Official

On February 22, 2024, the lending protocol Euler Finance announced its imminent relaunch and the release of its v2 version. This modular lending platform primarily includes two major components: Euler Vault Kit (EVK) and Ethereum Vault Connector (EVC), designed to enhance the protocol’s flexibility and functionality.(2)

Euler Vault Kit (EVK)

EVK is a toolkit that allows users to create and manage custom “vault” systems. EVK enables users to deposit their assets into vaults and set different strategies and rules as needed. It integrates with EVC, allowing developers to freely construct ERC-4626 vaults. Key features of EVK include:

• Custom Strategies: Users can set different strategies based on their needs and risk preferences, such as specific lending rates and liquidation rules.
• Multi-Asset Support: EVK supports various assets, allowing different types of crypto assets to be deposited into vaults.
• Flexible Management: Users can manage and adjust vault settings flexibly to adapt to market changes and personal needs.
• Security: EVK provides high security through smart contracts and decentralized technology, ensuring the safety of users’ assets.

Ethereum Vault Connector (EVC)

EVC is a tool designed to connect EVKs on Ethereum. It allows users to seamlessly transfer assets and strategies between different DeFi protocols, granting vaults superpowers to act as collateral for other vaults, facilitating seamless communication between ERC-4626 vaults and other smart contracts. Key features of EVC include:

• Unified Interoperability Layer: EVC enables users to transfer assets from one vault to another, regardless of whether they belong to the same protocol. This significantly increases asset liquidity and flexibility.
• Strategy Sharing: Users can share and apply the same strategies across different vaults, simplifying management processes.
• Automated Management: EVC automates the transfer of assets and application of strategies through smart contracts, reducing the complexity of manual operations.
• Enhanced Liquidity: By connecting different vaults, EVC improves overall DeFi ecosystem liquidity, enabling users to utilize their assets more effectively.

Euler Vault Kit (EVK) and Ethereum Vault Connector (EVC) are important features introduced by Euler Finance to provide greater flexibility and management efficiency. Through EVK, users can create and manage custom vaults, and through EVC, they can seamlessly transfer assets and strategies between different vaults. These tools enhance users’ control and management capabilities over their assets, contributing to improved liquidity and efficiency in the DeFi ecosystem.

V. Perspectives on Current Modular Lending

DeFi protocols refer to a series of decentralized applications (dApps) built on blockchain networks that offer traditional financial services like lending, trading, and insurance without relying on traditional financial institutions. Modular DeFi protocols improve flexibility and innovation by breaking these services into independent modules, allowing users and developers to mix and match different functionalities.

Currently, DeFi primarily consists of yield aggregators, lending protocols, derivatives and options, and insurance protocols. These modules can be freely combined to create new financial products and services. However, their nature is similar to the OP Stack’s “one-click chain deployment” logic; modular DeFi protocols need to establish module combinations within their own framework to create new financial products and services.

While modular DeFi brings flexibility, it also comes with potential risks. UniSwap ignited the DeFi boom, becoming the “blueprint” for various DeFi protocols today. Since its inception, UniSwap has never been hacked, primarily due to its reliance on a simple core invariant (tokenBalanceX * tokenBalanceY = k) and its integration with immutable smart contracts.

However, the flexibility of modularity also introduces relative complexity. The high interconnectivity between different DeFi protocols means that if an upgradeable contract in one protocol fails, it could trigger a chain reaction affecting other protocols, potentially leading to systemic risk in the entire ecosystem. This is an important aspect that needs consideration.

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