Introduction

After experiencing the bull-bear cycle of from 2020 to 2023, we come to realize that only DeFi, as the application layer in the Web3 business world, is the ruly established business model category, while Dex, lending and stablecoins still being the three bedrocks of DeFi, with impressible achievements made in recent years. They remain strong even in a bear market.

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, while stablecoin projects cover MakerDao , Frax, Terra, Liquidity, Angle, Celo and other projects. In this issue of Clips, we will refocus on the lending industry, with a particular emphasis on Morpho, a new force whose business data has been growing rapidly in the past year.

In this article, the author will sort out Morpho’s existing business and the recently announced lending base layer service Morpho Blue, and try to answer the following questions:

• What is the current market structure of the lending industry?
• What businesses does Morpho cover, and what problems is it trying to solve? How is the business developing currently?
• What is the prospect of the newly launched Morpho Blue business? Will it impact the dominated position of Aave and Compound ? What other potential impacts are there?

The content of the following article is the author’s staged opinions as of the time of publication. There may be errors and biases in facts and opinions. It is for discussion only. We also look forward to corrections from other investment research colleagues.

The landscape of the Decentralized lending protocols

Organic Demand becomes the mainstream focus, with Eclipsing Ponzi color

Decentralized lending has always been at the forefront in terms of its capital capacity, with its TVL now surpassing that of Dex, becoming the top track for capital allocation 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 demand fit). Although in the DeFi summer wave of 2020-2021, many projects have also provided high token subsidies for lending activities, such practices greatly declined after experiencing the bear market.

As shown in the figure below, the protocol revenue of Aave, the vanguard in the lending field, began to exceed the incentive withdrawals of its tokens in December 2022, and so far has far exceeded the incentive withdrawals of the tokens ( in September, the protocol revenue was US$1.6 million, and Aave Token incentive withdrawal was US$230,000). In addition, Aave’s token incentives are mainly used to encourage token holders to stake Aave to ensure repayment when bad debts occur in the protocol and the treasury compensation runs short, rather than to stimulate users’ deposit and borrowing behavior. Therefore, Aave’s current deposit and lending practice is completely “organic” but not a Ponzi structure supported by liquidity mining.

Aave’s Monthly Protocol Revenues vs. Monthly Claimed Token Incentives

Source: https://tokenterminal.com/

In addition, Venus, the leading lending protocol on BNBchain, has also realized sound operation with protocol income exceeding claimed token incentives after March 23, and currently it basically no longer subsidizes deposits and lending activities.

Venus’ Monthly Protocol Revenues vs. Monthly Claimed Token Incentives

Source: https://tokenterminal.com/

However, the supply and demand of many lending protocols are still supported by high token subsidies, and the subsidy value of the protocol for lending behavior is far greater than the income that can be obtained from it.

For example, Compound V3 still provides Comp token subsidies for deposits and borrowing activities.

Nearly half of USDC’s APR on the Compound V3 Ethereum mainnet is supported by token subsidies

Source: https://app.compound.finance/markets/weth-mainnet

84% of the APR for USDC on the Compound V3 Base mainnet is supported by token subsidies

Source: https://app.compound.finance/markets/weth-basemainnet

If Compound sustains its market share through high token subsidies, then another protocol, Radiant, is a pure Ponzi structure.

Exploring the Radiant’s lending market page, we can see two unusual phenomena:

Source: https://app.radiant.capital/

First, Radiant’s borrowing APY is significantly higher than the market APY. The daily stablecoin’s APY in the mainstream money market is usually around 3-5%, while that of Radiant is as high as 14-15%. The APR for other assets is 8-10 times higher than that in the mainstream money market.

The second is that Radiant mainly promotes “looping loans” on the product interface, which encourages users to use a single asset as deposit collateral, thus participating in a continuous cycle of depositing and borrowing. This strategy mainly aims to enlarge their “total deposits and borrowings” through looping loans, thus maximizing the mining incentives generated by Radiant platform. In essence, the Radiant project party is selling the project token RDNT to users in disguise by charging user borrowing fees.

But the problem is that the source of Radiant’s handling fees - that is, users’ borrowing behavior - does not come from real organic borrowing needs, but to obtain RNDT tokens, which constitutes a self-feeding Ponzi economic structure. In this process, there are no real “financial consumers” on the lending platform. Looping loan is not a healthy lending model, because the depositors and borrowers of the same asset are the users themselves, and the RDNT dividends also economically come from the users themselves. The only risk-free profit maker is the platform project that extracts profits from the handling fees, with a charge of 15% of interest income. Although, by introducing the RDNT’s dLP staking mechanism, the project has delayed the short-term death spiral pressure caused by the decline of RDNT tokens, in the long term, the death spiral will eventually advent unless Radiant can gradually shift its business from Ponzi to a normal business model in the future.

But in general, the leading projects in the decentralized lending market, exemplified by Aave, are slowly getting rid of their reliance on high subsidies to sustain operating income and returning to a sound business model.

The figure below shows the changes in active borrowing volume in the web3 lending market from May 2019 to October 2023, from the initial few hundred thousand US dollars to the peak of US$22.5 billion in November 2021, and then to 3.8 billion US dollars during the lowest period in November 2022. And now it is 5 billion US dollars. The business volume of the lending market is slowly recovering from its lowest point, showcasing business adaptability and remarkable resilience in the bear market.

Source: https://tokenterminal.com/terminal/markets/lending

Obvious competitive edges and enhanced market concentration

As both are DeFi infrastructures, when comparing to the fierce competition in the Dex market, the premier lending projects have stronger competitive edges, which is specifically reflected in:

1. Greater stability in Market share. The figure below shows the changes in the proportion of active borrowing volume of each project from May 2019 to October 2023. Since it made a push in mid-2021, Aave’s market share has been stable, ranging from 50% to 60%. Although the second-place Compound has experienced a compression in its market share, its ranking remains relatively stable so far.

Source: https://tokenterminal.com/terminal/markets/lending

In comparison, Dex has undergone even more dramatic changes in market share. After its launch, the leading project Uniswap quickly occupied nearly 90% of the trading volume, and then its market share fell to 37% due to the rapid growth of Sushiswap, Curve, and Pancakeswap. However, it now goes up to about 55%. In addition, the total number of projects on the Dex avenue is much more than that on the lending avenue.

Source: https://tokenterminal.com/terminal/markets/lending

1. Projects on lending avenue have stronger profitability. As mentioned in the previous section, projects such as Aave managed to generate positive cash flow without subsidizing borrowing behavior, with operating income of around US$1.5-2 million in monthly interest spreads. Most Dex projects, such as Uniswap, have not yet enabled charging at the protocol level (only front-end charging has been enabled), or the token emission value used for liquidity incentives is much greater than the protocol’s fee income, actually operating at a loss.

The competitive edges of top lending protocols can be roughly concluded as the brand power in security, which specifically can be broken down into the following two points:

• Long history of secure operations: Since the DeFi Summer of 2020, there have been many Aave or Compound fork projects established on various blockchains, but most of them suffered from coins stolen or large bad debt losses shortly after their establishment. Aave and Compound have not experienced serious ones of this kind so far. For deposit users, this long-term secure operation history in a real network environment is the most crucial security endorsement. The new lending protocol may have a more attractive concept and provide higher short-term APY, but it will be difficult to gain the trust of users, especially whale users, before it can showcase a proven, long-term operational record.
• More abundant secure budget: Top lending protocols gain higher commercial income, and have relatively abundant funds in its treasury, which can serve as a solid fund base for secure audit and asset risk control. This is crucial for the development of new features and the introduction of new assets in the future.

Overall, featured with a relatively concentrated market share, the lending market has demonstrated proven organic demand and a sound business model.

Morpho’s businesses and operational status

Business: Interest rate optimizer

What has been launched on Morpho is a peer-to-peer lending protocol (or interest rate optimizer) built on Aave and Compound. It serves as a means to solve the inefficiency problem in pool-to-peer lending protocols like Aave, where there is often a mismatch between the total funds deposited and the total funds borrowed.

It has a simple and clear value proposition: provide better interest rates for both borrowers and lenders, which means higher deposit returns and lower borrowing rates.

The reason why the peer-to-peer pool model of Aave and Compound has a low fund utilization is because its mechanism determines the total size of deposit funds (pool), which is always greater than the total size of lending funds (points). In most cases, the USDT money market holds 1 billion total deposits, but only 600 million USDT are lent.

For depositors, since the idle 400 million funds unlent also forms part of the interest generated by the 600 million borrowed, the interest allocated to each user becomes less; for borrowers, although only a part of the capital pool has been borrowed, interest must be paid to the entire capital pool. Subsequently, each person bears more interest. This is the problem caused by the mismatch between deposits and borrowed funds.

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: Deposit user BOB deposits 10,000 Dai into Morpho. Morpho will first deposit the funds into the money market of Aave V2. The deposit interest rate is Aave’s market interest rate of 3.67%.
• Borrowing collateral: Borrowing user ALICE first deposits 20 ETH as collateral into Morpho and requests borrowing 10,000 Dai. Morpho will deposit the collateral into the Aave V2 money market.
• Match between deposits and borrowed funds: Morpho then takes back the 10,000 Dai that BOB previously deposited into Aave, and directly lends it to ALICE. Note that at this time, BOB’s deposits completely match ALICE’s borrowings. BOB’s deposits are fully lent out, with none of his deposited funds being idle; ALICE only pays interest for the 10,000 Dai it lent, not the entire capital pool. Therefore, in this matching occasion, both parties enjoyed optimized rates: BOB obtained a higher deposit interest rate, that is, 4.46%, than the Aave peer-to-pool model, which is 3.67%; ALICE bore a lower borrowing interest rate, which was also 4.46%, than the Aave peer-to-pool model, which was 6.17%.

*Note: It is determined by Morpho’s parameters, which are controlled by the community governance, that whether the P2P APY of 4.46% in the example is closer to the lower limit (deposit APY) or the upper limit (borrowing APY) of the underlying protocol.

• Solve the mismatch: Assuming that BOB wants to get back the Dai it lent before, but ALICE has not paid back the money. Then if there is no other fund lender on Morpho, Morpho will use ALICE’s 20 ETH as collateral to borrow the equivalent amount (10,000 DAI + the interest) from Ave, allowing BOB to successfully withdraw his deposit.
• Matching order: Taking into account the gas cost, the P2P matching of deposited and borrowed funds follows the “matching larger funds first” principle. This means the platform gives priority to matching larger deposits and borrows before smaller ones. In this way, the proportion of Gas consumption per unit of funds will be low. When the gas consumption value required to execute a match is disproportionately high, the system will not conduct the match.

Source: https://aavev2.morpho.org/?network=mainnet

The above explanation tells us that The essence of Morpho’s business is to use Aave and Compound as a capital buffer pool to provide interest rate optimization services for deposit and borrowing users through matching.

The ingenuity of this design is that through the composability of the DeFi world, Morpho attracts users’ funds in a blank-handed manner. For users, the attraction is:

1. TA can obtain the same financial interest rate as Aave and Compound in Morpho at the worst, and when matching occurs, its benefits/costs will be greatly optimized.

2. Morpho’s products are mainly built based on Aave and Compound, and completely follow the same risk parameters. With its funds also being allocated in Aave and Compound, it inherits the brand reputation of the two old protocols to a great extent.

With this ingenious design and clear value proposition, Morpho reached nearly US$1 billion in deposits just over a year after its launch, ranking second only to Aave and Compound from the data.

Business data and token status

business data

The chart below shows the business trends of Morpho’s total deposits (blue line), total borrowings (light brown line) and matched amounts (dark brown line).

Source: https://analytics.morpho.org/

Overall, Morpho’s business scale continues to grow, with the matching rate of deposits reaching 33.4% and the matching rate of borrowings attaining 63.9%. The figure is quite impressive.

Token status

Source: official documentation

The total number of Morpho tokens is 1 billion, of which 51% goes to the community, 19% is sold to investors, the founder and the development company behind it, Morpho Labs, and the operating agency Morpho Association owns 24%, and the remainder goes to consultants and contributors.

Interestingly, although Morpho tokens have been issued and used in voting decisions and project incentives, they are in a non-transferable state. Therefore, it does not have a secondary market price. Users and investors who receive tokens can participate in voting governance, but cannot sell them.

Unlike projects such as Curve, whose future output and incentives of tokens is determined by hard-code, Morpho’s token incentives are more dynamic and flexible, which is determined in batches, quarterly or monthly, allowing the governance team to adjust the incentive level and strategies in response to market changes.

The author believes that this is a more pragmatic approach, and may become the mainstream model of token incentive distribution in Web3 business in the future.

Regarding the behavioral objects of incentives, Morpho simultaneously incentivizes deposit and borrowing behaviors. However, Morpho tokens that are currently allocated for incentives are not large. In the past year or so, only 30.8 million tokens have been distributed, accounting for 3.08% of the total. Moreover, judging from the incentive period and the corresponding token distribution in the figure below, official token spending on incentives is decreasing rapidly, and the reduction in spending has not hindered the growth of Morpho’s business.

This is a positive signal that Morpho’s PMF is relatively sufficient and users’ needs are becoming more and more organic. The community token share is 51%, and currently there is nearly 48% left, which leaves ample budget space for business incentives in new sections in the future.

However, Morpho does not charge for the service yet.

Team and financing

The core team of Morpho comes from France, with most of the members based in Paris. The core members of the team have their real names. The three founders are all from the telecommunications and computer industries, and have a background in blockchain entrepreneurship and development work.

Morpho has launched two rounds of financing in total, namely a $1.3 million seed round in October 2021, and an $18 million Series A round in July 2022 led by A16z, Nascent, and Variant.

Source: official website

If the above financing amount corresponds to the officially disclosed 19% investor share, then the corresponding comprehensive project valuation is approximately US$100 million.

Morpho Blue and its Potential Impact

What is Morpho Blue?

Simply put, Morpho Blue is a permissionless lending base layer. Compared to Aave and Compound, Morpho Blue opens up more lending possibilities for users, allowing anyone to build a lending market based on it. The dimensions available for builders to choose from include:

• Collateralization options
• Asset to be lent out
• Oracle to be used
• Determine loan to value (LTV) and liquidation loan-to-value (LLTV) ratios
• Use an interest rate model (IRM)

What value will Morpho Blue bring?

According to the official documentation, the features of Morpho Blue can be summarized as follows:

• Trustless:
  • Morpho Blue is designed to be upgradeable. This means no one can change it, reflecting its commitment to minimal governance.
  • With only 650 lines of Solidity code, it is simple and safe.
• Efficient:
  • Users can choose higher LTV and more reasonable interest rates.
  • The platform does not need to pay service fees for third-party audit and risk management.
  • A singleton smart contract based on simple code (singleton smart contract refers to a protocol that uses one contract rather than a combination of multiple contracts to execute rather. Uniswap V4 also uses a singleton contract), which significantly reduces gas costs by 70%.
• Flexible:
  • Both market construction and risk management (oracles, lending parameters) are permissionless. It no longer adopts a unified model, that is, the entire platform follows a set of standards established by DAO (the models of Aave and Compound).
  • Developer friendly: Introducing a variety of modern smart contract models. It implements no-GAS interaction and account abstraction functions in the account management. With free flash loans, it allows anyone to access assets in all markets simultaneously with one 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 constructs the basic layer of a large type of financial services, and opens up the modules above the basic layer to allow different people to access and provide services.

There is a difference from Aave. Although Aave’s fund deposits and borrows are permissionless, it is formulated and managed by Aave DAO and the various service providers behind the DAO such as Gaunlet and Chaos, which monitor and manage more than 600 risk parameters on a daily basis, regarding what kind of assets can you deposit and borrow in Aave, the conservative or aggressive risk control rules, which oracle to be used, and what the interest rates and liquidation parameters are.

Morpho Blue is like an open lending operating system. Anyone can build a lending portfolio that they think is optimal on Morpho Blue like Aave. Moreover, professional risk management institutions like Gaunlet and Chaos can also go to Morpho Blue to look for partners in the market to sell their risk management services to obtain corresponding fees.

In the author’s opinion, the core value proposition of Morpho Blue is not to be trustless, efficient and flexible, but to provide a free market for lending, which facilitates the collaboration of participants in all aspects of the lending market and provides customers in all aspects with richer services to choose from.

Will Morpho Blue pose a threat to Aave?

maybe.

Having accumulated some advantages over the past year or so, Morpho differentiates itself from many previous Aave challengers:

• With 1 billion mark managed capital, Morpho is already in the same level of vanguard Aave, which owns 7 billion managed capital. Although these funds are currently employed in Morpho’s interest rate optimizer, there are many ways to import them into new functions.
• Morpho, recognized as the fastest growing lending protocol in the past year and with its tokens to be released officially, presents a realm of possibilities. The launch of its major new features will easily attract users to engage in it.
• Morpho has a sufficient and flexible token budget, and it has the ability to attract users via subsidies in the early stage.
• With a stable operation history and amount of funds, Morpho is able to establish a notable degree of security branding.

Of course, this does not mean that Aave will definitely be at a disadvantage in future competitions, because most users may not have the ability and willingness to choose services from many lending solutions. Currently, lending products generated by Aave DAO under the unified management model may still be the most popular in the end.

Secondly, Morpho Interest Rate Optimizer largely inherits the safe credentials of Aave and Compound, which puts more funds at ease. But Morpho Blue is a brand new product with a separate code, so whales must be cautious before investing with confidence. After all, the stolen incidents in unlicensed lending markets like Euler are still lingering in our mind.

Furthermore, Aave is fully capable of building a set of functions similar to Morpho’s interest rate optimizer on existing solutions to meet users’ needs, so as to improve fund matching efficiency and potentially squeeze Morpho out of the P2P lending market. Although this seems unlikely at present, because Aave also issued Grants to NillaConnect, a P2P lending product similar to Morpho, in July this year, rather than doing it itself.

Finally, the lending business model adopted by Morpho Blue is fundamentally the same with Aave’s existing solution. Aave is also capable of observing and imitating Morpho Blue’s excellent lending model.

However, in any case, after Morpho Blue goes online, it will provide a more open lending testing ground, facilitating inclusive participation and combination across the whole lending process. Will these newly connected lending groups emerge with solutions that can challenge Aave?

We’ll see what happens.

Disclaimer：

1. This article is reprinted from [mintventures]. All copyrights belong to the original author [Alex Xu]. If there are objections to this reprint, please contact the Gate Learn team, and they will handle it promptly.
2. Liability Disclaimer: The views and opinions expressed in this article are solely those of the author and do not constitute any investment advice.
3. Translations of the article into other languages are done by the Gate Learn team. Unless mentioned, copying, distributing, or plagiarizing the translated articles is prohibited.