Exploring Morpho A P2P lending protocol that focuses on interest rate optimization, will it be a potential competitor to Aave?

Uncovering Morpho A P2P Lending Protocol Prioritizing Interest Rate Optimization – A Threat to Aave?

Author: Alex Xu

Having experienced the bull and bear market cycle from 2020 to 2023, we have found that in the Web3 business world, the only truly established business model in the application layer is DeFi. Dex, lending, and stablecoins are still the three pillars of DeFi (the derivatives track has also seen significant growth in recent years), and their business remains resilient even in bear markets.

Mint Ventures has written numerous research reports and analysis articles on Dex and stablecoins, including projects such as Curve, Trader Joe, Syncswap, Izumi, and Velodrome in the ve(3,3) category, as well as stablecoin projects such as MakerDao, Frax, Terra, Liquity, Angle, and Celo. This issue of Clips will focus on the lending track and will specifically highlight the emerging force of Morpho, which has experienced rapid business growth in the past year.

In this article, I will discuss Morpho’s existing business and its recently announced lending infrastructure service, Morpho Blue, and attempt to answer the following questions:

• Unibot encounters hacker invasion How should Telegram users ensure the security of their assets?
• Aragon, which raised 275,000 ETH, officially dissolves. Did DAO governance still fall victim to human nature?
• November Cryptocurrency Market Outlook Hot Projects and Catalysts to Watch

• What is the current market landscape of the lending track?
• What businesses does Morpho include and what problems does it attempt to solve? How is its business currently developing?
• What are the prospects of the newly launched Morpho Blue business? Will it have an impact on the leading positions of Aave and Compound? What other potential influences are there?

Decentralized Lending Market Landscape

Organic demand becoming mainstream, pyramid scheme-like structures fading

Decentralized lending has consistently had a high share of the total value locked (TVL) and has now surpassed Dex to become the track with the largest amount of capital in the DeFi space.

Source: https://defillama.com/categories

Decentralized lending is also one of the rare business categories in the Web3 field that has achieved Product-Market Fit (PMF). Although during the DeFi summer boom in 2020-2021, there were many projects that provided substantial subsidies for lending activities through tokens, such phenomena have greatly reduced during the bear market.

As shown in the chart below, the protocol revenue of Aave, one of the leading projects in the lending space, has been surpassing its token incentives since December 2022 and has far exceeded token incentives to date (protocol revenue in September was $1.6 million, while Aave token incentives were $230,000). In addition, Aave’s token incentives are mainly used to incentivize token holders to collateralize Aave to ensure the protocol can cover bad debts and compensate insufficiently from the treasury, rather than stimulating users’ borrowing and lending behaviors. Therefore, Aave’s current borrowing and lending activities are entirely organic and not supported by liquidity mining-based pyramid structures.

Comparison of Aave's incentive claims and protocol income on a monthly basis, source: https://tokenterminal.com/

In addition, Venus, a top lending protocol on the BNBchain, has also achieved a positive balance between protocol income and incentive claims after March 23, 2022, and is currently no longer subsidizing borrowing and lending activities.

Comparison of Venus' incentive claims and protocol income on a monthly basis, source: https://tokenterminal.com/

However, many lending protocols still provide substantial token subsidies behind the supply and demand. The value of protocol subsidies for lending activities far exceeds the income obtained from them.

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

Nearly half of the deposit interest rate of USDC on Compound V3 on the Ethereum Mainnet is provided by token subsidies, source: https://app.compound.finance/markets/weth-mainnet

84% of the deposit interest rate of USDC on Compound V3 Base on the Ethereum Mainnet is provided by token subsidies, source: https://app.compound.finance/markets/weth-basemainnet

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

On the lending market page of Radiant, we can see two unusual phenomena:

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

First, its asset lending rates are significantly higher than market rates. The stablecoin lending rates in mainstream currency markets are usually around 3-5%, while Radiant reaches 14-15%, and the lending rates for other assets are 8-10 times higher than mainstream currency markets.

The second is that it promotes the use of revolving loans as the main feature of its product interface, which encourages users to repeatedly cycle their assets as collateral for deposits and loans. By amplifying their “total borrowings” through revolving loans, users maximize their mining profits of the platform token Radiant. Essentially, the Radiant project team is indirectly selling the project token RDNT to users through collecting loan fees.

But the problem is that the source of Radiant’s fees – the users’ borrowing behavior – does not come from genuine organic loan demand, but in order to obtain RNDT tokens. This constitutes a “left foot stepping on the right foot” Ponzi economic structure. In this process, the lending platform does not have genuine “financial consumers”. 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 profit takers are the platform project team (which takes 15% of the interest income). Although the project team has delayed the short-term death spiral pressure caused by the decline of RDNT tokens through the dLP pledge mechanism, in the long run, unless Radiant gradually transitions its business from Ponzi to normal commercial models, the death spiral will eventually come.

But overall, decentralized lending markets, represented by Aave, a leading project, are gradually moving away from relying on high subsidies to sustain revenue and returning to a healthy business model.

The image below shows the changes in the active loan volume of the web3 lending market from May 2019 to October 2023, starting from a few hundred thousand dollars, reaching a peak of 22.5 billion dollars in November 2021, hitting a low of 3.8 billion dollars in November 2022, and now standing at 5 billion dollars. The lending market volume is slowly bottoming out and rebounding, demonstrating good business resilience in the bear market.

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

Obvious Moat, High Market Concentration

As a DeFi infrastructure, compared to the fierce competition in the Dex market, the moat of leading projects in the lending track is stronger, specifically:

1. More stable market share. The image below shows the changes in the percentage of active loan volumes for each project from May 2019 to October 2023. Since Aave’s strong performance in the middle of 2021, its market share has remained stable in the range of 50-60%, and although the second-ranked Compound’s share has been continuously squeezed, its ranking remains relatively stable.

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

On the other hand, the Dex market has seen more drastic changes in market share. After quickly capturing almost 90% market share in trading volume following its launch, leading project Uniswap’s market share dropped to 37% due to the rapid growth of Sushiswap, Curve, and LianGuaincakeswap. It has currently risen back to around 55%. Additionally, the number of projects in the Dex market is much higher compared to the lending market.

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

2. Lending projects have stronger profitability. As mentioned in the previous section, projects like Aave have already achieved positive cash flow without subsidizing lending activities, with monthly operating income ranging from $1.5 to $2 million from interest rate spreads. On the other hand, most Dex projects either haven’t started charging fees at the protocol level (only front-end fees are charged) or they operate at a loss due to the token emission value for liquidity incentives being much higher than the protocol’s fee income.

The moat of leading lending protocols can be broadly summarized as brand power in terms of security and can be further divided into the following two points:

Longstanding history of secure operations: Since the DeFi Summer in 2020, there have been numerous Aave or Compound fork projects established on various chains. However, most of them encountered coin theft or substantial bad debt losses shortly after their establishment. Aave and Compound, on the other hand, have yet to experience severe coin theft or unmanageable bad debt incidents. This long-term track record of safe operation 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 APYs, but it is difficult to gain the trust of users, especially whale users, without going through years of scrutiny.

More abundant security budget: Leading lending protocols have higher commercial income and ample treasury funds, which can provide abundant budgets for security audits and asset risk controls. This is crucial for the development of future new features or the introduction of new assets.

Overall, lending is a market that has proven to have a genuine demand, a healthy business model, and relatively concentrated market share.

The Business Scope and Operations of Morpho

Business Scope: Interest Rate Optimization

Morpho’s current online business revolves around a peer-to-peer lending protocol built on Aave and Compound, also known as an interest rate optimizer. Its purpose is to improve the efficiency of lending and borrowing funds in protocols like Aave, where the supply and borrowing funds do not match completely.

The value proposition is simple yet clear: to provide better interest rates for both lenders and borrowers, resulting in higher deposit returns and lower borrowing rates.

The inefficiency arises in the supply and borrowing funds due to the mechanism of Aave and Compound’s pool-to-pool model. The total supply (pool) of deposited funds is always greater than the total borrowing funds (tokens). In most cases, the USDT currency market may have a total supply of 1 billion, but only 600 million is borrowed.

For depositors, the idle 400 million funds are also used to distribute interest generated from the 600 million borrowed, resulting in lower interest for each individual. On the other hand, borrowers only borrow a portion of the funds from the pool, but are required to pay interest for the entire pool, resulting in higher interest burden. This mismatch between supply and borrowing funds leads to the problem.

Let’s take the interest rate optimizer module on Aave V2, which currently has the highest deposit volume, as an example to see how Morpho solves this issue.

• Depositing: Depositor BOB adds 10,000 Dai to Morpho, and Morpho first deposits the funds into Aave V2’s currency market at an interest rate of 3.67%.
• Borrowing Collateral: Borrower ALICE deposits 20 ETH as collateral into Morpho and requests to borrow 10,000 Dai. Morpho then deposits the collateral into Aave V2’s currency market.
• Matching Supply and Borrowing: Morpho retrieves the 10,000 Dai previously deposited by BOB into Aave and directly matches it with ALICE’s loan request. At this point, BOB’s deposit is fully utilized without any idle funds, and ALICE only pays interest for her borrowed 10,000 Dai instead of the entire pool. Therefore, in this matched scenario, BOB receives a higher deposit interest rate of 4.46%, compared to Aave’s pool-to-pool model of 3.67%. ALICE, on the other hand, benefits from a lower borrowing interest rate of 4.46%, compared to Aave’s 6.17%. Both parties enjoy optimized interest rates.

* Note: The 4.46% P2P interest rate in the example is determined by Morpho’s parameters, which are governed by the governance system, and it represents either the lower limit (deposit APY) or upper limit (borrowing APY) of the underlying protocol.

• Resolving Mismatches: In the scenario where BOB wants to withdraw the previously lent Dai but ALICE has not repaid it yet, and there are no other lenders on Morpho, Morpho will borrow 10000+ Dai using ALICE’s 20 ETH as collateral from Aave to facilitate BOB’s redemption.
• Matching Order: Considering gas costs, the P2P matching of supply and borrowing funds follows the rule of “matching with larger funds first.” The larger the supply and borrowing funds, the higher the priority for matching. This minimizes the gas consumption for each unit of funds. If the gas consumption for executing a match becomes disproportionately high compared to the matched funds, the match will not be executed to avoid excessive wear and tear.

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

From the explanation above, we found out that the essence of Morpho’s business is to use Aave and Compound as capital buffers and provide interest rate optimization services for borrowers and lenders through matching.

The cleverness of this design lies in how Morpho attracts funds from users through the composability of the DeFi world. The attractiveness for users is:

1. Even in the worst case, users can still obtain the same financial interest rates as Aave and Compound in Morpho, and when a match occurs, their returns/costs will be significantly optimized.

2. Morpho’s products are mainly built on Aave and Compound, and the risk parameters are completely copied and executed. Its funds are also allocated in Aave and Compound, thus inheriting the brand reputation of these two well-established protocols to a great extent.

This clever design and clear value proposition have allowed Morpho to obtain nearly $1 billion in deposits just over a year after its launch, ranking second only to Aave and Compound based on the data.

Business Data and Token Situation

Business Data

The chart below shows the trends in Morpho’s total deposits (blue line), total borrowings (light brown line), and matching amount (dark brown).

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

Overall, Morpho’s business scale continues to grow, with a deposit funding matching rate of 33.4% and a borrowing funding matching rate of 63.9%. The data looks pretty impressive.

Token Situation

Source: Official documentation

Morpho has a total token supply of 1 billion, with 51% belonging to the community, 19% sold to investors, and 24% owned by the founders and the development company Morpho Labs and operating organization Morpho Association. The remaining percentage is allocated to advisors and contributors.

It is worth mentioning that although Morpho tokens have been issued and applied in voting decisions and project incentives, they are in a non-transferable state. Therefore, there is no secondary market price for the tokens, and users and investors who receive tokens can participate in voting governance but cannot sell them.

Different from projects like Curve that hard code the future token issuance and incentives, Morpho’s token incentives are decided in batches, based on quarterly or monthly periods. This allows the governance team to flexibly adjust the intensity and specific strategies of incentives according to market changes.

I believe this is a more practical approach and may become the mainstream model for token incentive distribution in Web3 business in the future.

In terms of incentivized behaviors, Morpho incentivizes both borrowing and lending activities. However, currently, the distribution of Morpho tokens in incentives is not significant. In the past year, only 30.8 million tokens have been distributed, accounting for 3.08% of the total supply. Moreover, from the incentive periods and corresponding token distribution shown in the chart below, it can be seen that the official token expenditure on incentives is rapidly decreasing, but this reduction in expenditure has not slowed down the growth rate of Morpho’s business.

This is a positive signal, indicating that Morpho has a relatively solid product-market fit, and the demand from users is becoming more organic. Currently, the community token share is at 51%, leaving nearly 48% available for budget allocation in future new segments.

However, Morpho currently does not charge fees for its services.

Team and Financing

The core team of Morpho is from France, with most members based in Paris. The core members of the team have been verified, and all three co-founders have backgrounds in the telecommunications and computer industries, with experience in blockchain entrepreneurship and development.

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

Source: Official Website

If the above financing amounts correspond to the officially disclosed 19% investor share, the comprehensive valuation of the project would be approximately $100 million.

Morpho Blue and Its Potential Impact

What is Morpho Blue?

In simple terms, Morpho Blue is a permissionless lending infrastructure layer. Compared to Aave and Compound, Morpho Blue opens up most of the lending dimensions, allowing anyone to build lending markets based on Morpho Blue. The dimensions that builders can choose from include:

• What can be used as collateral
• What can be used as borrowed assets
• What oracle to use
• What is the loan-to-value ratio (LTV) and liquidation ratio (LLTV)
• What is the interest rate model (IRM) like

What value does this bring?

In the official article, the features of Morpho Blue are summarized as:

No trust required, because:

• Morpho Blue is not upgradable, no one can change it, following the principle of minimal governance
• Only 650 lines of Solidity code, simple and secure

Efficiency, 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
• Based on a simple code singleton smart contract (referring to a protocol that uses a single contract for execution, not a combination of multiple contracts, Uniswap V4 also uses singleton contract), which greatly reduces gas costs by 70%

Flexibility, because:

• Market building and risk management (oracles, lending parameters) are permissionless and no longer follow a unified pattern, the entire platform follows a set of standards set by a DAO (such as the models of Aave and Compound)
• Developer-friendly: Introduces various modern smart contract patterns, account management realizes GAS-free interaction and account abstraction, free flash loans allow anyone to access assets in all markets with a single call and repay in the same transaction

Morpho Blue adopts a similar approach to Uni V4, that is, it only serves as a fundamental layer for one type of financial services, and opens up the modules above the fundamental layer, allowing different people to provide services.

The difference from Aave is that although Aave’s fund deposit and borrowing are permissionless, everyone can decide what kind of assets to deposit and borrow in Aave, whether the risk control rules are conservative or aggressive, which oracle to use, and how to set the interest rates and liquidation parameters. These are determined and managed by the Aave DAO and various service providers behind the DAO, such as Gauntlet and Chaos, which monitor and manage over 600 risk parameters on a daily basis.

On the other hand, Morpho Blue is like an open lending operating system, where anyone can build their own preferred lending portfolio, just like Aave, and professional risk management institutions like Gauntlet and Chaos can seek partners in the market to sell their risk management services and earn corresponding fees.

In my opinion, the core value proposition of Morpho Blue is not just about trustlessness, efficiency, and flexibility. It provides a free lending market, making it convenient for participants in various stages of the lending market to collaborate and provide richer market choices for customers in each stage.

Will Morpho Blue pose a threat to Aave?

Possibly.

Morpho is different from many previous challengers to Aave and has gained some advantages over the past year or so:

• $1 billion in assets under management, which is now at a similar level to Aave’s $7 billion, although these funds are currently stored in Morpho’s rate optimizer feature, there are many ways to channel them into new features.
• Morpho, as the fastest-growing lending protocol over the past year, and with its token not yet in circulation, leaves a lot of room for imagination. The launch of its heavyweight new features can easily attract user participation.
• Morpho has a sufficient and flexible token budget, with the ability to attract users in the initial stage through subsidies.
• Morpho’s stable operating history and fund size have already built up a certain level of security brand.

Of course, this does not mean that Aave will definitely be at a disadvantage in future competition, as most users may not have the ability or willingness to choose services from many lending schemes. Currently, the output of lending products under the centralized management model of Aave DAO may still be the most popular.

Furthermore, Morpho’s rate optimizer largely inherits the security reputation of Aave and Compound, which gives more funds the confidence to gradually use it. However, Morpho Blue is a brand new product with separate code, so whales will inevitably have a period of hesitation before they feel comfortable investing. After all, the recent theft incidents in previous generations of permissionless lending markets like Euler are still fresh in memory.

Moreover, Aave has the capability to build a set of functionalities similar to Morpho’s rate optimizer on its existing platform to meet the demand for improving fund matching efficiency, squeezing Morpho out of the P2P lending market. Although this possibility seems unlikely at the moment, as Aave gave grants to a P2P lending product called NillaConnect in July of this year, similar to Morpho, instead of developing their own.

Finally, the lending business model adopted by Morpho Blue ultimately does not have a fundamental difference from Aave’s existing solution. Aave also has the ability to observe and mimic successful lending models on Morpho Blue.

However, regardless of the situation, after the launch of Morpho Blue, it will provide a more open lending experimental field, offering the possibility of participation and combination in the entire lending process. Will there be schemes emerging from these newly connected lending clusters that are strong enough to challenge Aave?

We will wait and see.

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