Delphi: Modular Lending is the Next Phase of the DeFi Market

Original Author: Delphi Digital

Original Compilation: Luffy, Foresight News

The DeFi lending industry has been sluggish, primarily due to the complexity of multi-asset lending pools and governance-driven project decisions. Our latest report explores the potential of a new type of lending product—modular lending—revealing its features, design, and impact.

Current State of DeFi Lending

DeFi lending protocols have become active again, with borrowing volume increasing by nearly 250% year-on-year, rising from $3.3 billion in Q1 2023 to $11.5 billion in Q1 2024.

At the same time, there is a growing demand to whitelist more long-tail assets as collateral. However, adding new assets significantly increases the risk of the asset pool, thereby hindering lending protocols from supporting more collateral assets.

To manage the additional risks, lending protocols need to adopt risk management tools such as deposit/borrowing limits, conservative loan-to-value (LTV) ratios, and high liquidation penalties. Meanwhile, isolated lending pools provide flexibility in asset selection but face issues of liquidity fragmentation and capital inefficiency.

DeFi lending is reviving from innovation, shifting from purely "permissionless" lending to "modular" lending. "Modular" lending caters to a broader asset base demand and allows for customized risk exposure.

The core of modular lending platforms lies in:

• A foundational layer that handles functions and logic
• An abstraction layer and aggregation layer that ensure user-friendly access to protocol features without adding complexity

The goal of modular lending platforms is to have foundational layer primitives with a modular architecture that emphasizes flexibility, adaptability, and encourages end-user-centric product innovation.

In the transition to modular lending, two major protocols worth noting are Morpho Labs and Euler Finance.

The following will highlight the unique features of these two protocols. We delve into the trade-offs required for modular lending to go beyond DeFi money markets, all unique features, improvements, and conditions.

Morpho

Morpho was initially launched as an enhancer of lending protocols and has successfully become the third-largest lending platform on Ethereum, with deposits exceeding $1 billion.

The solution for developing a modular lending market by Morpho consists of two independent products: Morpho Blue and Meta Morpho.

Morpho's Liquidity Amplification

Before Morpho Blue, liquidity fragmentation was a major criticism of isolated lending markets. However, the Morpho team addressed this challenge through aggregation at both the lending pool and vault levels.

Reaggregating Liquidity

Lending to isolated markets through the MetaMorpho vault avoids liquidity fragmentation. The liquidity of each market is aggregated at the vault level, providing users with withdrawal liquidity comparable to multi-asset lending pools while maintaining market independence.

Shared Model Expands Liquidity Beyond Lending Pools

The Meta Morpho vault enhances the liquidity position of lenders, making it superior to a single lending pool. The liquidity of each vault is concentrated on Morpho Blue, benefiting anyone lending to the same market.

The vault significantly enhances the liquidity of lenders. As deposits accumulate on Blue, subsequent users depositing funds into the same market increase the withdrawal funds for users and their vaults, releasing additional liquidity.

Euler

Euler V1 changed DeFi lending by supporting non-mainstream tokens and permissionless platforms. Euler V1 was phased out due to losses exceeding $195 million from a flash loan attack in 2023.

Euler V2 is a more adaptive modular lending primitive that includes:

(1) Euler Vault Kit (EVK): Allows for permissionless deployment and customization of lending vaults.

(2) Ethereum Vault Connector (EVC): Enables vaults to connect and interact, enhancing flexibility and functionality.

Euler V2 is set to launch this year, and we are curious how long it will take to establish itself in the competitive DeFi lending market.

Below is an overview of use cases for Euler V2, highlighting the unique DeFi products that can be achieved with the modular architecture of Euler V2.

Comparison of Morpho and Euler

When comparing Morpho and Euler side by side, the main differences become apparent as a result of different design choices. Both projects have designed mechanisms to achieve similar end goals, such as lower liquidation penalties, easier reward distribution, and bad debt accounting.

Morpho's solution is limited to isolated lending markets, a single liquidation mechanism, and is primarily used for lending ERC-20 tokens.

In contrast, Euler V2 supports lending using multi-asset pools, allows for customizable liquidation logic, and aims to serve as a foundational layer for all types of fungible and non-fungible token lending.