The origin of lending is related to the unbalanced development of production. In primitive society, people borrowed food, seeds, livestock, etc. The most primitive lending is Peer-to-Peer lending, which directly connects the needs of both parties and has high resource utilization efficiency.
Aave’s predecessor, ETHLend, began to try to move Peer-to-Peer lending to blockchain as early as 2017, which is what we call the “peer-to-peer” mode, but this mode has obvious limitations:
Low matching efficiency: the borrower and the lender must agree on the interest rate, loan period and other terms to successfully match.
Lack of instant liquidity: the lender has no way to withdraw the funds he/she lent at any time.
Limited loan period: the borrower theoretically has no way to achieve permanent borrowing.
High risk of default: if the borrower defaults, the lender can only obtain the borrower’s collateral. Once the price of the collateral falls sharply, the borrower’s willingness to default will be very high.
In the early days of DeFi development, such a “peer-to-peer” mode lacked the soil for development and the necessary infrastructure, so ETHLend turned to a new paradigm in time, which is the “peer-to-pool” lending mode adopted by Aave and Compound that we are familiar with today. This mode aggregates the funds of lenders to form a pool from which borrowers can obtain funds. All lenders in the pool share the same APY, regardless of whether the money is actually lent or not. For the borrower, permanent loan can be realized, as long as the corresponding interest is paid, the loaned funds can be used all the time. “Peer-to-pool” also provides instant liquidity for both borrowers and lenders. Lenders can provide and withdraw funds at any time, and borrowers can also realize borrowing and repayment at any time. Although the advantages of this mode are obvious, its disadvantages are gradually emerging:
Low capital efficiency: a large amount of funds are deposited in the pool and have not been lent out, failing to leverage more borrowing demand.
Large spread in lending interest rates: it is precisely because a large amount of funds are in the pool, but all lenders share interest rates, resulting in high borrowing costs for borrowers and low borrowing income for lenders.
Is there a way to combine the advantages of these two modes, which can increase the efficiency of capital while ensuring immediate liquidity and narrowing the spread? Morpho has their own answer.
Morpho, a “peer-to-peer” layer built on top of lending protocols like Compound and Aave, is currently available on the ethereum mainnet. Its essence is to implement a layer of matching logic on the underlying protocol, and Morpho defines a fair interest rate to allow willing borrowers and lenders to achieve matching.
Due to the existence of small amounts of funds, it is likely that one lender will match multiple borrowers or one borrower will match multiple lenders, which may lead to high gas fees. In order to avoid the loss of users caused by this situation, Morpho has set a maxGasForMatching in the protocol.
If no counterparty is found or when the gas fee for matching exceeds the maxGasForMatching set by Morpho, the loan demand will be moved to the underlying lending protocol Aave or Compound. This fair interest rate is shared by both borrowers and lenders, and users who achieve Peer-to-Peer matching can enjoy lower loan costs/higher borrowing income than Aave and Compound.
If a user’s loan demand is only partially matched in P2P, and the remaining demand is transferred to the underlying protocol pool, the user’s comprehensive interest rate will be slightly worse than the P2P interest rate, but it is also better than direct lending in Compound/Aave.
Considering the gas cost and operational feasibility on Ethereum network, the current matching or un-matching logic of Morpho P2P mainly prioritizes large funds (for AaveV2 and Compound pool).The larger the amount, the higher the matching order.
For the Morpho-AaveV3-ETH lending pool, the matching mechanism also considers “Logarithmic Buckets”, that is, to match demands with similar amounts, making the use of funds more efficient.
The P2P APY is initially calculated as follows:
p2pRate = α * poolBorrowRate + (1-α) * poolSupplyRate
Where:
α is called the peer-to-peer index cursor, set by Morpho Dao.
poolBorrowRate and poolSupplyRate correspond to the underlying pool’s Borrow and Supply rates. Morpho updates this information every time one of Morpho’s functions is called by anyone or if someone directly calls the Update function.
When Delta Mechanism is triggered, the P2P APY will be adjusted accordingly by DAO (See the next section for details).
Unlike traditional P2P lending, Morpho can provide users with instant liquidity due to the existence of the underlying protocols.
If there is an existing P2P matched order, and the supplier/borrower wants to redeem/repay, the system will first look for a matching P2P counterparty in the system. If there is, it will re-match the loan. If not , then the Feedback Mechanism will start, and Morpho will obtain/provide liquidity in the underlying protocol to meet the needs of users.
A specific example:
User 1 deposited 60 USDC in Morpho. This 60 USDC is matched to 6 debits via P2P mode, as follows:
Now that User1 wants to withdraw funds, but none of the six borrowers have paid, the following will happen:
Scenario 1: There are sufficient lenders to take over these loans, User1 gets the USDC from the new lender and exits smoothly, and the loan interest rate of the remaining 6 users remains unchanged.
Scenario 2: Some lenders take over the loans of the first three users, User1 gets the USDC from the new lenders, and the loan interest rate of the first three users remains unchanged.The remaining three users are removed from P2P matching, their collateral are transferred to the underlying protocols and lend USDC to return it to User1. The borrowing rate of these three users is adjusted to be consistent with the underlying protocol.
Scenario 3: Due to the lack of liquidity in Morpho, the loans of these 6 borrowers are not rematched, and the unwinding process does not reach the maxGasForMatching and all are returned to the underlying pool. Thus, the borrowing rates of these 6 borrowers are converted from P2P APY to Pool APY.
Scenario 4: All the collateral of User2-User7 has been returned to the underlying protocol to meet the liquidity needs of User1, but due to maxGasForMatching, only 3 users can cancel the P2P matching.
The P2P matching of the remaining 3 users should actually be removed, but GasLimit is still recorded as the P2P matching state in Morpho.
The P2P account in Morpho now is supposed to be 0, but there are still 30 registered. Morpho uses Delta to describe this difference. In fact, User5-User6 should enjoy On-Pool APY, but their status is still P2P matching, and they enjoy a lower APY, there is a spread. when Delta is not 0, Delta Mechanism will be triggered, the agreement will adjust the APY of all P2P matching remaining users to match the actual interest rate.
Using the underlying protocol as a liquidity pool, Morpho solves the problem that traditional “peer-to-peer” lending mode cannot be withdrawn at any time.
Morpho has its own liquidation mechanism, which replicates the exact same mechanism as the underlying protocols (Compound and Aave). With its own set of liquidation bots that attempt to circumnavigate the risk of a “peer-to-peer” agreement in which borrowers are only given depreciated collateral if they default.
For quotation, Morpho uses the same oracles as the underlying protocol, and the price changes exactly as the underlying protocol.
Risk Alert: Morpho’s liquidation risk comes from the underlying lending protocol.
Morpho’s total supply of tokens is one billion, with 19% sold to early investors in 2021 and 2022. In July 2022, Morpho received $18 million in funding led by a16z and Variant, with an undisclosed amount of token sales.
Morpho DAO began distributing tokens to Founders, Morpho Labs, and Independent Contributors and Advisors on December 25, 2022. This portion of the token has a six-month lock-up period, followed by a 30-month vesting period.
51% of the tokens are for Communities, and Morpho’s release program is long-term and divided into seven ages.
It is currently at Age 6, having released a total of 28.1 million tokens prior to this. Age6, which plans to emit 1 million tokens, began on 06/07/2023 and will end on 20/07/2023. This emission will focus on the incentive distribution on the market activated by peer-to-peer matching. And emphasis is placed on WETH’s distribution of rewards on the supply side of the market, not on the borrower side.
So far, Morpho’s Total Supply exceeds 850m, Total Borrow exceeds 410m, and the capital utilization rate is about 48.5%, which is higher than that of many peer-to-pool lending protocols.
For the user, Morpho gets at least the same rewards as Aave and Compound, with a higher credit APY and a lower debit APY if the match is successful, as well as mining rewards.
At present, the matching rules of the protocol give priority to large funds, which is very friendly to large funds users. Thus, customers with large amount of capital can participate in the platform to gain a higher yield and obtain token incentives.
As more lending agreements will be added, Morpho is expected to leverage more lending demand.
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Thanks to Vertex for the image data of Cover Page.
❗Risk Warning: This report is an internal analysis by Brillian Research and is not intended as investment advice. The cryptocurrency market is a high-risk investment and investment assets are subject to various possibilities of loss and return to zero, so please be aware of the risks!