What is Modular Lending and Could It Be the Next DeFi Trend?

Chris Powers compares traditional DeFi lending leaders (MakerDAO, Aave, and Compound) with several major modular lending projects, including Morpho, Euler, and Gearbox, highlighting the positive impact of modular lending on risk management and value flow in the DeFi world.

An ancient concept in both business and technology is that there are only two ways to make money: bundling and unbundling. This is even more evident in the world of cryptocurrency and DeFi due to its permissionless nature.

In this article, we will explore the rising trend of modular lending (and those who have already entered the post-modular era) and examine how it is disrupting mainstream DeFi lending. With unbundling, new market structures form new value flows—who will benefit the most?

Modular Lending Projects

A significant unbundling has already occurred at the core infrastructure level. Previously, Ethereum had a single solution for execution, settlement, and data availability. However, it has now adopted a more modular approach, providing dedicated solutions for each core element of the blockchain.

The same scenario is unfolding in the DeFi lending sector. Initially successful products were comprehensive, despite the numerous moving parts of the first three DeFi lending platforms—MakerDAO, Aave, and Compound—they all operated within predefined structures set by their core teams. However, today, the growth of DeFi lending comes from a new batch of projects that are breaking down the core functions of lending protocols.

These projects are establishing independent markets, minimizing governance, separating risk management, relaxing oracle responsibilities, and eliminating other single dependencies. Other projects are building easy-to-use bundled products that combine multiple DeFi components to offer more comprehensive lending products.

This new drive to unbundle DeFi lending has become the meme of modular lending. At Dose of DeFi, we love memes, but we also see new projects (and their investors) trying to hype the market with new topics rather than genuine innovation (consider DeFi 2.0).

Our View: The Hype is Not Fiction

DeFi lending will undergo a transformation similar to the core technology layer, like Ethereum, with new modular protocols emerging, such as Celestia, while existing leaders adjust their roadmaps to become more modular.

In the short term, the main competitors are forging different paths. New modular lending projects like Morpho, Euler, Ajna, and Credit Guild are succeeding, while MakerDAO is adopting a more decentralized SubDAO model. Additionally, the recently announced Aave v4 is also moving towards modularity, echoing Ethereum's architectural shift. The paths being forged today may determine the value accumulation in the DeFi lending stack in the medium to long term.

According to Token Terminal data, there has always been a question of whether MakerDAO belongs to the crypto DeFi lending market or the stablecoin market. However, with the success of the Spark Protocol and the growth of MakerDAO's RWA (Real World Assets), this will no longer be an issue in the future.

Why Choose Modular?

There are two main strategies for building complex systems. One is to focus on the end-user experience, ensuring that complexity does not affect usability, which means controlling the entire tech stack (like Apple through hardware and software integration).

Another strategy is to let multiple participants build various components of the system. In this approach, the central designers of the complex system focus on establishing core standards for interoperability, relying on the market for innovation. This can be seen in core internet protocols, which remain unchanged while applications and businesses based on TCP/IP drive internet innovation.

This analogy also applies to economies, where the government is seen as the foundational layer, similar to TCP/IP, ensuring interoperability through the rule of law and social cohesion, while economic development occurs in the private sector built upon the governance layer. Many companies, protocols, and economies operate somewhere between these two methods.

Unbundling Analysis

Proponents of modular lending theory believe that DeFi innovation will be driven by specialization in each part of the lending stack rather than solely focusing on the end-user experience.

A key reason is to eliminate single points of failure. Lending protocols require close risk monitoring, and a minor issue can lead to catastrophic losses, so establishing redundancy mechanisms is crucial. Single-structure lending protocols often introduce multiple oracles to prevent a single failure, but modular lending applies this hedging method to every layer of the lending stack.

For each DeFi loan, we can identify five essential but adjustable components:

1. Loan Asset
2. Collateral Asset
3. Oracles
4. Maximum Loan-to-Value (LTV) Ratio
5. Interest Rate Model

These components must be closely monitored to ensure the platform's solvency and prevent bad debt accumulation due to rapid price changes (we could also add the liquidation system to the above five components).

For Aave, Maker, and Compound, token governance mechanisms make decisions for all assets and users. Initially, all assets were combined, sharing the system's overall risk. However, even single-structure lending protocols quickly began establishing independent markets for each asset to isolate risk.

Understanding the Major Modular Players

Isolating markets is not the only way to make your lending protocol more modular. True innovation is happening in new protocols rethinking the essential components of the lending stack. The biggest players in the modular world are Morpho, Euler, and Gearbox:

Morpho

Morpho is currently the clear leader in modular lending, although it seems uncomfortable with this label recently, trying to become "non-modular, non-single-structure, but aggregated." With a total value locked (TVL) of $1.8 billion, it undoubtedly ranks among the top DeFi lending platforms, but its ambition is to become the largest.

Morpho Blue is its main lending stack, where a vault optimized based on desired parameters can be established without permission. Governance only allows modifying some components, currently five different components, without specifying what those components should be.

This is configured by the vault owner (usually a DeFi risk manager). Morpho's other main layer, MetaMorpho, aims to be an aggregated liquidity layer for passive lenders, focusing specifically on the end-user experience. It's akin to Uniswap on Ethereum's DEX, with Uniswap X for efficient trade routing.

Euler

Euler launched its v1 version in 2022, generating over $200 million in outstanding contracts, but a hack almost drained all protocol funds (although they were later returned). Now, it's preparing to launch v2 and re-enter the mature modular lending ecosystem as a major player.

Euler v2 has two key components. One is the Euler Vault Kit (EVK), a framework for building compatible ERC4626 vaults with additional lending features, allowing it to function as a passive lending pool, and the other is the Ethereum Vault Connector (EVC), an EVM primitive mainly implementing multi-vault collateral, i.e., multiple vaults can use collateral from one vault. v2 is planned for release in the second or third quarter.

Gearbox

Gearbox provides a user-centric clear framework where users can easily set up positions without much supervision, regardless of their skill or knowledge level.

Its main innovation is the "credit account," a list of allowed operations and whitelisted assets denominated in borrowed assets. It's essentially an independent lending pool, similar to Euler's vault, except Gearbox's credit account combines user collateral and borrowed funds in one place. Like MetaMorpho, Gearbox demonstrates that in the modular world, there can be a layer focused on bundling for the end-user.

Unbundling and Then Rebundling Specialization in parts of the lending stack offers opportunities to build alternative systems targeting specific segments or future growth drivers. Here are some leading pioneers adopting this approach:

Credit Guild Credit Guild intends to enter the established pooled lending market through a trust-minimized governance model. Existing participants, like Aave, have very strict governance parameters, often leading to apathy among small token holders as their votes seem to make little difference.

Therefore, an honest minority controlling most tokens is responsible for most changes. Credit Guild disrupts this dynamic by introducing an optimistic, veto-based governance framework that specifies various quorum thresholds and delays for different parameter changes, combining a risk response approach to handle unforeseen consequences.

Starport

Starport aims to develop cross-chain. It implements a basic framework for integrating different types of EVM-compatible lending protocols. It handles data availability and term enforcement through two core components:

1. Starport Contract - Responsible for loan origination (term definition) and refinancing (term update). It stores data for protocols built on Starport Core and provides this data when needed.
2. Custody Contract - Primarily holds collateral for borrowers originating protocols on Starport, ensuring debt settlement and closure according to the terms defined in the originating protocols and stored in the Starport Contract.

Ajna

Ajna offers a truly permissionless, oracle-free pooled lending model with no governance at any level. Pools are established based on the specific pair of lender/borrower provided quotes/collateral assets, allowing users to assess asset demand and allocate capital. Ajna's oracle-free design stems from lenders being able to determine borrowing prices by specifying the number of collateral assets each quote token from the borrower should cover. This is particularly attractive for long-tail assets, similar to what Uniswap v2 did for small tokens.

Joining Forces if You Can't Beat Them

The lending sector has attracted many new entrants and re-energized the largest DeFi protocols to launch new lending products:

Aave v4, announced last month, is very similar to Euler v2. Previously, Aave's ardent supporter Marc "Chainsaw" Zeller stated that Aave v3 would be Aave's final version due to its modular nature. Its soft liquidation mechanism was first pioneered by Llammalend (see below); its unified liquidity layer also resembles Euler v2's EVC. While most upcoming upgrades aren't novel, they haven't been widely tested in a highly liquid protocol (which Aave already is). Aave's success in gaining market share on each chain is incredible. Its moat may not be deep, but it's wide, giving Aave a strong tailwind.

Curve, colloquially known as Llammalend, is a series of isolated, one-way (non-borrowable collateral) lending markets where crvUSD (already minted), Curve's native stablecoin, is used as collateral or debt asset. This allows it to combine Curve's expertise in automated market maker (AMM) design to offer unique lending market opportunities. Curve has always operated uniquely in the DeFi space, but this has worked well for them. Besides the giant Uniswap, Curve has carved out a significant niche in the decentralized exchange (DEX) market and rethought its token economics through the success of the veCRV model. Llammalend seems to be another chapter in Curve's story:

Its most interesting feature is its risk management and liquidation logic, based on Curve's LLAMMA system, enabling "soft liquidation."

LLAMMA is implemented as a market-making contract that incentivizes arbitrage between isolated lending market assets and external markets. Similar to concentrated liquidity AMM (clAMM, e.g., Uniswap v3), LLAMMA evenly deposits the borrower's collateral within user-specified price ranges (called tranches), which diverge significantly from oracle prices to ensure consistent arbitrage incentives.

In this way, when the collateral asset price drops below the tranche, the system can automatically convert part of the collateral into crvUSD (soft liquidation). Although this method reduces overall loan health, it is much better than full liquidation, especially considering the explicit support for long-tail assets.

Since 2019, Curve founder Michael Egorov has deflected over-engineering criticism.

Curve and Aave both place significant emphasis on their respective stablecoins' development. This is a long-term effective strategy that can generate substantial revenue. Both are following MakerDAO's approach. MakerDAO has not abandoned DeFi lending and has launched the standalone brand Spark.

Despite the absence of native token incentives (not yet), Spark has performed very well over the past year. Stablecoins and immense monetary creation capacity (credit is a powerful drug) are significant long-term opportunities. However, unlike lending, stablecoins require on-chain governance or off-chain centralized entities. For Curve and Aave, this path makes sense as they have some of the oldest and most active token governance (of course, second only to MakerDAO).

What is Compound Doing?

We currently cannot answer what Compound is doing. It was once the leader in the DeFi space, initiating the DeFi summer and establishing the concept of yield farming. Clearly, regulatory issues have limited the core team's and investors' activity, leading to its declining market share.

However, like Aave's broad yet shallow moat, Compound still has $1 billion in outstanding loans and extensive governance distribution. Recently, development has continued on Compound outside the Compound Labs team. We're not sure which market it should focus on—maybe the large blue-chip market, especially if it can gain some regulatory advantages.

Value Accrual

The top three DeFi lenders (Maker, Aave, Compound) are adjusting strategies to respond to the shift towards modular lending architectures. Lending against crypto collateral used to be a good business, but when your collateral is on-chain, the market becomes more efficient, squeezing profits.

This doesn't mean there are no opportunities in an efficient market structure; it just means no one can monopolize their position and extract rents.

The new modular market structure provides more permissionless value capture opportunities for private enterprises like risk managers and venture capitalists. This makes risk management more practical and translates directly into better opportunities as economic losses significantly impact vault managers' reputations.

The recent Gauntlet-Morpho incident is a great example of this during the ezETH de-pegging process.

During the de-pegging, the seasoned risk manager Gauntlet operated an ezETH vault, suffering losses. However, due to clearer and more isolated risks, users of other metamorpho vaults were mostly unaffected, while Gauntlet had to provide post-event assessments and take responsibility.

Gauntlet initially launched the vault because it saw better future prospects on Morpho, allowing it to directly charge fees rather than providing risk management advisory services to Aave governance (which is more politically focused than risk analysis, you try tasting or drinking "Chainsaw").

Just this week, Morpho founder Paul Frambot revealed that a smaller risk management firm Re7Capital, also a company with excellent research newsletters, earned an annualized on-chain income of $500,000 as a Morpho vault manager. While not enormous, it shows you can build a financial company on DeFi (not just a wild yield farm).

This does raise some long-term regulatory issues, but that's commonplace in today's cryptocurrency world. Moreover, it won't stop risk managers from becoming one of the biggest beneficiaries of modular lending in the future.