Morpho: The Rising Star of Decentralized Lending Protocols

The funding capacity of lending protocols ranks first in the DeFi track, and it is the sector with the largest amount of funds absorbed in DeFi.

Morpho, a decentralized lending protocol, has experienced remarkable growth since receiving funding from a16z in mid-2022. Its innovative approach and adaptability to the evolving DeFi landscape have propelled it to become a leading protocol in the lending sector.

Morpho's journey can be broadly divided into two distinct phases, each characterized by a pivotal transition that has progressively elevated the protocol's market share.

Phase 1: Optimizing Aave and Compound for Rapid Growth

Initially, Morpho focused on enhancing the efficiency of capital utilization within lending protocols, particularly addressing the common issue of mismatched funds in peer-to-poor pool models like Aave and Compound. To optimize this aspect, Morpho introduced a peer-to-peer matching mechanism that offered users more favorable interest rates, both for deposits (higher) and loans (lower).

A key limitation of the peer-to-pool model lies in the frequent disparity between the total deposits and loans within a fund pool. This imbalance resulted in two main inefficiencies:

- Depositors' interest earnings were diluted by the presence of idle funds.

- Borrowers were charged interest on the entire fund pool, rather than just the portion they utilized.

Morpho's solution involved introducing a novel workflow that allocated users' deposits and collateral to Aave and Compound to establish baseline interest rates. Simultaneously, Morpho employed a peer-to-peer matching mechanism to prioritize large orders and directly allocate deposits to borrowers, minimizing the amount of idle funds. This approach ensured maximum utilization of deposits and enabled borrowers to pay interest only on the funds they actually borrowed, optimizing interest rates for both parties.

The primary advantage of this matching mechanism was its ability to eliminate the efficiency bottlenecks inherent in the traditional model:

- For users, the model offered an attractive proposition with higher deposit rates and lower borrowing rates, ultimately enhancing their capital efficiency.

- For lending protocols, the optimized capital utilization led to increased capital inflows and a boost in overall lending volume.

- As a protocol, Morpho positioned itself as a mediator that facilitated efficient capital flows between users and protocols, earning a portion of the interest spread as revenue.

Through innovative design, Morpho effectively harnessed the composability of DeFi protocols to attract more user funds at minimal risk and provided more efficient interest rate optimization services.

Phase 2: Transitioning from Applications to Decentralized Infrastructure

As mentioned earlier, the Morpho optimizer represented only the first transition in Morpho's evolution, enabling it to stand out among numerous lending protocols and become a significant player in the market. However, whether considering product design, protocol positioning, or openness to ecological development, the optimizer had limited potential for broader imagination.

Firstly, the growth of the optimizer was inherently constrained by the current design of the underlying lending pool, which relied heavily on its DAO and trusted contractors to monitor and adjust hundreds of risk parameters or large smart contracts on a daily basis. If Morpho remained static in this aspect, it would be unable to attract a wider range of dev and native protocols and could only be positioned as an ecological protocol of Aave and Compound in the market.

To overcome this limitation, Morpho adopted a product concept similar to that of Uni V4, essentially creating a base layer for a broad financial service and opening up all modules above this base layer. In other words, the team aimed to "minimize the product, which we call "primitive", and open all lending parameters to individuals and ecological protocols in a permissionless manner." By shifting the risk from the platform to third parties, Morpho's own ecological value would continue to expand.

But why did Morpho specifically choose to minimize the component and open the risk parameters to third parties?

The Morpho platform provided users with a completely autonomous construction space, where any individual or institution could自由に design and implement their own lending risk management mechanism. Professional financial institutions could also leverage the platform to collaborate with other market participants and generate fees by offering management services. Its permissionless nature empowered users to flexibly set various parameters and independently create and deploy separate lending markets without relying on external governance to add assets or adjust market rules. This flexibility granted market creators a high degree of freedom, enabling them to independently manage the risks and returns of lending pools based on their own risk assessments, ultimately catering to the diverse needs of different users in terms of risk preferences and usage scenarios.

However, upon closer examination, the trustless design was essentially a strategy to accumulate reputation and TVL at a low cost. Currently, there were hundreds of Vaults on Morpho, but among those listed on the Morpho interface, the majority were designed by risk management experts. While Morpho permitted anyone to create a Vault, this approach posed minimal risk to the protocol and offered a convenient method to increase TVL. Even if the majority of these Vaults ultimately failed, it would not significantly impact Morpho. Conversely, the Vaults that operated exceptionally well would stand out and be recognized as risk management experts, gaining access to the user volume generated by the Morpho platform. Prior to this development, Vaults created by individuals typically required a lengthy period