Reuniting Borrowers and Lenders on Defi

The advent of decentralized finance lending pools enabled the rise of a liquid decentralized money market. Improving DeFi lending in 2022 requires a revision of that advance and a return to the individual borrower and lender.

Paul Frambot co-founded Morpho, an Ethereum application that appends peer-to-peer borrowing and lending possibilities onto the lending pools of protocols such as Aave and Compound. Morpho’s goal, as he put it in an interview with CoinDesk, is to “make efficient lending a common good.”

Lending pools solve the shortfall in liquidity when matching individual lenders and borrowers. On Aave and Compound billions of dollars are held in lending pools, but this arrangement has its own costs.

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Pooled lending creates a notable spread between the interest rates that borrowers pay and lenders receive. Right now on Aave, lenders of USDC receive a variable interest rate of ~0.6% while borrowers pay a variable rate of ~1.7%.

Peer-to-peer lending brings rates in step, improving the transaction for both borrowers and lenders. But configuring it at scale has proven tricky. Luckily, Paul Frambot raised $20 million to solve just this issue.

It hasn’t been a simple fix. The Morpho white paper runs 19 pages long, and that’s the abbreviated version – an internal yellow paper proving Morpho’s math unfurls to 70 pages. Satoshi Nakamoto wrapped up the Bitcoin white paper in a tidy eight.

To be brief: In Aave and Compound, lenders pool their money and the borrowers take from these pools of funds. Large sums in the pool lie dormant, unborrowed. To keep the bargain interesting for all lenders, borrowers pay higher rates and lenders collectively share the total interest.

The arrangement hurts both parties, but without viable alternatives it has become the default. Morpho has found a clever workaround – it sits atop these pools and opportunistically matches individual lenders and borrowers when possible. When matching fails, the unpaired capital reverts to the Aave or Compound pools.

The one-to-one transaction principle seems simple enough and is thoroughly tested. Airbnb connects you to one shelter, Uber connects you to a single car; in no case would a vagrant pedestrian accept their fractional share of a pool of the available homes and cars. Frambot calls Morpho a “mathematical improvement of the underlying protocol.”

If Morpho creates a better bargain for both lender and borrower, who should be using Aave and Compound?

Well, Morpho has a thorny relationship with its pool-oriented peers. It relies on Aave and Compound pools when individual borrowers and lenders can’t be matched, but Morpho also hopes to siphon money from the pools into its own protocol. “The system is not generating more rewards,” says Frambot, “Aave users are just going to earn less and it’s going to be deposited to the Morpho users.”

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While the share of deposited funds that Morpho can match in a direct lender-borrower match differs depending on the asset, Frambot reported that at the time of the interview ~$150 million total was in Morpho and ~$30 million of that was matched peer to peer. That leaves a sizable sum to Aave and Compound.

Frambot resists stereotyping Morpho’s relationship with Aave and Compound as symbiotic or vampiric. He calls it neutral. “This is going to grow the overall pie because Morpho is going to give access to rates that were not possible before,” he says.

Morpho’s near-term goal is the education and evangelization of users. The protocol is complicated and exotic. The discerning lender must mull plenty of weekend reading before depositing.

In the long term, Morpho’s road map plays on the protocol’s eponymous creature, the Morpho butterfly. We live in the era of the Morpho caterpillar in the apple (who knew?), where the inchoate protocol simply seeks to prove its matching mechanism constitutes an improvement over present state lending.

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With luck, we’ll soon bear witness to the “chrysalis” and “butterfly” stages of development. Morpho plans to become (in the vein of UniSwap version 3) a protocol that improves the efficiency of their algorithms day over day and siphons funds from traditional finance.

Morpho needs to demonstrate its lending algorithms are competitive with those of traditional finance. From there, Frambot says, it can leverage DeFi’s inherent advantages. With lower infrastructure and development costs (and the inherent decentralization and transparency of DeFi), Morpho hopes to grow from niche crypto lending product to underpin lending operations of brand names in the finance world.

It’s an ambitious pursuit, though if it fails it won’t be for lack of effort. Baffled when asked what he does beyond crypto, Frambot coined the mantra, “Always build Morpho. Always. Always. Always.”