The risk of DeFi lies not in decentralization, but in its lack of decentralization. ???? Let's talk about Morpho, which has recently been in the spotlight.
I was researching how to build Delta-neutral and partially Delta-neutral strategies using Morpho. Unexpectedly, the series of stablecoin de-pegging and lending redemption incidents has thrust Morpho into the eye of the storm.
The value of financial instruments lies in improving capital efficiency.
By this standard, Morpho is an excellent project for improving capital efficiency. Morpho v1, building on the peer-to-peer lending models of Aave and Compound, matches peer-to-peer lending needs, reducing the interest rate spread between depositors and borrowers to zero.
Morpho Blue allows individuals or institutions to create lending markets for mainstream or long-tail assets without requiring a license, and allows customization of parameters such as collateral and liquidation loan-to-value ratio (LLTV).
This makes Morpho more than just a lending market. Users can use Morpho to freely create Delta-neutral or near-neutral return strategies, or hedge their exposure risk.
This is also why traditional institutions like BlackRock are promoting RWA – blockchain is a significant complement to traditional finance in terms of efficiency.
Morpho's exceptional composability and customizability also bring external risks. First, there's the moral hazard: in order to attract more deposits with higher returns, strategy creator Curator increased the liquidation loan-to-value (LLTV) ratio, effectively increasing leverage and raising the risk of revolving loans.
Secondly, there is the risk associated with collateral, specifically the risk arising from the underlying collateral in the lending yield pool. The lack of qualified collateral, especially the inherent risks and transparency of the collateral itself, is a significant factor currently hindering the development of DeFi.
This article will explore:
1) What is Morpho? What can be achieved with Morpho?
2) Risks of Morpho.
3) After events like USDe and xUSD, can we still trust DeFi? What are the real issues highlighted by these events?
What is Morpho? What can be achieved with Morpho?
Morpho offers two main options: Earn and Borrow.
On the Earn page:
1) Curator is the creator of the current lending yield pool.
2) Collateral is the collateral recovered from the current lending products. Collateral risk determines the risk of the strategy pool.
The core feature of Morpho Blue is the flexibility of Curator's customizable parameters. Curator can determine:
1) Accepted deposit types are usually stablecoins with good liquidity such as USDC.
2) Acceptable collateral can be mainstream assets such as ETH and WBTC, as well as long-tail assets and PT tokens. The collateral determines the risk of this strategy.
3) Deposit allocation strategy, i.e., which fund pools to allocate to earn returns. See the diagram below.
4) Oracle type, which can be Chainlink or TWAP, etc.
5) LLTV (Liquidation Loan-to-Value), which is the percentage of the collateral value at which liquidation is triggered. A higher value indicates a more aggressive approach and is more conducive to revolving loans.
6) Liquidation and punishment.
7) Cost structure. See the diagram below.
8) Supply ceiling.
9) Dynamically enable or disable this strategy based on market data.
etc.
Based on these custom modules, other project teams and organizations can implement different strategies:
1) Leveraging the future yield redemption features of Pendle PT-Token and LST, this allows these two tokens to be used as collateral, attracting deposits from stablecoins such as USDC and USDT. Essentially, it uses future yields as collateral to obtain current liquidity, thus constructing a bond market.
2) Increase LLTV, support stablecoins or PT-stablecoins as collateral, amplify leverage, and attract revolving loans.
3) Leverage the leverage of mortgage lending (especially revolving loans) to go long, short the equivalent asset on Hyperliquid, complete Delta-neutral hedging, and earn contract funding rates.
4) Establish a bilateral collateralized lending market between the new stablecoin and mature stablecoins such as USDT, USDC, and DAI, and combine the forward yield attributes of PT-Token to expand the liquidity of the new stablecoin.
Morpho's risks
1) Moral hazard
Moral hazard, also known as the "tragedy of the commons," refers to the situation where Curator, the creator of a yield strategy, deliberately increases the LLTV (Limited Lending Total Value) to encourage revolving lending and allocates funds to a higher-risk pool with a higher APY (Average Per Year) in order to obtain more management fees.
The higher the LLTV, the larger the revolving lending space, the higher the leverage, and the greater the risk. Typically, the LLTV of stablecoins and assets such as ETH in lending protocols like Aave and Compound is between 75% and 83.5%, while some pools in Morpho can exceed 90%.
However, Morpho has marked the LLTV value on its Earn page. The details page also indicates the allocation of funds and the collection of management fees.
2) Collateral Risk
The risk of collateral arises from the collateral backed by the yield pools created by Curator. This is especially true for new stablecoin projects, which often combine PT-tokens with future high yields to absorb current USDC and USDT liquidity, frequently accepting these new stablecoin PT-tokens as collateral. When the underlying mechanism of the new stablecoin encounters problems—such as the Delta-neutral hedging strategy or liquidation strategy failing—the yield pool will collapse.
Fortunately, the risks between Morpho's yield pools are isolated and will not affect the overall security of the protocol.
3) Excessive capital utilization leads to repayment problems.
In the peer-to-peer lending model, a common phenomenon is that for the same ETH pool, the deposit APY may be only 0.1%, but the borrowing rate can reach 2.7%.
To keep capital utilization below 100% and ensure funds can be deposited and withdrawn at any time, depositors contribute far more funds to the pool than are ultimately used. Therefore, a large amount of capital remains idle in the pool, resulting in an actual deposit APY lower than the borrowing APY.
If the Morpho pool's LTV (Limited Time To Value) is too high, it becomes overly favorable to revolving loans, sometimes leading to insufficient liquidity. In extreme cases, all funds may be in use, preventing depositors from withdrawing their funds.
After events like USDe and xUSD, can we still trust DeFi? What are the real issues behind these events?
I have always believed that the recent USDe and xUSD incidents have precisely exposed the problems brought about by centralization.
In fact, Ethena discloses detailed information about its reserves and the proportion of its holdings across various exchanges on its official website, https://app.ethena.fi/dashboards/transparency. This data has also been certified by oracle reserves, including those from Chainlink.
The de-pegging of USDe on Binance stemmed primarily from massive sell orders. These sell orders, coupled with withdrawal restrictions, triggered panic regarding the de-pegging. The source of these massive sell orders may involve vested interests, and the truth will likely never come to light.
However, the result was that USDe quickly returned to its peg—because on the Ethena website, USDe redemptions were normal and reserves remained at 100%.
Whether xUSD's de-pegging was triggered by excessive leverage and thus ADL remains to be seen and is only speculation; the truth is unknown.
Therefore, these events do not highlight the vulnerability of DeFi, but rather the vulnerability of CeFi and the lack of transparency in data and rules.
Morpho was originally developed to address the issue of capital utilization in the peer-to-peer lending model, where borrowing rates are significantly higher than deposit APY.
For example, in the same ETH pool, the deposit APY may be only 0.1%, but the borrowing rate can reach 2.7%.
To keep capital utilization below 100% and ensure readily available deposits and withdrawals, depositors provide far more funds than they actually use. As a result, a large amount of capital remains idle in the pool, and the actual deposit APY is lower than the borrowing APY.
On the other hand, peer-to-peer matching is inefficient, requiring both lenders and borrowers to agree on repayment time and amount of funds.
Morpho's design is ingenious—it leverages existing peer-to-peer lending protocols Compound and Aave to create a peer-to-peer lending market, resulting in zero interest rate spreads between lenders and borrowers.
Specifically, when a user deposits money into Morpho, Morpho will transfer the funds to Aave or Compound. If a loan request comes in, the user's needs will be matched first, and the interest rate will be optimized.
Let's say Alice is the first Morpho user and deposits 1 ETH. If no one else uses Morpho, after one year Alice will earn 0.1% annualized, which is no different from depositing directly into Compound.
Now, suppose Bob borrows 1 ETH through Morpho. These two users will be matched peer-to-peer. Within a year, Alice will earn a compromise annualized rate of 1.4%, and Bob's interest payment will also become 1.4%, instead of Compound's original 2.7%.
Therefore, the worst outcome of using Morpho for deposits and loans is using the current interest rates of Aave and Compound, but once the demand is matched peer-to-peer, an optimized interest rate can be obtained.
After 2024, the launch of Morpho Blue established Morpho as part of the DeFi infrastructure. Most importantly, despite having already issued its token, cashed out, and attracted billions of dollars in TVL, the project team continued to rebuild and improve the existing product rather than starting a new one, demonstrating that their ambitions extend beyond simply making money.
Going back to the beginning, if the value of financial instruments lies in improving capital efficiency, and the reason why institutions promote RWA is that blockchain can supplement the efficiency problems of traditional finance, then Morpho is an excellent project worth paying attention to and that fits the current narrative.
