Key Insights
- Morpho is an Ethereum-based lending pool optimizer, providing better rates for lenders and borrowers by matching them peer-to-peer rather than peer-to-pool.
- There are currently over 2,000 outstanding peer-to-peer loans facilitated through Morpho’s two instances, with $380 million in total value supplied (TVS).
- The Morpho token (MORPHO) is currently non-transferable and follows a unique emission schedule based on ages and epochs voted on by the DAO.
- A seven-step process has been outlined to slowly phase out the Morpho team’s control over the protocol and reach a level of sufficient decentralization.
What Problem Does Morpho Address?
Lending protocols have grown to be one of DeFi’s most successful primitives, with over $5 billion in total value supplied. A good case study of the industry’s history is Aave. Starting as ETHlend, it was designed to match lenders and borrowers peer-to-peer (P2P). This was revolutionary because it allowed users to borrow and lend directly to one another, achieving market-based rates and a high level of capital efficiency. The optimization has a tradeoff: it falls short in attracting enough liquidity for users to enter in and out of borrows seamlessly.
With this issue in mind, lending protocols shifted their focus from a peer-to-peer lending model to a peer-to-pool lending model. This is most familiar today on protocols such as Aave and Compound, and it solves the liquidity problem. Lenders can deposit their assets into a liquidity pool to earn a yield, while borrowers can tap into this liquidity when they want to take out a loan. As a result of using a pool of funds, these lending protocols can offer on-demand liquidity with interest paid by borrowers, socialized among lenders.
The tradeoff? Reduced capital efficiency. Spreads on Aave’s largest lending pools were at times over 250 bps in 2022. Variable pool utilization leads to unpredictable rates and a necessarily wide spread between borrowing and lending rates.
With these inefficiencies in mind, Morpho builds upon pre-existing lending protocols such as Aave and Compound acting as a lending pool optimizer. Composability to the rescue.
Morpho offers users access to Aave and Compound through their front end at the same rates they would get by accessing either protocol directly – there is no additional fee for using Morpho. When possible, Morpho will match users peer-to-peer, meaning instead of a user borrowing from a liquidity pool they are borrowing directly from another user. Morpho brings capital efficiency to the lending pool model.
How Does Morpho Work?
Currently, Morpho optimizes Aave and Compound on the Ethereum blockchain, although it could work with any existing peer-to-pool lending protocol. These two markets are denoted by Morpho-Aave and Morpho-Compound and can be accessed through the Morpho front end.
Any time a user enters or exits a given market, Morpho relies on its matching engine to match users peer-to-peer. For example, when a lender deposits into Morpho, the matching engine is triggered and looks for potential liquidity on the borrow side to pair with. If a match cannot be made, those assets are deposited into the pools depending on which instance the user chooses. At this point, Morpho depositors inherit the same liquidation conditions, collateral factors, token incentives, and price oracles of the underlying lending protocol they choose, Aave or Compound. However, if later on a Morpho borrower can be matched with a Morpho lender, Morpho will withdraw liquidity from the pool and pair the borrower and lender directly, all done without any additional transactions from the user’s side.
When matching lenders and borrowers, it does not have to be a direct 1:1 match. Meaning, if a user wants to borrow 1000 ETH, it can be sourced from multiple lenders starting with the largest lender first. Utilizing its unique matching engine, Morpho matches lenders and borrowers from largest to smallest to minimize gas spent on matching while maximizing matched volumes. Additionally, if there are not enough Morpho lenders to completely fill a requested borrow P2P, Morpho can fill some of the loan through P2P matching while utilizing Aave or Compound for the remainder of the loan resulting in a blended rate.
Now, if a lender matches P2P with a borrower and wants to withdraw their funds before the borrow is repaid, the protocol will attempt to match the borrower with another lender before reverting to the peer-to-pool model. If Morpho is forced to fall back to the underlying pool, this triggers the fallback mechanism reverting to the peer-to-pool model.
Morpho Tokenomics
To incentivize usage and decentralization, Morpho distributes MORPHO token rewards for using the protocol. Currently, MORPHO is non-transferable, but this can be changed in the future by the community with a governance vote. In its current state, the sole utility of MORPHO is for the governance of the protocol.
With most DeFi protocols, token emissions are generally planned years in advance. However, this is not the case with MORPHO. The Morpho team wanted to maintain flexibility with token incentives and, therefore, implemented a system of ages and epochs. Ages occur every three months, and the community votes on the number of tokens to be emitted for each age. Within the ages are three epochs, and these are periods where users can claim their MORPHO rewards. Furthermore, at each epoch MORPHO token holders will vote on gauges that direct token incentives for specific pools, with the first gauge vote taking place before the first epoch of Age 3.
To date, there have been two ages with the third to begin on Dec. 29, 2022. Five million MORPHO were emitted in the first age, while ten million MORPHO were emitted in the second. Voting for the third age completed on December 4, and a further ten million MORPHO will be emitted as a result. The maximum total supply for MORPHO is 1 billion. Therefore, by the end of the third age, 2.5% of the total supply will be in circulation.
The DAO also maintains the ability to activate protocol fees. These fees, if turned on, would be taken from the spread on the peer-to-peer APY and distributed to the protocol reserve. There would not be a fee for users matched peer-to-pool, as Morpho ensures that the rate you receive is the same as what is offered by the underlying protocols directly, plus additional MORPHO token incentives.
Road to Decentralization
When building the Morpho protocol, the team created a 7-step process to reach what they consider a sufficient level of decentralization. This began with the deployment of the protocol in June 2022, with ownership transferred to a 5/9 multisig. The multisig is responsible for replicating the voting of the community on snapshot. Furthermore, there is a second 3/5 multisig that is assigned certain emergency functionality like pausing or unpausing markets, updating non-critical matching engine parameters or enabling peer-to-peer matching for specific markets.
Using a multisig that replicates voting on snapshot is similar to what most protocols practice, but the integration of Gnosis Zodiac that over time will levy a system of checks and balances, distinguishing it from other protocols. Gnosis Zodiac is advertised as an “expansion pack” for DAOs that provides a collection of tools built according to an open standard. Some of the benefits of the Gnosis Zodiac implementation in its final stages are:
- Role Modifier – allows the DAO to give a multisig specific functionalities like pausing markets, as seen with the 3/5 multisig.
- Reality Module – enables the execution on-chain of voting that was done off-chain on apps like Snapshot or Discord. It also allows the DAO to separate proposals into “Low Consensus Proposals” and “High Consensus Proposals,” enabling different voting timelines and quorums needed to pass proposals.
- Scope Guard – enables the community to vote and limit the actions of multisig signers (an example could be only allowing multisig signers to veto votes).
- Bridge Module – this module allows the DAO on Ethereum to control the assets and systems on a different chain if it chooses to operate on different blockchains.
Over time, the goal is for the team’s responsibility to slowly phase out and for all protocol decisions to be made by the DAO. Although there is no specific timeline noting when this will occur, this will be something to watch as the protocol continues to grow.
Risks and Competition
As with any DeFi protocol, smart contract vulnerabilities are the primary risk. Operating atop lending protocols, Morpho inherits the risks involved with those protocols in addition to the risks involved with Morpho’s own smart contracts. As such, it should be noted that Morpho is currently integrated on Aave and Compound, two protocols with 15 audits between them. On Morpho’s side, +10 audits have been completed.
In addition to smart contract vulnerabilities, another risk for Morpho is the ability to handle liquidations in scenarios of high volatility. Morpho has its own liquidators for their P2P markets in addition to the liquidators it relies on from the underlying protocols it utilizes. As Morpho relies on the liquidators of the underlying protocols it utilizes, there is the possibility of accumulating bad debt, as seen recently on Aave with their CRV market. Morpho has additional risk in its peer-to-peer markets. These markets do not inherit Aave or Compound’s liquidators as Morpho’s P2P markets have their own set of liquidators, which for the P2P markets were solely run by the Morpho team until the recent release of an open-source repository for a liquidation bot.
Regarding competition, since Morpho functions as a lending pool optimizer, it acts rather symbiotically with existing lending protocols. The Morpho front end provides users with a one-stop solution for comparing rates on the two most popular lending protocols. As it stands, Morpho is the only protocol that optimizes atop existing lending protocols, and as a result, it does not have any direct competition.
Final Thoughts
With over $380 million in TVS and over 2,000 peer-to-peer loans currently active, Morpho has already achieved a great deal of success in its short lifetime. The benefits of the protocol are simple: better rates for borrowers and lenders while maintaining the same on-demand liquidity and risk parameters of the underlying protocol. With no protocol fees and a non-transferable native token, the emphasis with Morpho is to provide an optimal experience for DeFi users – not to extract value wherever possible. As Morpho continues to develop, success may look like higher levels of P2P matching, increases in TVS, and the implementation of the 7-step decentralization process.
