Morpho Labs: optimized crypto lending and APY

Updated 20 Sep. 2022 at 2:18 p.m.

Although its Morpho protocol is still in its infancy, the fact remains that Morpho Labs is starting to get people talking about it. Its innovation makes it an interesting DeFi protocol. Acting as an additional layer of optimization on the Aave and Compound protocols, its objective is to maximize the gains of its users around an advantageous lending/borrow system. Here’s everything you need to know about this high-potential DeFi protocol.

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What is Morpho the French DeFi protocol?

Morpho is the flagship protocol supported by Morpho Labs. Launched in 2021, it is the work of a 21-year-old French student.

This DeFi protocol is based on a mechanism of lending/borrowtranslated as lending/borrowing, in peer to peer (P2P) and operates on the Ethereum blockchain. Based on a live, user-to-user exchange system, it works as an additional layer Aave and Compound protocols.

The idea of ​​Morpho comes from an observation made by its founder. Indeed, by analyzing DeFi lending protocols, he found that the spread between the borrowing rate and the lending rate was relatively high. In other words, there is a significant difference between the rate paid by borrowers and the reward rate obtained by liquidity providers.

In the example displayed on the Morpho Labs White Paper on the Compound Protocol, liquidity providers on ETH get 0.25% APY as a reward for their effort. For their part, borrowers must pay 3.41% interest. The difference is therefore substantial and this observation is identical in other pools.

However, in a context of decentralization and the elimination of third parties, lenders and borrowers should be in direct and APYs should be identical on one side or the other. It is therefore surprising to observe such a large spread.

This difference, this spread, is none other than the result of the operation in Peer-to-Pool of Aave and Compound.

Indeed, by following this model, two essential elements must be understood:

  • By definition, users are not not directly related. Liquidity providers supply pools. Borrowers help themselves to the pool.
  • The protocol requires the borrower to provide collateral in order to encourage him to repay his loan. When this moment arrives, the interest he pays is reinjected into the pool and then redistributed proportionally to the suppliers. These interests are socialized.

In reality, pools work like liquidity reserves and the supply is, in theory, always greater than that of the demand for borrowing. The major advantage of this mechanism lies in the fact that the stakeholders have the possibility of resume their cash at any time.

Thus, lending rates are systematically lower than borrowing rates. This has two drawbacks:

  • Liquidity providers receive fees diminished yields ;
  • Borrowers pay very high interest.
Peer-to-pool protocol - Morpho Labs
Simplified diagram of how Peer-to-Pool works. Since there are more liquidity providers, they share the interest paid by borrowers, which considerably reduces their rewards

A win-win system

The Morpho protocol from Morpho Labs intervenes with the aim of reduce this gap to eventually make it zero. With this in mind, borrowers and lenders have the opportunity to obtain the best interest rates. Borrowers pay less interest and lenders earn more.

This vision win-win (win-win) is ensured by an innovative mechanism: the matching system.

As its name suggests, correspondence tends to pair a liquidity provider with a borrower user dynamically.

Let’s take a concrete example.

User A wishes to provide liquidity for an amount of 10 X cryptos. If no borrower can match, then the Morpho Labs protocol will deposit their 10 X cryptos into the underlying pool.

User B steps in to borrow 10 X cryptos. Then the protocol will take A’s tokens out of the pool to pair the two users. They act in this way in P2P, the interest paid by B will be automatically and totally attributed to A. In this way, the interest is no longer socialized and both parties optimize their interest rates.

Similarly, each party is free to break the pairing at any time without constraint.

Graphic representing Morpho Labs' objective
Graph representing Morpho Labs’ objective to optimize the interests of protocol users
Source : docs by Morpho Labs

A dynamic matching mechanism

The matching system works through a priority waiting list on chain. It allows users to be sorted according to the amount they wish to lend or borrow.

Thus, when a new supplier comes along, its liquidity is automatically assigned to the largest borrower first. Then to the following ones until all is assigned.

If we take the example of user A and his 10 X tokens. These tokens will first be assigned to user B who wishes to borrow 6 tokens. Then to user C who borrows 3 tokens. Finally to D who wants 1 token.

The converse is also true. When a borrower establishes his request, he will be assigned to the largest supplier in priority then to the following ones until his request is fulfilled.

By acting in Peer-to-Peer, the interest rates are the same from either side. They are thus optimized for each stakeholder.

This system induces a form of competition since dynamic assignment favors the most involved users.

The interest rates are established by the Morpho Labs protocol which is based on the rates provided by the underlying protocols to be efficient and competitive.

To note

Morpho does not deny Peer-to-Pool, but uses it as a last resort when no correspondence emerges for a liquidity provider.

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What returns can you expect from Morpho Labs?

As we have seen, the rewards due to the lenders are paid directly by the borrowers. Remember, however, that the Morpho Labs protocol acts as an additional layer on the underlying Aave and Compound protocols. These are the platforms that distribute the rewards.

Morpho automatically accumulates rewards on behalf of its users, who can claim them at any time like on any DeFi protocol.

Morpho Labs protocol interface
Morpho Labs protocol interface. On the left side, Compound APYs for lenders. On the right side, the APY imposed on borrowers. In the middle, the APYs proposed by Morpho for the two stakeholders

Of course, the Morpho protocol does not yet reach the APYs offered by popular protocols such as Beefy or Yearn Finance. It acts more like a public good whose mission is to make crypto returns fairer.

Thereby, its APYs depend on the underlying protocols and are defined so that each stakeholder receives optimized benefits on a win-win model.

Morpho Labs also distributes its own tokens MORPHO to its users as a reward. Although the tokenomics guidelines are not yet fully drawn, Morpho Labs has revealed that the maximum supply will reach 1 billion tokens.

The role of the MORPHO token will provide in the future a power of governance in the Morpho DAO structure. The latter will determine the evolution of the protocol. It will regularly decide on the amount of the rewards distributed.

Morpho Labs has defined a distribution schedule for the first 2 years of its existence. The first year ends on September 20, 2022 with a total allocation of 5 million tokens over a little over 3 months.

This first step marks the development of the protocol but also the marketing development aimed at making it known.

The second and final period will allow Morpho to complete its full decentralization. This involves throwing Morpho CAD and consolidate the associated governance system.

MORPHO distribution over the next year
Distribution plan of MORPHO for the second year
Source : docs Morpho Labs

Morpho Labs’ protocol does not yet compete with large DeFi yield aggregators. However, despite its young age, the project has found an interesting niche that is attracting more and more followers.

In a bear market context, Morpho Labs managed to raise nearly $18 million in a financing round that ended in July 2022 with the participation of a16z crypto in particular. It will therefore have no trouble deploying its protocol and attracting more and more users.

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Morpho Labs: optimized crypto lending and APY

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