TBW - On-chain Lending: Market Analysis & Future Outlook

Lending onchain is a core activity of DeFi that connects borrowers and lenders in a disintermediated way on a global scale. It makes lending and borrowing accessible to anyone, while improving the terms and conditions of borrowing and lending by greatly reducing the role of intermediaries and the costs they charge. The sector evolved little in the first few years of its emergence, but a new wave of projects is reviving innovation.

Lending onchain is the area of DeFi where the protocols are recording the largest volumes of deposited liquidity, with the total deposited value (TVL) of the sector weighing in at $44 billion, of which $25 billion is on Ethereum. Aave accounts for almost half of this, with $20 billion deposited on its protocol, followed by Morpho with $3 billion. Furthermore, Aave accounts for almost two-thirds of the total value borrowed among all the lending protocols, proving that the liquidity deposited on the protocol has a high utilisation rate.

The lending market is tending towards concentration within a small number of protocols, as the liquidity they possess and their ability to manage risk create lasting comparative advantages that will only increase as long as there are no new entrants that are truly innovative or already have a large customer base.

We therefore offer an overview of the market-leading projects, their future developments and the new innovative projects that are emerging.

Aave: the champion of lending

Aave is still the largely dominant lending application, both in terms of the liquidity deposited in it and the liquidity borrowed.

Aave operates as a liquidity pool that pools deposits from lenders to make them available to borrowers. This pool encompasses a variety of assets, each with its own parameters, including:

• Deposit and borrowing limits
• The "loan-to-value" ratio (or Loan To Value), which determines the maximum amount that can be borrowed in relation to the value of the collateral deposited by the user
• The liquidation threshold, which defines the point at which a position can be liquidated - anyone can then liquidate this position and obtain a premium
• The interest rate model, which adjusts dynamically according to the use of each asset: the more liquidity is borrowed, the higher the interest rates

These parameters are designed to protect the capital of the protocol and its users, the major risk being the accumulation of bad debt.

Bad debt occurs when a borrower cannot repay their loan and the lender cannot recover the full amount owed, even after seizing the collateral.

Aave has a main instance as well as more specialised instances around specific sectors such as liquid staking or restaking. Each instance represents a separate pool of assets with its own parameters. Any major changes to these parameters, as well as the addition of new asset types to the pools, must first be approved by a DAO governance vote.

Globally, the way Aave works has changed relatively little since its launch, but major developments are in the pipeline: Umbrella and Aave V4.

Umbrella will strengthen the protocol's protection against bad debt. People depositing liquidity on the protocol will have the option of temporarily blocking their deposits in order to benefit from additional returns; in return, these deposits can be seized by the protocol to reimburse it in the event of bad debt.

On the other hand, Aave V4 will notably enable the implementation of a unified liquidity layer that will allow users to automate and optimise their deposits between all Aave instances deployed on multiple blockchains, as well as carry out cross-chain borrowing.

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Morpho & Euler: the customisable lending platforms

Morpho is an immutable infrastructure that allows anyone to create their own customised lending marketplace. Morpho provides the primitives needed to build lending and borrowing markets, without exercising control over the management of their risks.

This approach allows isolated loan markets to be created by specifying only the essential elements:

• a collateral asset
• a loan asset
• a liquidation ratio
• an interest rate model
• an oracle

The advantage of being able to create any isolated market without prior authorisation is that it offers great flexibility and accelerates innovation.

On top of this layer, it is possible to deposit funds in vaults that will automate lending within the various markets. Anyone can create their vault, although this is aimed more at risk management professionals. This system allows each lender to choose which vault suits them best according to their risk profile.

Thus, the Morpho protocol does not make any decisions about risk management and leaves that to third parties.

Euler works in a similar way, but the collateral that can be borrowed within a market is no longer an asset, but a vault that can be made up of several assets. This operation creates more complexity, but facilitates rehypothecation and the creation of customised loan systems such as the one set up by Usual, which allows borrowers to borrow at a fixed USD0 rate by putting USD0++ as collateral.

Finally, unlike Morpho, Euler's DAO has deployed its own loan market on its infrastructure. It is therefore a hybrid approach between the way Aave and Morpho operate.

>> Paul Frambot (Morpho Labs): "Aave is a bank whereas Morpho is an infrastructure for banks"

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Fluid: merging lending and trading

Fluid is an innovative application that vertically integrates its lending activity with an Automated Market Maker (AMM).

Fluid introduces the concept of "smart collateral", which makes it possible to borrow against it, lend it and provide liquidity on the AMM at the same time. On the other hand, "smart debt" allows debt to be used as a source of liquidity for trading and also generates interest.

On top of this, Fluid can offer much higher Loan-to-Value ratios than most other lending applications, meaning greater leverage is possible.

Fluid currently only works with BTC, ETH and dollar stablecoins as well as liquid staking tokens. The protocol offers greater capital efficiency in return for increased complexity.

Wildcat: setting up under-collateralised loans

Almost all lending protocols only offer over-collateralised loans where the borrower must deposit more collateral than the amount of their loan. This is partly because these protocols do not have KYC and there is a need to ensure that borrowers can repay their debts.

Wildcat offers market makers, investment funds and other registered legal entities the opportunity to borrow on credit. Each offer can be customised by its issuer, for example borrowing for a flexible or defined term as well as the option to add a legal agreement.

On the other side, lenders must comply with the borrowers' legal restrictions, most of the time this just boils down to not having a crypto address on the Office of Foreign Assets Control (OFAC) sanctions list.

This type of lending is much riskier than over-collateralised loans, but offers higher returns in return.

Loopscale & Avon : loans based on an order book

The pool system invented by Compound and then taken over by Aave has been extremely successful because it simplifies the relationship between lenders and borrowers by defining a common borrowing and lending rate for all participants that evolves according to the pool's utilisation rate, i.e. the quantity of assets borrowed compared with the quantity of assets available.

On the other hand, this model has two problems:

• interest rates soar above-beyond a certain utilisation rate to encourage borrowers to repay part of their debt and thus leave a margin allowing lenders to withdraw their deposit whenever they wish
• the interest rate received by lenders will always be lower than that paid by borrowers since the unused assets in the pool also earn interest

The improved transaction speed of blockchains makes it possible to use an order book to match lenders and borrowers at the rates that suit them best. This model allows the capital lent to receive the full rate paid by the borrower, facilitates better rate setting by the market and makes changes in rates much more predictable.

On the other hand, this operation creates more complexity for lenders, who must regularly adjust their offers. This can be resolved with the introduction of vaults that automate lending, as Loopscale does. Avon plans to set up a vault curator system quite similar to those of Morpho and Euler.

Conclusion

Lending onchain is diversifying to better meet users' needs. Some projects are deciding to manage risk parameters themselves, while others are delegating all or part of this work to third parties.

Allowing rehypothecation offers better returns for users, but increases risk and requires much more careful adjustment of parameters.

The pool-based model simplifies access for all users and makes the borrowing or lending period more flexible, while the peer-to-peer model based on an order book offers greater efficiency and predictability.

Each model therefore serves different types of needs and it is still too early to tell which will be dominant in the coming years. Furthermore, it is not certain that the most widely adopted model will also be the most profitable for its investors, since each of them does not have the same capabilities to capture the value generated on their application.

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