<p dir="ltr">Peer-to-peer (P2P) lending was the usual design for lending and borrowing until the peer-to-pool (P2Pool) money market model became the standard in DeFi. ETHLend, Aave's predecessor, enabled loans in 2018, with borrowers requesting their preferred interest rate, loan amount, and tenure. Lenders were then free to pick and choose whatever debtors they wanted to finance.</p><p dir="ltr">Money markets gradually started to migrate to the peer-to-pool model, in which lenders deposit their liquidity in a common pool, and borrowers may acquire a loan from that liquidity pool comprised of individual depositors. The P2Pool architecture allows for more flexibility and fast liquidity. Lenders may withdraw their deposits whenever they want as long as there is enough money in the pool, and borrowers can repay their loans whenever they want. The amount borrowed is determined not by a single lender but by the total amount of deposits in the pool.</p><p dir="ltr">Because P2Pool lending pools are not intended to be completely used, capital efficiency is not maximized. Interest rate algorithms establish ideal utilization rates considerably below 100% to ensure that lenders who wish to withdraw may do so.</p><p dir="ltr">As a result, interest money received by used funds is distributed over the whole pool. As a consequence, there is a disparity between borrowing and lending rates. Morpho is a promising lending/borrowing optimizer that blends peer-to-peer lending with the advantages of the P2Pool model to produce a more efficient market for users.</p><p dir="ltr">Morpho's primary benefits are increased returns for lenders and reduced interest rates for borrowers.</p><h2>Morpho's mechanism</h2><p dir="ltr">Morpho is based on current lending protocols such as Aave and Compound. It provides zero-spread loans by connecting lenders and borrowers automatically whenever feasible. Morpho maintains the same liquidity and liquidity assurances as the underlying lending market. As counterparties are discovered or lost, debt and lending positions are immediately transferred between the underlying P2Pool marketplaces and a P2P credit line.</p><h3>Hybrid Design</h3><p dir="ltr">Morpho employs a mixed approach rather than solely P2Pool matching like Aave and Compound do. As a backup, it integrates P2P matching with the underlying P2Pool market. Morpho's current backup markets are Aave and Compound, opening the door for "Morpho-Aave" and "Morpho-Compound."</p><p dir="ltr">Consider a borrower who obtains a loan from Morpho-Compound. Morpho's matching engine searches for a counterparty that matches the user's loan.</p><h4>Scenario 1: A Match Is Discovered</h4><p>If a provider deposits the desired token into Morpho-Compound, Morpho utilizes the supplier's stacking ibToken to take liquidity from the pool and directly send it to the borrower. The lender and borrower at Morpho-Compound are now paired on a peer-to-peer basis. As a consequence, the utilization rate is 100%, resulting in an efficient interest rate for both parties.</p><p>If the supplier wants to withdraw their money and the borrower has not yet repaid them, Morpho leverages Compound's liquidity pool to offer liquidity to the provider. It then reconnects the borrower to Compound's liquidity pool immediately.</p><h4>Scenario 2: No Match Found</h4><p>If no match is identified, Morpho borrows from the underlying liquidity pool using the borrower's collateral. The APY paid by the borrower is the same as the APY paid by the underlying market — in this example, Compound.</p><h4>Scenario 3: A Partial Match Is Found</h4><p>If just a partial match is feasible due to a lack of lenders, the borrower will get an improved APY on their matched capital, while unmatched capital will receive the same APY as the base Compound pool.</p><h3>Search Engine</h3><p dir="ltr">Morpho's matching engine is in charge of sorting and choosing P2P loans. To identify matches, the matching engine employs an on-chain priority queue that classifies users from biggest to lowest volume. This implies that the biggest lender will receive priority on borrower matching, followed by the second-largest lender, third-largest lender, and so on. As long as the transaction remains below the set maximum gas cost, this will continue until there are no more counterparties. In other words, simply though there is a counterparty does not automatically imply that the matching will occur. Morpho establishes a maximum gas cost that is determined by governance. If the predetermined gas limit is reached, the remaining liquidity will not be matched P2P, whether or not there is a counterparty. Finally, the process returns to the underlying Compound/Aave pool.</p><h3>Improved borrow and lending rates</h3><p dir="ltr">As previously stated, the P2Pool model includes a gap between borrowing and lending rates. Morpho introduces a new metric: the P2P APY, which is the difference between the supply and borrow APYs of the underlying liquidity pool.</p><p dir="ltr">When Morpho's borrowers and suppliers are paired peer-to-peer, they both profit from this APY. When users are matched, they may enjoy an optimal APY, while the underlying pools' APY is used when they are not.</p><p dir="ltr">The underlying pool is seen as the "supplier/borrower of last resort," and the user benefits economically in the same way as they would if they used the underlying pool directly. As seen in the graph below, Morpho's P2P rates are always higher than the underlying market.</p><p dir="ltr">Because of the comparatively strong borrowing demand, the disparity between CRV supply and borrowing rates is wider than for stable assets like USDC. The current CRV spread is 4% compared to 1% for USDT, implying that CRV lenders and borrowers gain significantly by utilizing Morpho.</p><p dir="ltr">Similarly, the Morpho-Compound P2P rate is always better than the supply or borrowing rate. This feature is shown below using the USDT market on Morpho-Compound.</p><h2>Drawbacks</h2><p dir="ltr">On the surface, switching from Aave to Morpho seems to be a no-brainer, given the promise of lower lending and borrowing rates. However, there are several limitations and caveats to consider.</p><p dir="ltr">Morpho is a suite of smart contracts built on top of existing money markets. Therefore it inherits the underlying markets' security vulnerabilities as well as the possibility of added risk from its own smart contracts. Morpho's smart contracts are also more sophisticated and computationally demanding since it takes an additional step to locate a match. As a result, depositing into Morpho would very certainly use more gas than depositing straight into Aave/Compound. These are especially critical issues for</p><ul><li><p dir="ltr">Protocols considering integrations and shifting cash from Aave/Compound to Morpho-Aave/Morpho-Compound.</p></li><li><p dir="ltr">Smaller users whose cost savings/yield gain are insufficient in view of rising gas fees.</p></li></ul><p dir="ltr">The underlying liquidity sources are critical to Morpho's hybrid model and cannot be depleted since Morpho depends on them as a "lender of last resort" when P2P matches are not available.</p><p dir="ltr">While Morpho ensures the same liquidity and liquidation conditions as the underlying markets, it also limits LTVs and risk factors. For example, if Aave demands a 150% collateralization ratio to borrow ETH, Morpho-Aave would require the same, even if the loan is matched P2P and does not directly tap into Aave's liquidity.</p><p dir="ltr">Another thing to keep in mind is that if borrowing rates are lower than lending rates, Morpho's P2P matching service becomes obsolete. Because of COMP incentives, this is the case for certain of Compound's marketplaces. Because COMP incentives subsidize borrowing more than it rewards lending, borrow rates for assets like USDC and DAI are lower than lending rates, implying that there is no middle ground for borrowers and lenders to meet.</p><p dir="ltr">As a result, Morpho has blocked peer-to-peer matching in certain marketplaces. Morpho will re-enable P2P matching once the favorable spreads between rates resume. Meanwhile, borrowers and lenders may continue to utilize Morpho-Compound while collecting both Morpho and Compound liquidity mining incentives.</p><h2>Current traction</h2><p dir="ltr">TVL has been on the upswing since Morpho-Compound went live. Morpho-Aave was founded approximately two months ago and had been steadily garnering funds.</p><p dir="ltr"><img src="https://lh5.googleusercontent.com/Rqm6qF3GlIo7KhWejGjMziMJ5fuV-h2CSGEFisF-jDlcZH7rH75NuTVi-IHv7NHxK84j46c6ZkWohdH-pMTaDYI_OdRSKls_SYGYPK05YH03PFeZ-ApvBTdhrkRRuIGkNFcKyvtnhGmvBg6ffDenM7o" width="624" height="285"></p><p dir="ltr">Source: Defillama</p><p>It's unclear how much of this money was transferred from the underlying markets to Morpho, although many protocols (Sense Finance, Spool Finance, and Nested Finance) have announced connections with Morpho. Some of these protocols, such as Spool Finance, have completely replaced Compound with Morpho-Compound.</p><p dir="ltr">However, this is hardly a full-fledged vampire attack. Over the last two quarters, Morpho has been the second-largest depositor of money on Compound, adding considerably to Compound's TVL.</p><p dir="ltr">When evaluated by the number of unique addresses each day, activity on Morpho-Aave has been exceptional. Morpho Aave's daily average unique addresses have surpassed Aave in the recent month.</p><p dir="ltr"><img src="https://lh6.googleusercontent.com/8o-67e35xQsRvdz81ZNlYdxb3RG46pRNnv918gyqY9nXcEao3UUpHZtJx8jTUAKVLIstSb-Q5q85uASFoS0wZWxebCFKmPqyUYyyOUmXKffwhqjuSOTUAe__bqR8qL2NLz03kzf6fM6CrGmg6LJtD1I" width="624" height="396"></p><p dir="ltr">Source: Dune analytics</p><p dir="ltr">Morpho's efficacy is measured by the number of loans matched on a P2P basis over time, as well as the proportion matched out of total liquidity available for P2P lending. Overall matching efficiency is calculated as the USD amount matched P2P over the amount provided or borrowed, i.e. min(supply in P2P, borrow in P2P) over min(deposits, borrows) in P2P-enabled marketplaces. Morpho's total matching efficiency is presently 100%.</p><p dir="ltr">This implies that new users will nearly always be matched as long as they are providing or borrowing on the side of the market that is restricting P2P. For example, if CRV supply exceeds borrows, a new user borrowing CRV will always be matched with the extra supply.</p><h2>Value accrual</h2><p dir="ltr">The cost reductions are due to Morpho reducing the margins between borrow and supply rates, as well as the fact that customers do not yet pay a reserve charge to any protocol. Morpho currently charges no fees to users, which implies that the economic advantages of lower interest rate spreads are distributed solely to customers.</p><p dir="ltr">In the future, governance may decide to activate a fee switch, allowing the protocol to earn a percentage of the spreads. This implies Morpho would take a portion of the user's cost savings in return for establishing a P2P match.</p><p dir="ltr">The table below provides a glimpse of the Morpho-Aave and Morpho-Compound markets, as well as the underlying market difference between borrowing and lending spreads. The spread shows the efficiency advantages that borrowers and lenders experience as a result of Morpho's P2P matching. If Morpho were to accept a fee decrease, it would come from the excess. The average spread across markets and assets, weighted by the number of P2P loans granted, is about 1.43%.</p><p dir="ltr"><img src="https://lh6.googleusercontent.com/awP6zuJxZAoipLCjQBsreFn9-SnIGta_YFVR0GvcTN2jvDFMNH9ntzceP3As1UK3gJ87VpS_i74H5BQExIF7_hff4rkGL8_58Ryb2cran1dQ0oASz9BCHm6mcSfzWR01qgsnp47nGzmrO8wxouKPYj8" width="624" height="239"></p><p dir="ltr">Source: Morpho finance</p><p>Morpho now has over $50 million in P2P loans across both of its markets, with an average efficiency benefit of 1.43%. If and when deposits and borrows transfer to Morpho, the number of P2P loans should increase in tandem with TVL, assuming the same or greater matching efficiency. Borrower COMP incentives will be switched off in all markets shortly, allowing Morpho to enable P2P matching in these marketplaces.</p><p dir="ltr">We speculate on annual revenues based on P2P loan origination and the spread take rate, i.e., what Morpho charges as protocol fees. For the sake of simplicity, we assume that the average efficiency gain will stay at 1.43% throughout the year and that if one side pulls out, another user will quickly replace the P2P position. Morpho's P2P loans, as seen in the following table, have a long way to go before producing a substantial return.</p><p><strong>Final thoughts</strong></p><p dir="ltr">Almost all lending and borrowing in DeFi is now done under the P2Pool model with underutilized lending pools. Morpho offers a service that allows customers to get a Pareto-efficient interest rate by connecting lenders and borrowers P2P, without sacrificing the liquidity assurances provided by the P2Pool model.</p><p>Morpho has the potential to disrupt the lending business, which is presently worth $40 billion in TVL. Aside from Compound and Aave, Morpho can build on and improve a variety of different money markets and blockchains. However, Morpho's success is primarily dependent on education and people's willingness to move their deposits out of traditional money markets in order to benefit from possibly higher interest rates.</p><p>This is more likely to appeal to protocols and users with significant deposit and borrow quantities than small retail customers who would cost more to move their positions than they would save in interest savings. Furthermore, since Morpho's matching engine prefers bigger lenders, they are more likely to be P2P matched and earn a better return as they move up the priority queue.</p><p>Morpho is an attractive product with an explicit value proposition, but even with a high take rate, it does not have the potential to be a cash cow. We've seen this previously with DeFi money markets, where the product itself is important and offers customers a really useful service, but revenue creation and value accrual aren't very outstanding. Morpho is also included in this category in its present form. However, as the product changes, there is an opportunity to re-evaluate value accrual. And the product will develop as well.</p><p>Morpho's product's initial version is this hybrid model. Morpho anticipates that loan markets will eventually migrate away from the pool model and toward one in which market makers may supply active liquidity within the spread of the two rates, enabling the customer to pick a rate between the two APYs while utilizing the underlying pool as backup liquidity. This idea ultimately develops into an order book-style paradigm in which providers select their own rate based on competitive marketplaces rather than an underlying pool APY.</p><p>Morpho's present offering is a start on the right path toward creating more efficient and deeper interest rate markets on which DeFi can flourish.</p><div class="pr-block-special"><strong>Disclaimer:</strong><br>This article is intended for and only to be used for reference purposes only. No such information provided constitutes advice or a recommendation that any investment or trading strategy is suitable for any specific name.</div><p><br><br></p>

A potential lending/borrowing optimizer called Morpho combines peer-to-peer lending with the benefits of the P2Pool model to provide consumers access to a more effective market.

Morpho Finance: the DeFi lending optimizer