Decentralised finance (DeFi) promises to democratise access to financial products traditionally reserved for professionals. Lending and borrowing are a perfect example.

Protocols such as Compound, Aave, Morpho or Euler bring lenders and borrowers together directly. Lenders are paid for their capital, while borrowers pay to borrow cryptocurrencies or stablecoins. Unlike traditional finance, these protocols offer instant, non-discriminatory borrowing, subject to meeting set conditions.

Paul Frambot, CEO of Morpho Labs, stresses the importance of a shared infrastructure: "A public blockchain is essential for efficiency. We're aiming for a single place where everything converges and settles, allowing more efficiency to be unlocked."

However, one major obstacle persists: the need for investors to over-collateralise their position in order to borrow. This hurdle is all the more problematic given that on-chain lending is still struggling to establish itself in DeFi.

Appearing in 2017, lending protocols really exploded at the 2020 "DeFi Summer", with the emergence of Compound and Aave. Despite their success, these systems still have significant limitations to mass adoption. Players such as Morpho are trying to meet these challenges.

Changes in the sector, from the emergence of liquidity pools to the abuses associated with "liquidity mining", are now calling into question the power of decentralised autonomous organisations (DAOs). The aim is to give players more freedom and control over the protocols.

Compound and "liquidity mining"

Officially deployed on Ethereum in 2018, Compound, created by Americans Robert Leshner and Geoffrey Hayes, has established itself as a pioneer in many respects.

While the beginnings of lending can be attributed to EthLend (now Aave), launched in 2017 by Finnish entrepreneur Stani Kulechov with his peer-to-peer lending model, it was Compound's liquidity pool concept that revolutionised the business.

EthLend's model required a lender to find a loan request matching its criteria, or a borrower to accept a specific loan offer.

In contrast, Compound's liquidity pools free lenders from the constraint of individually choosing borrowers. They simply deposit their funds in a pool accessible to all borrowers. This innovation makes lending more accessible, without the need for a direct match between supply and demand. Lending and borrowing rates automatically adjust according to market conditions - a revolutionary concept for its time.

In June 2020, the launch of the COMP governance token marked a turning point for the protocol and DeFi as a whole. In addition to granting voting rights within the protocol's decentralised autonomous organisation (DAO), the COMP above all introduced the concept of "liquidity mining".

This mechanism rewarded users in COMP tokens in proportion to their activity on the protocol, whether for deposits or borrowings. The reward rate adjusted according to overall protocol activity.

When COMP was launched, the total locked value (TVL) on the protocol was around $150 million. A year later, it exceeded $20 billion. Over the same period, the price of COMP has risen from $90 to $800 per unit.

Many investors have been lured by COMP rewards, not to actually use the lending or borrowing services, but to take advantage of the quick wins through token distribution.

This practice, known as "yield farming", created a flow of short-term liquidity, also known as mercenary capital. These users would withdraw their funds as soon as the rewards became less attractive or better return opportunities appeared elsewhere.

Some investors exploited this system by using leverage: they would borrow funds on Compound, redeposit them, then repeat the process. This strategy artificially inflated the value of the protocol, while increasing the risks of liquidations and interest rate volatility.

"At some point, Compound had to stop this practice, in particular because it was losing too much money and the inflationary pressure on the token was too great," explains Sébastien Dérivaux, CEO of Steakhouse Financial, a crypto consultancy that was notably responsible for drawing up MakerDAO's financial statements.

Jesse Pollak, creator of Base - layer 2 of US platform Coinbase, which has no plans to launch a token - stressed in an interview with The Big Whale: "The risk with this kind of practice is that you no longer really know whether your product is being used because it's good or simply because users are being paid to use it."

Compound found itself trapped by its own mechanism: only holders of the COMP token could vote to stop liquidity mining via the DAO. However, many holders had no interest in this programme ending, even if it put the protocol in economic difficulty and led to significant losses.

Aave also used liquidity mining, but with a different approach: its programme was adjusted every three months according to market conditions, following a vote by the DAO.

Today, the trajectories of the two protocols diverge sharply: Aave has a TVL (total locked value) of nearly $20 billion, while Compound's has stagnated at around $3 billion.

Aave serving DeFi users

Aave has navigated the turbulence of the market by constantly adapting over the past eight years, earning a solid reputation.

"Our aim has always been to create a protocol that fully meets our users' expectations, offering a simple product and robust software," explains Stani Kulechov to The Big Whale. "We have also strived to remain flexible to best adapt to changing market conditions," he adds.

Aave can be seen as a huge "liquidity pot" from which lenders and borrowers draw according to their needs. This pot is managed by the DAO and companies in charge of risk parameters. So far, this has proved to be the most robust and efficient model for allocating liquidity.

One of Aave's strengths is the usefulness of its AAVE token. Holders can store it in the "Safety Module" for an annual return of around 4%. To avoid being equated with dividends, these rewards are justified by the fact that these tokens can be used as collateral for the protocol in the event of a potential threat.

Aave has also innovated with "flash loans", a DeFi special feature allowing investors to borrow without collateral. If the borrower fails to repay in the same transaction, the transaction is simply cancelled.

In July 2023, Aave launched its decentralised stablecoin GHO, aiming to diversify its revenue streams. Inspired by MakerDAO's DAI, all interest paid by borrowers goes into the protocol's treasury.

In just over a year, Aave has generated $2.8 million in revenue through GHO, out of the protocol's $63 million treasury.

Despite its ultra-dominant position, Aave is struggling to attract institutional investors from the traditional financial world. The failed launch of Aave Arc, a version of the protocol specifically designed for these players, is testament to this.

Aave Arc offers a "permissioned" environment that restricts participation via KYC (know your customer) and anti-money laundering checks, meeting the requirements of traditional finance.

Fireblocks, one of the leading crypto custody solutions for institutions, was among the first "whitelisted" entities. However, the project was put on pause as its TVL never exceeded $8 million. Aave's governance attributes this setback to the series of deals like FTX and the bankruptcies following the Terra-Luna crash in the summer of 2022, which drove institutional investors away from DeFi.

Nearly before the FTX debacle, JP Morgan "forked" Aave Arc - i.e. copied its code to create its own version - to carry out transactions involving tokenised Singapore and Japanese government bonds, as well as Singaporean yen-dollar exchanges. This pilot project involved MAS (Monetary Authority of Singapore), DBS Bank and SBI Digital Asset Holding.

Despite this false start, Stani Kulechov remains optimistic. In his view, "financial institutions, especially traditional ones, are looking for access to excellent liquidity and partnerships with experienced DeFi teams like Aave."

However, doubts persist. Jean-Marie Mognetti, CEO of CoinShares, an asset manager specialising in crypto, points out, "Aave's major challenge lies in the opacity of the management of incoming flows and their origin. This raises significant regulatory issues for traditional financial institutions such as ours."

These issues, while not exclusive to Aave, are prompting some players such as Morpho to seek the ideal formula for DeFi to finally appeal to financial institutions, without sacrificing its principles of decentralisation and accessibility.

The new generation of infrastructures with Morpho

While it is tempting to pit Morpho and Aave against each other, the two structures are not in direct competition. Nevertheless, in the long term, Morpho could indirectly nibble away at Aave's market share.

Conceived in 2021, the project has forged a solid reputation thanks to raising $18 million in 2022 - a record for a student project, surpassing even Facebook. Prestigious investors such as the American venture capital fund Andreessen Horowitz (a16z) have been won over. This summer, Morpho Labs announced a new $50 million round, led by Ribbit Capital.

Initially, with Morpho Optimizer, Morpho was content to connect to major lending protocols such as Aave and Compound to optimise their rates. "But we quickly reached the limits of the system", explains Paul Frambot, CEO of Morpho Labs.

Earlier this year, the start-up launched "Morpho Blue", an infrastructure protocol enabling anyone to create liquidity pools, or even entire protocols such as Aave, from its immutable technical stack.

"If a financial institution wants to use Aave, it will come up against many constraints, not having control over most of the risk or compliance parameters. With Morpho Blue, traditional players can create liquidity pools, or even entire protocols like Aave, while controlling the entire process," explains Paul Frambot.

In recent months, Morpho has managed to attract historical players in Aave risk management, such as Gauntlet and Block Analitica. According to a very active investor in DeFi, the latter would be "very tempted to recreate Aave, but in their own way and much more optimised". So while Morpho is not strictly speaking a competitor to Aave, it could quickly become one.

"Eventually, Morpho could form a homogeneous whole accessible via a web interface, with users not perceiving the complexity of the system behind the scenes," he continues.

Morpho Labs has also chosen to limit the power of the DAO, which cannot, for example, directly modify the parameters of markets or pools launched on the protocol.

"While DAOs promote transparency and inclusion, they have also demonstrated numerous inefficiencies. What's more, their governance is often under the influence of an individual or a small group with control over the entire protocol," observes Sébastien Dérivaux.

Although the protocol launched by Morpho Labs seems better suited to the arrival of institutional DeFi, it remains far behind Aave today. Its TVL (total locked value) stands at just under $2 billion, ten times less than that of Aave.

Moreover, Morpho Labs does not currently receive any revenue generated by the protocol. Paul Frambot assumes this choice: "If we activated the fees, vault managers could question our added value. They could simply copy our code and recreate the same thing at no cost. Only once the network effect has been established can the fee mechanism (fee switch) be activated by the DAO."