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Derivatives of modular narratives: the modular evolution of DeFi lending

Derivatives of modular narratives: the modular evolution of DeFi lending

BlockBeatsBlockBeats2024/08/06 09:19
By:BlockBeats

The modular design provides higher security, flexibility, and scalability, allowing risk isolation, independent module upgrades, and rapid response to market changes, while improving the transparency of the system.

Original title: "Derivative of Modular Narrative: Modular Evolution of DeFi Lending"
Original author: Ac-Core, YBB Capital Researcher  


TLDR


●      The essence of modular lending is not only cross-chain and aggregation, but both play an important role in modular lending;


●      Modular lending utilizes the security, consensus and data availability provided by the base layer, and it mainly focuses on functional modularization at the execution layer and application layer;


●      Modular lending breaks down its process into multiple independent modules, such as collateral management, interest rate calculation, risk assessment, and liquidation mechanism, and communicates with each module through a standardized interface;


●      The characteristics of the current modular DeFi protocol are similar to the logic of OP Stack's one-click chain release. Deployment requires the establishment of a module combination based on its own protocol to create new financial products and services.


1. The origin of modularity


The concept of modular blockchain originated from two white papers. In 2018, Mustafa Albasan and Vitalik Buterin co-authored the paper "Data Availability Sampling and Fraud Proofs", which proposed a system that allows light clients to receive and verify fraud proofs from full nodes, and designed a data availability sampling protocol to reduce the trade-off between on-chain capacity and security, solving the scalability problem of blockchain without sacrificing security and decentralization.


Later in 2019, Mustafa Albasan detailed a new architecture in the Lazy Ledger white paper that uses blockchain for ordering and ensuring the availability of transaction data without being responsible for the execution and verification of transactions. This new architecture aims to solve the scalability problems of existing blockchain systems and was then called a "smart contract client". The execution of smart contracts is carried out on this client through another execution layer, which is the prototype of Celestia (the first modular data availability layer project).


With the emergence of Rollup technology, this concept has become more specific. Its logic is to execute smart contracts off-chain and upload the results as proof to the execution layer of the "client". By reflecting on the architecture of blockchain and new expansion technologies, Celestia was born and defined a new paradigm of "modular blockchain".


2. The emergence of modular blockchain


The modular blockchain aims to solve the "impossible triangle" problem in the blockchain field through decoupling and reorganization. Simply put, it is to decompose the main functions of a single chain into multiple layers, each layer focuses on realizing specific functions, so as to achieve scalability. Generally speaking, the basic functions of a single chain can be divided into the following four functional layers:


1. Data Availability Layer:Responsible for ensuring that data in the network can be accessed and verified, including data storage, transmission and verification functions, to ensure the transparency and trust of the blockchain network. At present, representative DA projects include Celestia, Avail, EigenDA, etc. Monolithic public chains such as Ethereum and Solana can also carry DA needs (Bitcoin has no good verification solution for traditional Rollup due to its non-Turing completeness, but the mining of its expansion capacity is progressing rapidly);


2. Consensus Layer:Responsible for the agreement between nodes to achieve consistency of data and transactions in the network. Transactions are verified and new blocks are created through consensus algorithms (such as PoW or PoS). Most DA projects also need their own consensus layer, which is usually designed as a light node method with low hardware requirements and simple verification;


3. Execution Layer:Responsible for processing transactions and executing smart contracts, including transaction verification, execution, and status updates. Layer2 projects (such as Arbitrum, Optimism, and ZKsync) are modular blockchains that only have execution layer functions. They verify the correctness of transactions through the main chain and inherit the security of the main chain; 4. Settlement Layer: Responsible for completing the final settlement of transactions and ensuring that the transfer and record of assets are permanently stored on the blockchain. The main function of the modular settlement layer is to verify the validity proof and status data of the Rollup. Well-known projects include Dymension, Cevmos, etc.


In the early history, solutions around Bitcoin such as Lightning Network and sidechain can be seen as "pioneers of modularization". However, due to the non-Turing completeness of Bitcoin, these expansion solutions have been slow to progress and have various defects, and have not been widely adopted. Traditional blockchains try to solve the trilemma by reconstructing the underlying framework, but the effect is limited. To solve this problem, Vitalik Buterin proposed a solution around Rollup. With the maturity of fraud proofs and zero-knowledge proofs, the way to use the Lego-style building method to build the execution layer on Ethereum has gradually become a reality, and Ethereum has also set its final outcome as a layered expansion path around Rollup upgrades. The upgrade method centered on Rollup is expected to surpass previous expansion solutions and become the ultimate solution for public chain expansion.


3. Modular Derivatives - Modular Lending


Derivatives of modular narratives: the modular evolution of DeFi lending image 0

Image source: Legend Quant


DeFi modular lending utilizes the security, consensus and data availability provided by the base layer, mainly focusing on the execution layer and application layer for functional modularization, and running these functional modules on the blockchain. Its main modular parts include: collateral management module, which is responsible for storing, managing and processing users' collateral to ensure the security and compliance of collateral; interest rate calculation module, which dynamically adjusts the lending rate based on market supply and demand, user credit score and other factors; risk assessment module, which assesses the credit risk of the borrower and decides whether to approve the loan request and the amount of collateral required; liquidation mechanism module, when the borrower fails to repay on time, triggers the liquidation procedure to protect the interests of the platform and other users.


The modular lending system needs to obtain all necessary transaction and contract data from the data availability layer for interaction and verification between modules. The operation results of each module need to be confirmed and recorded through the consensus layer to ensure that the state changes of all modules are safe and consistent. Most of the logic of modular lending runs on the execution layer, and the functions of each module are implemented through smart contracts. The final settlement and clearing of lending transactions depend on the settlement layer to ensure the finality of lending and clearing transactions.


3.1 Core Concept


1. Modular design: decompose the lending process into multiple independent modules, such as collateral management, interest rate calculation, risk assessment, and liquidation mechanism. Each module can be developed, tested and deployed independently;


2. Interoperability: The modules communicate through standardized interfaces, which makes it easy to combine different modules, and even use some modules across platforms;


3. Upgradability: Since each module is independent, a module can be upgraded separately without affecting the operation of the entire system. This feature allows the system to quickly respond to market changes and technological advances;


4. Security: Modular design can isolate risks. For example, if a module has a security vulnerability, only the module needs to be repaired without affecting the entire system.


3.2 Key components


1. Collateral management module: handles the deposit, withdrawal and management of collateral to ensure the security and compliance of users' collateral;


2. Interest rate calculation module: dynamically adjusts the lending interest rate based on market supply and demand, borrower's credit score and other factors;

3. Risk assessment module: assesses the borrower's risk, decides whether to approve the loan request and the amount of collateral required;


4. Liquidation mechanism module: when the borrower is unable to repay on time, the liquidation procedure is triggered to ensure the financial security of the lending platform.


3.3 Advantages


● Flexibility: different modules can be combined as needed to meet diverse lending needs;


● Efficiency: by optimizing the performance of each module, the efficiency of the overall system is improved;


● Innovation: allows developers to innovate on specific problems and launch new modules to enhance functionality;


● Transparency: the modular system has higher transparency, and the operating logic and status of each module can be audited and verified individually.


3.4 The role of cross-chain and aggregation in modular lending


Derivatives of modular narratives: the modular evolution of DeFi lending image 1

Image source: Cross-Chain Bridges Explained


The essence of modular lending is not just cross-chain and aggregation, although these two play an important role in modular lending. The core concept of modular lending is to improve the flexibility, scalability, security and innovation of the system by modularizing each function in the lending process. Cross-chain and aggregation are part of the core concept of modular lending, but not the only or all of it.


Interoperability:


●   Cross-chain technology: enables assets and functional modules on different blockchains to interoperate. This is crucial for modular lending as it allows users to transfer assets between different blockchains and utilize various decentralized applications (dApps);


●   Multi-chain support: By supporting multiple blockchains, lending platforms can improve their usability and flexibility and attract more users and assets.


Aggregation:


●   Aggregation protocol: Aggregates multiple lending protocols and liquidity pools to provide a unified interface and better user experience. For example, users can access multiple lending markets through an aggregation platform to obtain the best lending rate;


●   Liquidity aggregation: Improve capital utilization efficiency and market liquidity by aggregating multiple liquidity sources.


3.5 Other key aspects of modular lending


Modular design:


●  Functional modularization: Decompose the lending process into independent functional modules (such as collateral management, interest rate calculation, risk assessment, liquidation mechanism), each module can be independently developed, deployed and upgraded;


●  Standardized interface: Each module communicates through a standardized interface to ensure compatibility and interoperability between modules.


Security and risk management:


●   Risk isolation: Modular design can isolate risks in specific modules. If a module has a problem, it will not affect the entire system;


●   Security audit: Each module can be audited separately to improve the security of the overall system.


Flexibility and scalability:


● Flexible combination: Users and developers can flexibly combine different modules according to their needs to adapt to diverse lending needs;


● Scalability: System functionality and performance can be expanded by adding or replacing modules without rebuilding the entire system.


Nowadays, some established DeFi platforms such as Aave, Compound, and MakerDAO have also begun to adopt modular design concepts. For example, MakerDAO is moving towards a less centralized SubDAO model. Aave's protocol consists of multiple smart contracts that handle borrowing, collateral management, liquidation and other functions. Developers and users can combine these contracts according to their needs, and even develop new contracts to expand the functionality of the platform.


4. Modular Lending Projects


4.1 Morpho Labs


Morpho Labs aims to improve the efficiency and user experience of the decentralized lending market and promote the development of the DeFi ecosystem through technological innovation and optimization. Through modular design and frictionless transaction mechanisms, Morpho Labs hopes to attract more users and funds into the decentralized financial sector. Morpho Blue and Meta Morpho are innovative in improving DeFi lending efficiency and interoperability.


Derivatives of modular narratives: the modular evolution of DeFi lending image 2

Image source: Morpho Labs official


Morpho Blue


Morpho Blue is an advanced version of a lending protocol provided by Morpho Labs. It can achieve minimal deployment and independent lending markets for crypto assets (ERC20 and ERC4626 tokens) on the Ethereum virtual machine. It aims to provide a trustless base layer for lenders, borrowers and applications. It adopts dual licenses (BUSL-1.1 and GPLv2). Once deployed, it will run permanently under the premise of the existence of the Ethereum blockchain (1). Basic features and components:


1. Collateral: Users of borrowed assets must provide crypto assets supported by the protocol as collateral;


2. Liquidated Loan Value (LLTV): The protocol stipulates the minimum value requirement of the collateral relative to the borrowed assets. For example, if the ratio is 90%, the value of the borrowed assets must not exceed 90% of the collateral value, otherwise the position will be liquidated; 3. Borrowing: Users initiate the borrowing process by interacting with the protocol. They specify the amount of assets they want to borrow and provide the required collateral; 4. Interest rate: Borrowers pay interest on the borrowed amount. The amount of interest paid is based on the interest rate model used by the protocol. Interest accrues over time and is paid when the borrower repays the loan; 5. Repayment: Borrowers can repay the loan at any time by returning the borrowed assets and accrued interest. Once the repayment is confirmed on the chain, the borrower can retrieve the collateral from the smart contract; 6. Liquidation mechanism: In order to reduce the risk of default, the protocol includes a liquidation mechanism. Assume that the value of the borrowed assets exceeds the LLTV (due to market fluctuations or accrued interest). The position can be partially or fully liquidated to repay the loan and any outstanding interest;


7. Borrowing: Users initiate the lending process by interacting with the protocol. They specify the amount of assets to be borrowed and transfer these assets to the smart contract;


8. Withdrawal: Lenders can withdraw loan assets and accrued interest at any time, provided that there is sufficient liquidity in the market.


A notable feature of Morpho Blue is the ability to create permissionless trading markets, allowing users to create independent markets consisting of loan assets, collateral assets, liquidation loan value (LLTV), oracles, and interest rate models (IRM). Each parameter is selected at market creation and is permanent and immutable, with LLTV and interest rate models having to be selected from a range of options approved by Morpho management.


Meta Morpho


Meta Morpho is an independent meta-protocol for creating Meta Morpho Vaults on top of Morpho Blue for seamless integration and interoperability across different DeFi platforms and protocols. The following are its main features:

1. Cross-platform integration: Meta Morpho allows users to seamlessly transfer assets and strategies between different DeFi protocols;


2. Enhanced interoperability: Through standardized interfaces and protocols, Meta Morpho provides better interoperability, making collaboration between different


3. DeFi protocols smoother;


4. Automated management: Smart contracts and automation tools make asset management and strategy execution more efficient and reliable;


5. Liquidity aggregation: Aggregating liquidity from different platforms improves the liquidity and efficiency of the overall market.


4.2 Euler Finance


Derivatives of modular narratives: the modular evolution of DeFi lending image 3

Image source: Euler Finance official


According to news on February 22, 2024, the lending protocol Euler Finance announced that it will be restarted and release version v2. This version is a modular lending platform, mainly including two major components, Euler Vault Kit (EVK) and Ethereum Vault Connector (EVC), which aims to enhance the flexibility and functionality of the protocol (2).


Euler Vault Kit (EVK)


EVK is a toolkit that allows users to create and manage custom "vault" systems. EVK enables users to deposit their assets into vaults and set different policies and rules as needed. EVK is integrated with EVC, allowing developers to freely build ERC-4626 vaults. Here are some key features of EVK:


1. Custom strategies: Users can set different strategies based on their needs and risk preferences. For example, specific lending rates and liquidation rules can be set;


2. Multi-asset support: EVK supports multiple assets, and different types of crypto assets can be deposited into the vau<


3. Flexible management: Users can flexibly manage and adjust the settings of the vault to adapt to market changes and personal needs;


4. Security: Through smart contracts and decentralized technology, EVK provides a high degree of security to ensure the safety of user assets.


Ethereum Vault Connector (EVC)


is a tool designed to connect EVK on Ethereum. EVC enables users to seamlessly transfer assets and strategies between different DeFi protocols, giving vaults superpowers so that they can be used as collateral for other vaults to facilitate seamless communication between ERC-4626 vaults and other smart contracts. Here are some key features of EVC:


1. Unified interoperability layer: EVC allows users to transfer assets from one vault to another, regardless of whether these vaults belong to the same protocol. This greatly increases the liquidity and flexibility of assets;


2. Strategy sharing: Users can share and apply the same strategy between different vaults, simplifying the management process;


3. Automated management: Through smart contracts, EVC can automatically manage the transfer of assets and the application of strategies, reducing the complexity of manual operations;


4. Enhanced liquidity: EVC improves the liquidity of the entire DeFi ecosystem by connecting different vaults, enabling users to use their assets more efficiently.


Euler Vault Kit(EVK) and Ethereum Vault Connector (EVC) are important features introduced by Euler Finance, designed to provide greater flexibility and management efficiency. Through EVK, users can create and manage customized vaults; through EVC, users can seamlessly transfer assets and strategies between different vaults. These tools enhance users' control and management of assets, helping to improve the overall liquidity and efficiency of the DeFi ecosystem.


V. Views on Modular Lending at the Current Stage


DeFi protocols refer to a series of decentralized applications (dApps) built on blockchain networks that provide traditional financial services such as lending, trading, and insurance on the chain without relying on traditional financial institutions. Modular DeFi protocols improve the flexibility and innovation of DeFi protocols by splitting these services into independent modules, allowing users and developers to flexibly combine and use different functions.


At this stage, DeFi mainly consists of yield aggregators, lending, derivatives and options, and insurance protocols. These modules can be freely combined to create new financial products and services. But in essence, its characteristics are similar to the logic of OP Stack's one-click chain issuance. Modular DeFi protocols need to establish module combinations based on their own protocols to create new financial products and services.


Modular DeFi brings flexibility, but also comes with potential risks. UniSwap started the DeFi craze and became the "source code" of various DeFi protocols today. Since its emergence, UniSwap has never been attacked by hackers. The fundamental reason is that it relies on a simple core invariant (tokenBalanceX* tokenBalanceY = k) and is related to its combination with non-upgradeable smart contracts.


However, modular flexibility also brings relative complexity. It is also an important aspect to consider whether the failure of the potential upgradeable contracts of individual protocols will have a chain reaction on other protocols and lead to overall systemic risks.


Extended links:
(1) https://github.com/morpho-org/morpho-blue/blob/main/LICENSE
(2) https://www.euler.finance/blog/euler-v2-the-new-modular-age-of-defi


This article comes from a contribution and does not represent the views of BlockBeats.

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Disclaimer: The content of this article solely reflects the author's opinion and does not represent the platform in any capacity. This article is not intended to serve as a reference for making investment decisions.

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