Introduction

Lending has always has always been a foundational part of financial systems. From helping people buy their first home by taking out a mortgage loan to supercharging the growth of corporations worldwide, lending is a catalyst for growth in economies everywhere.

In the world of decentralized applications, the need for robust lending systems is even more crucial. In the fiat world (off-chain), banks are the major provider of loans, considering parameters like credit scores when underwriting loans. In the world of crypto applications, achieving true decentralization requires replicating aspects of a bank in a permissionless and noncustodial manner. This is where decentralized lending comes into play.

Decentralized lending brings three main benefits: an increase in capital efficiency on-chain, a decrease in risk for lenders, and an overall boost in on-chain credit that stimulates further activities and decentralized applications.

The Significance of Decentralized Lending

• Capital Efficiency: Lending and borrowing activities breathe life into crypto markets, fostering liquidity and promoting the efficient allocation of resources. Borrowers seek funds for various purposes such as liquidity provisioning, leveraging positions, and maintaining exposure. Lenders supply these funds to earn interest on their capital. This continuous flow of capital ensures liquidity and supports the seamless operation of crypto markets and decentralized protocols.

• Risk Management: Lending provides a mechanism for transferring risk from those less inclined or equipped to bear it (borrowers) to those better suited (lenders). Traditionally, lenders evaluate borrowers' creditworthiness and price loans accordingly, facilitating risk management and distribution within the financial system. In decentralized finance, credit scores are replaced by over-collateralized loans, enabling truly permissionless and open lending for all.

• Credit Creation: Lending acts as a catalyst for credit creation within the decentralized economy. When a money market extends a loan, it effectively generates new money, appearing as a deposit in the borrower's account. This credit multiplication mechanism has a multiplier effect on the money supply, stimulating economic activity both on and off-chain.

While money markets have found their place in DeFi, it's essential to acknowledge the challenges and vulnerabilities they currently face. Despite lending and collateralized debt position (CDP) protocols accounting for roughly 45% of Total Value Locked (TVL) across all chains, as per DeFiLlama, the market still grapples with substantial liquidity fragmentation and sluggish growth attributed to current protocol designs.

Open Problem: Inherent Asset Risk Creates Liquidity Fragmentation and Rigid Market Structures

The two primary designs for money markets to date are the peer-to-peer (P2P) model and the pool-based model. P2P models place the burden of loan terms and bad debt risk explicitly on the lender, allowing them to select both loan and collateral assets. In contrast, most pool-based models are very strict with permitting collateral assets to minimize risk.

P2P vs. Pool-based Designs: Trade-offs Between Usability and Risk Tolerance

P2P Models

P2P models, like EthLend (before the rebrand to Aave) and Dharma, struggled to scale and suffered from inadequate liquidity due to fragmentation and yield dilution. Analyzing and establishing fair loan configurations, especially in the volatile crypto landscape, remain challenging. This inefficiency hampers liquidity attraction, making it difficult for borrowers to secure loans and occasionally results in unfavorable configurations leading to lender losses. Furthermore, legacy P2P models necessitate locking liquidity until specific custom terms are violated, prohibiting instant withdrawals.

Pool-Based Models

Meanwhile, pool-based models, like Aave and Compound, provide significantly better user experiences by aggregating liquidity and sharing risk among all depositors and assets. Aave and Compound operate as cross-collateralized pools, meaning that the presence of bad debt associated with one asset can affect the entire protocol. Consequently, there is a need for caution in implementing strict asset restrictions (not truly permissionless lending) and conservative risk parameters for both of these protocols.

As stated in the paper On the Inherent Fragility of DeFi Lending, "DeFi protocols struggle to achieve efficiency and stability while maintaining a high degree of decentralization.”

Since Aave and Compound only enable a few select assets to be managed on their protocols, this leads to fragmentation for users across multiple protocols. Not only is this a poor user experience, but it creates significant overhead for users to manage their assets across multiple protocols and keep track of which assets are where.

Improvements on the design of pool-based lending

Some protocols have tried to improve the pool-based model by introducing isolated pools, like Beta, Euler, and Rari Fuse. While the isolated pool model solves the issue of supporting borrowing for risky assets, it fails to solve the challenge of allowing more collateral types without fragmentation. Protocols are still required to create a separate isolated pool for each collateral type configuration they wish to support, creating fragmentation and overhead for users.

Likewise, some protocols have sought to improve the P2P model through shared isolated pairs, like Sushi Kashi. Although this reduces the burden on users to configure loan terms, liquidity fragmentation persists. It shares the same issue as isolated pools, where new pairs must be created for each collateral set configuration, further complicating the user experience and hurting capital efficiency.

Due to the drawbacks from a lack of capital efficiency and a worse UX in the isolated pool lending models, traditional pool-based models like Aave and Compound still dominate DeFi lending for now as shown below.

The Ideal

The open problem for money markets in DeFi is to find a protocol mechanism capable of handling various collateral types and various borrow types with zero fragmentation and maximal capital efficiency. This protocol would be permissionless, composable, and dynamic on-chain, eliminating the need to use multiple money market protocols, dramatically improving capital efficiency, and greatly simplifying the user experience.

This is a challenging problem that has no solution… yet.

Conclusion

Challenges persist in decentralized money markets, and designing a secure, risk-managed money market protocol is challenging. However, we see strong opportunities for innovation in on-chain money markets right now. We're excited about the money market problem and reaffirm our commitment to decentralized finance.

Follow our socials on Twitter and join our Discord to stay updated. Stay tuned for something very soon.

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