The Derivative of Modular Narrative: The Modular Evolution of DeFi Lending
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The Derivative of Modular Narrative: The Modular Evolution of DeFi Lending
Modular design enhances flexibility and scalability, enabling users and developers to freely combine functional modules.
Navigating Web3 tides with focused insightsAuthor: Ac-Core, YBB Capital Researcher
TL;DR
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The essence of modular lending goes beyond cross-chain and aggregation, although both play important roles in modular lending;
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Modular lending leverages security, consensus, and data availability provided by the base layer, focusing primarily on functional modularity at the execution and application layers;
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Modular lending breaks down its process into multiple independent modules—such as collateral management, interest rate calculation, risk assessment, and liquidation mechanisms—and enables communication between these modules via standardized interfaces;
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Current modular DeFi protocols resemble the OP Stack's one-click chain deployment logic, requiring new financial products and services to be built upon customized module combinations within their own protocol frameworks.
1. Origins of Modularity
The concept of modular blockchains originated from two whitepapers. In 2018, Mustafa Al-Bassam and Vitalik Buterin co-authored the paper "Data Availability Sampling and Fraud Proofs," which proposed a system allowing light clients to receive and verify fraud proofs from full nodes. It introduced a data availability sampling protocol that reduced the trade-off between on-chain capacity and security, solving blockchain scalability issues without sacrificing security or decentralization.
Then, in 2019, Mustafa Al-Bassam detailed a new architecture in the "Lazy Ledger" whitepaper—a design using blockchains solely for transaction ordering and ensuring data availability, without handling execution or validation. This architecture aimed to address scalability limitations in existing blockchain systems and was initially called the "smart contract client." Smart contract execution would occur on a separate execution layer atop this client, forming the prototype of Celestia—the first modular data availability layer project.
With the emergence of rollup technology, this vision became more concrete: executing smart contracts off-chain and uploading results as validity proofs to the "client’s" execution layer. Through rethinking blockchain architecture and new scaling techniques, Celestia emerged, defining a new paradigm of "modular blockchains."
2. The Rise of Modular Blockchains
Modular blockchains aim to solve the blockchain "impossible trinity" dilemma through decoupling and reconfiguration. In simple terms, they break down a monolithic chain’s core functions into distinct layers, each dedicated to a specific task, thereby improving scalability. Typically, the core responsibilities of a single blockchain can be divided into four functional layers:
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Data Availability Layer (DA Layer): Ensures network data is accessible and verifiable, including storage, transmission, and verification. It maintains transparency and trust in the blockchain network. Representative DA projects include Celestia, Avail, and EigenDA. Monolithic public chains like Ethereum and Solana can also serve DA needs (Bitcoin, being non-Turing complete, lacks viable verification schemes for traditional rollups, though efforts to scale it are progressing rapidly);
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Consensus Layer: Coordinates agreement among nodes to ensure consistency of data and transactions across the network. Uses consensus algorithms (e.g., PoW or PoS) to validate transactions and create new blocks. Most DA projects require their own lightweight consensus layers, often designed for low hardware requirements and easy verification;
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Execution Layer: Handles transaction processing and smart contract execution, including validation, execution, and state updates. Layer 2 solutions (e.g., Arbitrum, Optimism, ZKsync) are examples of modular blockchains with only execution-layer functionality, relying on the mainchain for security and finality verification;
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Settlement Layer: Finalizes transactions and ensures permanent recording of asset transfers on-chain. The primary role of a modular settlement layer is to verify rollup validity proofs and state data. Notable projects include Dymension and Cevmos.
In early history, Bitcoin-based solutions like the Lightning Network and sidechains were precursors to modularity. However, due to Bitcoin’s lack of Turing completeness, these scaling approaches progressed slowly and suffered various flaws, limiting adoption. Traditional blockchains attempted to resolve the trilemma by reconstructing their underlying frameworks, but with limited success. To tackle this, Vitalik Buterin proposed a rollup-centric roadmap. With the maturation of fraud proofs and zero-knowledge proofs, the "Lego-like" approach of building execution layers atop Ethereum has become feasible. Ethereum has thus positioned its long-term vision around rollup-based layered scaling—an upgrade path expected to surpass previous scaling methods and become the ultimate solution for public chain expansion.
3. Evolution of Modularity — Modular Lending
Image source: Legend Quant
DeFi modular lending leverages security, consensus, and data availability from the base layer, focusing primarily on functional modularity at the execution and application layers, with these modules operating on top of blockchains. Key modularized components include: collateral management modules responsible for storing, managing, and processing user collateral securely and compliantly; interest rate calculation modules that dynamically adjust borrowing and lending rates based on market supply/demand and credit scores; risk assessment modules evaluating borrower creditworthiness to determine loan approval and required collateral levels; and liquidation mechanism modules that trigger liquidations when borrowers fail to repay, protecting platform and user interests.
A modular lending system must retrieve all necessary transaction and contract data from the data availability layer to enable interaction and verification among modules. Module operation results must be confirmed and recorded via the consensus layer to ensure secure and consistent state transitions. Most of the lending logic runs on the execution layer via smart contracts. Final settlement and liquidation of lending transactions depend on the settlement layer to guarantee finality.
3.1 Core Principles
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Modular Design: Breaking down the lending process into independent modules such as collateral management, interest rate calculation, risk assessment, and liquidation mechanisms. Each module can be independently developed, tested, and deployed;
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Interoperability: Modules communicate through standardized interfaces, enabling flexible composition and even cross-platform reuse of certain modules;
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Upgradeability: Since modules are independent, individual modules can be upgraded without affecting the entire system, allowing rapid adaptation to market changes and technological advances;
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Security: Modular design isolates risks. If one module suffers a vulnerability, only that component needs fixing, minimizing systemic impact.
3.2 Key Components
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Collateral Management Module: Handles deposit, withdrawal, and management of collateral, ensuring user assets remain secure and compliant;
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Interest Rate Calculation Module: Dynamically adjusts lending/borrowing rates based on market conditions and borrower credit profiles;
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Risk Assessment Module: Evaluates borrower risk to decide whether to approve loans and determine required collateral ratios;
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Liquidation Mechanism Module: Triggers liquidation procedures when borrowers default, safeguarding platform funds.
3.3 Advantages
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Flexibility: Different modules can be combined as needed to meet diverse lending demands;
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Efficiency: Optimizing individual modules improves overall system performance;
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Innovation: Developers can innovate around specific problems by introducing new modules to enhance functionality;
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Transparency: Higher transparency allows each module’s logic and state to be independently audited and verified.
3.4 Role of Cross-Chain and Aggregation in Modular Lending
Image source: Cross-Chain Bridges Explained
The essence of modular lending is not merely cross-chain interoperability and aggregation, although both play significant roles. The core idea of modular lending lies in breaking down lending processes into discrete functional modules to enhance flexibility, scalability, security, and innovation. Cross-chain and aggregation are tools that support this vision but do not constitute its entirety.
Cross-Chain (Interoperability):
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Cross-chain technology enables assets and functional modules across different blockchains to interoperate. This is crucial for modular lending, as it allows users to transfer assets and access various decentralized applications (dApps) across chains;
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Multi-chain Support: By supporting multiple blockchains, lending platforms increase accessibility and flexibility, attracting more users and capital.
Aggregation:
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Aggregation Protocols: Combine multiple lending protocols and liquidity pools into a unified interface, enhancing user experience. For example, users can access multiple lending markets through a single aggregator to find optimal rates;
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Liquidity Aggregation: Pools liquidity from various sources to improve capital efficiency and market depth.
3.5 Other Key Aspects of Modular Lending
Modular Design:
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Functional Modularity: Decompose the lending process into independent modules (e.g., collateral management, interest rate calculation, risk assessment, liquidation), each independently developable, deployable, and upgradable;
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Standardized Interfaces: Modules communicate via standardized APIs, ensuring compatibility and seamless integration.
Security and Risk Management:
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Risk Isolation: Modular design confines risks to specific modules, preventing cascading failures;
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Security Audits: Individual modules can undergo separate audits, strengthening overall system resilience.
Flexibility and Scalability:
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Flexible Composition: Users and developers can mix and match modules to suit varying lending needs;
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Scalability: System capabilities and performance can be expanded by adding or replacing modules, without requiring full system redesign.
Today, established DeFi platforms such as Aave, Compound, and MakerDAO are increasingly adopting modular design principles. For instance, MakerDAO is evolving toward a less centralized SubDAO model, while Aave consists of multiple smart contracts handling lending, collateral management, and liquidation separately. Developers and users can combine these contracts as needed, even creating new ones to extend platform functionality.
4. Modular Lending Projects
4.1 Morpho Labs
Morpho Labs aims to advance the efficiency and user experience of decentralized lending markets through technological innovation, driving the evolution of the DeFi ecosystem. With modular design and frictionless trading mechanisms, Morpho Labs seeks to attract more users and capital into DeFi, particularly through innovations in Morpho Blue and Meta Morpho that enhance lending efficiency and interoperability.
Image source: Official Morpho Labs
Morpho Blue
Morpho Blue is an advanced version of a lending protocol developed by Morpho Labs, enabling minimal deployment of crypto assets (ERC20 and ERC-4626 tokens) and independent lending markets on the Ethereum Virtual Machine. It provides a trustless foundational layer for lenders, borrowers, and applications, using a dual license (BUSL-1.1 and GPLv2), designed to run permanently on Ethereum once deployed. Its core features include:
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Collateral: Borrowers must provide supported crypto assets as collateral;
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Loan-to-Value Threshold (LLTV): Specifies the minimum value ratio of collateral to borrowed assets. For example, if LLTV is 90%, the loan value cannot exceed 90% of the collateral value, otherwise the position will be liquidated;
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Borrowing: Users initiate borrowing by interacting with the protocol, specifying the amount and providing required collateral;
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Interest Rates: Borrowers pay interest based on the protocol’s interest rate model, accruing over time and settled upon repayment;
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Repayment: Borrowers can repay principal and accrued interest anytime. Once confirmed on-chain, they can withdraw their collateral;
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Liquidation Mechanism: To mitigate default risk, the protocol includes liquidation. If the loan value exceeds LLTV (due to price volatility or accrued interest), the position may be partially or fully liquidated to repay the debt;
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Lending: Users deposit assets into the protocol by transferring them to the smart contract;
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Withdrawal: Lenders can withdraw lent assets and earned interest anytime, subject to sufficient market liquidity.
A key feature of Morpho Blue is its ability to create permissionless markets, allowing users to define custom markets composed of lending assets, collateral types, LLTV, oracles, and Interest Rate Models (IRM). All parameters are fixed at market creation and immutable, with LLTV and IRM options selected from a pre-approved list managed by Morpho.
Meta Morpho
Meta Morpho is an independent meta-protocol built atop Morpho Blue for creating Meta Morpho Vaults—lending vaults enabling seamless integration and interoperability across different DeFi platforms and protocols. Key features include:
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Cross-Platform Integration: Allows users to seamlessly transfer assets and strategies across different DeFi protocols;
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Enhanced Interoperability: Standardized interfaces and protocols enable smoother collaboration between DeFi platforms;
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Automated Management: Smart contracts and automation tools improve efficiency and reliability in asset and strategy management;
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Liquidity Aggregation: Combines liquidity from multiple platforms, boosting overall market liquidity and efficiency.
4.2 Euler Finance
Image source: Official Euler Finance
On February 22, 2024, lending protocol Euler Finance announced its imminent relaunch with a v2 version—a modular lending platform featuring two main components: the Euler Vault Kit (EVK) and the Ethereum Vault Connector (EVC)—aimed at enhancing protocol flexibility and functionality.
Euler Vault Kit (EVK)
EVK is a toolkit enabling users to create and manage custom "vault" systems. Users can deposit assets into vaults and configure personalized strategies and rules. EVK integrates with EVC, empowering developers to build ERC-4626-compliant vaults. Key features include:
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Custom Strategies: Users can define unique strategies based on risk tolerance, such as setting specific interest rates or liquidation thresholds;
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Multi-Asset Support: EVK supports various crypto assets, allowing mixed deposits;
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Flexible Management: Users can dynamically adjust vault settings in response to market shifts and personal needs;
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Security: Leveraging smart contracts and decentralized architecture, EVK ensures high-level asset protection.
Ethereum Vault Connector (EVC)
EVC is a tool designed to connect EVK vaults on Ethereum. It enables seamless transfer of assets and strategies across different DeFi protocols, giving vaults superpowers—such as serving as collateral for other vaults—and facilitating smooth communication between ERC-4626 vaults and other smart contracts. Key features include:
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Unified Interoperability Layer: EVC allows asset transfers between vaults—even across different protocols—greatly enhancing liquidity and flexibility;
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Strategy Sharing: Users can apply identical strategies across multiple vaults, simplifying management;
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Automated Management: Smart contracts automate asset transfers and strategy execution, reducing manual complexity;
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Enhanced Liquidity: By linking disparate vaults, EVC increases liquidity across the DeFi ecosystem, enabling more efficient capital utilization.
The Euler Vault Kit (EVK) and Ethereum Vault Connector (EVC) are pivotal additions by Euler Finance, designed to offer greater flexibility and management efficiency. With EVK, users create and manage custom vaults; with EVC, they seamlessly move assets and strategies across vaults. Together, these tools strengthen user control over assets and boost overall liquidity and efficiency in the DeFi ecosystem.
5. Perspectives on Current Modular Lending
DeFi protocols are decentralized applications (dApps) built on blockchain networks that offer traditional financial services—such as lending, trading, insurance—without reliance on centralized institutions. Modular DeFi protocols enhance flexibility and innovation by breaking these services into standalone modules, enabling users and developers to freely compose and utilize different functionalities.
Currently, DeFi is primarily composed of yield aggregators, lending, derivatives and options, and insurance protocols. These modules can be freely combined to create novel financial products and services. However, their fundamental characteristic resembles the OP Stack’s one-click chain deployment logic: modular DeFi protocols must build custom module combinations atop their own base frameworks to launch new offerings.
While modular DeFi brings flexibility, it also introduces potential risks. Uniswap sparked the DeFi boom and has since served as the “source code” for countless DeFi protocols. Since its inception, Uniswap has never been hacked—largely due to its simple, immutable core invariant (tokenBalanceX * tokenBalanceY = k) and non-upgradable smart contracts.
However, modular flexibility introduces added complexity. As DeFi protocols become highly interconnected, a failure in an upgradable contract within one protocol could trigger cascading effects across others, leading to systemic risk—an important consideration moving forward.
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