How Morhpo-Aave V3 works

Morpho enables money market users to be seamlessly matched peer-to-peer when available. There currently exists a large spread in existing lending protocols as numerous lenders share the interests generated by a few borrowers. With Morpho, the yield is no long socialized. Instead, the supplied liquidity is matched peer-to-peer with borrowers on a come-and-go basis. Lenders' interests correspond to the interests paid by the borrowers they are paired with. Due to this, the protocol's lending and borrowing rates can be freely adjusted by Morpho but must stay within the spread of the underlying protocol's pool to be profitable for both parties. To match users, Morpho holds an on-chain priority queue that sorts users according to the amount they want to lend or borrow. When new lenders supply liquidity to the protocol, their liquidity is matched with the largest borrower first. And when new borrowers seek liquidity, their demand is first matched with the most significant lender. Overall, users who use Morpho receive in the worst-case scenario the yield of the underlying money market pool or an improved yield due to peer-to-peer matching. There is currently no interest-bearing token because each user has a non-fungible position (similar to Uniswap V3).

What are the new features?

Morpho-Aave V3 is similar to the Aave V2 version but also introduces several new features and design choices. One of the new features that Morpho-Aave V3 introduces is efficiency mode (E-mode), a feature that enables users to borrow more when their collateral and borrowed assets are correlated in price, such as stablecoins or ETH derivatives. Currently, Morpho only offers E-mode for ETH, which includes WETH and wstETH. Another feature is account management, which allows users to delegate their borrowing and withdrawing actions to a manager contract, which can perform multiple actions in one transaction and save gas fees. A third feature is gasless token approvals, which uses the Permit2 contract to let users approve any token on any protocol with a signature, without having to pay gas for each approval. Finally, Morpho-Aave V3 also features an improved matching engine, which uses logarithmic buckets to match users with similar volumes, resulting in lower gas costs, better fairness, and higher efficiency.

What are the mechanism changes?

Aave V3 introduced new supply and borrow caps, which limit the amount of liquidity available in each pool. To overcome this challenge, Morpho-Aave V3 implements a new mechanism that splits suppliers into two types: suppliers and collateral providers. Suppliers are users who lend their assets without borrowing anything, and they can enjoy fixed rates by being matched with other users in a peer-to-peer fashion. Collateral providers are users who lend their assets as collateral for borrowing other assets, and they deposit their assets directly into the Aave V3 pool to ensure liquidations can happen smoothly. By using this mechanism, Morpho Aave V3 can offer better rates for borrowers and suppliers, while also managing the risk of liquidity constraints. However, suppliers should be aware that there is a tradeoff involved: if the Aave V3 pool reaches its borrow cap, they may not be able to withdraw their peer-to-peer matched funds instantly, and they may have to wait until some liquidity becomes available in the pool.