Lending Protocol Supply-Side Complexity

In recent years, we’ve seen DEXs slowly shift protocol complexity to the supply (lender) side, which we view as a dangerous trend due to a higher barrier of entry, and likely a further concentration of entities providing liquidity. For example, the advent of Uniswap V3 and concentrated liquidity made the liquidity provision experience much more complicated, and likely only more available to sophisticated participants. This trend will be further exacerbated by Uniswap V4’s hooks and UniswapX which shifts complexity to entities such as sophisticated market makers. 

A similar trend is occurring in lending/borrowing markets where increasingly complex lending mechanisms, and thus risk management, are being handed off to suppliers. In my opinion, shifting complexity to lenders for money markets is non-optimal. In models where lenders can set all their own risk parameters, it results in vastly more fragmented markets/liquidity and a fragmented user experience. History has shown that crypto lenders are horrible at pricing risk, both on the CeFi side with entities lending billions upon billions under-collateralized to firms such as 3AC and Alameda, and on the DeFi side with Blend NFT borrowers getting mass liquidated and lenders showing that they lack the know-how to appropriately price collateral risk back in July 2023. I do not believe the average DeFi user will know what best interest rate model to choose according to their risk preferences.

I believe one key reason for this shift in supplier sophistication is the centralization of money market risk management. For example, Aave is currently heavily reliant on risk-management firms such as Gauntlet and Chaos Labs to manage protocol risk/solvency. In addition, these entities are mostly reactive rather than proactive, and furthermore, the governance process surrounding these risk parameter changes is vastly inefficient with a strong lack of voter participation and understanding. However, I believe that over time, new technological unlocks, such as having dynamic interest rates based on available onchain liquidity verified through storage proofs could reduce the reliance on centralized risk managers. 

As a result, I expect to see lackluster adoption of these products and for simplified lending protocols to continue to retain capital across the sector.