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Rehypothecation

Introduction​

Rehypothecation in decentralized lending is the practice of lending out assets deposited as collateral by borrowers to other borrowers. This practice is common in platforms like Aave and Compound (V2), where most collateral assets are also borrowable.

In Morpho (formerly known as Morpho Blue), assets deposited as collateral are not lent out directly. However, it is possible to create markets with collateralized tokenized lent assets, typically via Morpho Vaults (formerly known as MetaMorpho). This section aims to provide an understanding of rehypothecation within the Morpho ecosystem, focusing on risk curation and its implications.

Rehypothecation for Borrowers​

Benefits​

  1. Productive Collateral: Borrowers can earn interest on their collateral, potentially reducing the overall cost of their loan. In some cases, borrowers might even profit from this setup.
  2. Increased Capital Efficiency: Rehypothecation increases the capital efficiency of the platform by utilizing idle assets.

Risks​

  1. Illiquidity: Rehypothecated collateral can become illiquid, which might prevent timely liquidations. This increases the risk of bad debt.
  2. Bad Debt: If a Morpho Vault experiences bad debt, the value of its shares decreases instantly, potentially making some accounts liquidatable and reducing the time available for liquidation.

Rehypothecation for Risk Curators​

Effective risk curation is crucial for maintaining the stability of Morpho markets. The following concepts are key:

Key Metrics​

  1. Time to Liquidate: This is the duration during which an account can be safely liquidated without incurring bad debt. It is influenced by the speed at which the price of the collateral asset relative to the loan asset can decrease, the over-collateralization level (LLTV), and the liquidation incentive (LI).
  2. Liquidation Duration: This is the time required to liquidate an account. It depends on the liquidity of the assets on various exchanges (DEXes, CEXes), the speed of arbitrage, the LI, and the size of the position.

For a market to remain stable, the time to liquidate should be greater than the liquidation duration.

Specific Considerations for Rehypothecation​

  1. Illiquidity Risk: The liquidity of Morpho Vault shares is crucial. Illiquidity can arise from large positions or illiquid underlying markets. Platforms with rehypothecation usually target lower utilization rates to accommodate liquidations.
  2. Bad Debt Risk: This risk is heightened when using Morpho Vaults as collateral. Any bad debt in the vault's market impacts the value of its shares, affecting the collateral's liquidation time.

General Prerequisites for Rehypothecation​

  1. Set Conservative LLTVs: Lower LLTVs provide more collateral buffer, extending the time available for liquidation.
  2. Curate Market Caps: Limiting the market size can help curating the liquidation duration by reducing the potential size of positions.
  3. Monitor Vault Liquidity: Regularly assess the liquidity of the Morpho Vaults to ensure they can support liquidations.

Example Use Case​

Morpho Vaults Tokens as Collateral​

Here’s a general workflow for using Morpho Vaults tokens as collateral:

  1. Deposit Assets into a Morpho Vault: Users deposit assets (e.g., ETH) into a Morpho Vault and receive vault tokens (e.g., mmETH) representing their share.
  2. Use Vault Tokens as Collateral: Users can then use these vault tokens as collateral in a Morpho market to borrow another asset (e.g., USDA).
  3. Rehypothecation: The initial deposited assets are lent out, and the vault tokens are used as collateral, enabling rehypothecation.

Conclusion​

Rehypothecation in Morpho provides opportunities for increased capital efficiency and reduced borrowing costs. However, it also introduces risks that require careful curation. By setting conservative LLTVs, monitoring closely market caps and vault liquidity, market participants can mitigate these risks and maintain the stability of the platform.

Additional Resources​