Merlin Egalite, co-founder of Morpho Labs, addressed the issue of temporary liquidity shortages in certain Morpho vaults on Ethereum. This comes as the market recovers from a stress event that saw Stream Finance’s xUSD stablecoin depeg, which led to a $93 million loss across DeFi protocols, including some exposure in one Morpho vault.
Merlin Egalite’s statement comes as the market struggles to regulate itself after the Stream Finance debacle. He began by defining lending.
“When you lend money onchain, that capital is being borrowed and used; it’s not just sitting idle waiting to be withdrawn at any time,” Egalite wrote. “When markets come under stress, people tend to de-risk, meaning many lenders try to withdraw all their funds at once, resulting in higher utilization and less liquidity, or in extreme circumstances, no short-term available liquidity. This isn’t a bug. It’s how lending pools naturally function under stress.”
He proceeded by pointing out that for balance to be restored after such an event, the interest rate model automatically raises borrowing rates. This encourages borrowers to repay and/or attract new suppliers to deposit, pushing utilization back down and increasing available liquidity over time.
“For Morpho specifically, the target utilization is 90%, meaning that most of the time, 90% of deposited funds are borrowed,” Egalite explained. “When it spikes to 100% (all funds are borrowed), the rate increases by 4x. The market rate then usually returns to equilibrium (around 90% utilization) within a few minutes in most cases, or a few hours during periods of significant market stress.”
Merlin Egalite on what he thinks about “illiquidity” in vaults
According to Egalite, any illiquidity is isolated and contained to the given markets with an imbalance, which is why he boasted that during the market stress, only 3–4 out of 320 vaults on the Morpho App experienced temporary illiquidity while the rest operated normally.
“Claims of protocol-wide illiquidity are mispresented,” he stated. “In the end, illiquidity doesn’t mean losses or bad debt. It means a short-term imbalance where most funds are borrowed, while the market responds in real time, repricing risk and finding its equilibrium.”
Paul Frambot, Morpho’s CEO and co-founder, echoed the sentiment in a separate tweet, pointing out the risky nature of DeFi.
“A vault is comparable to an onchain fund, and just like traditional funds, some will perform well and others won’t, but this is what we must accept and mitigate if we want to build a truly open and decentralized system,” he wrote before claiming that the fact that “only 1 out of ~320 vaults on the Morpho App had limited exposure to xUSD is evidence that the model works.”
“Morpho’s isolated market + vault model meant all 319+ other vaults and their depositors, each with different risk profiles, had zero exposure,” Frambot continued. “Many assume losses equal system failure. However, in open financial systems, losses are a natural consequence of risk-taking, even when systems operate exactly as designed.”
Frambot urged the industry to focus on better surfacing and educating about risks because for DeFi to become the backend of finance and scale to trillions in lending volume, “lending infrastructure must remain separate from risk management.”
The Stream Finance situation remains unsolved
As of the time of this writing, the Stream Finance debacle remains unresolved, with ongoing investigations and frozen operations that have resulted in the protocol suspending all deposits and withdrawals while retrieving remaining liquid assets. Meanwhile, the outfit’s stablecoin, Stream USD (xUSD), continues to trade depegged at around $0.165, down dramatically from its $1 target.
DeFi research group Yields and More has since identified nearly $285 million in direct debt exposure across multiple lending protocols, an exposure that affects the likes of Euler, Silo, Morpho, and Gearbox, with curators TelosC, Elixir, MEV Capital, and Varlamore among the most exposed creditors.
It remains unclear how settlements will occur between xUSD, xBTC, and xETH holders and lenders against these tokens. xBTC and xETH are Stream’s yield-bearing wrapped versions of Bitcoin and Ethereum and were used as collateral across DeFi lending markets.
A CoinMarketCap report claims an anonymous on-chain trader, Cbb0fe, had cried wolf days earlier, warning that Stream’s on-chain data reportedly showed xUSD’s supporting assets at only approximately $170 million, even though borrowing had reached $530 million, an imbalance that created a leverage ratio exceeding 4x through the protocol’s recursive looping strategy.
There has been backlash since users discovered Stream had allegedly been accumulating an undisclosed insurance fund from profits, with pseudonymous user chud.eth going as far as accusing the team of allegedly retaining a 60% undisclosed fee.
In response, Stream claimed that those funds were to be used always as an insurance fund, citing internal communications and investor updates. The protocol has since acknowledged that they have not been very transparent about how the insurance fund works, but no recoveries have been reported yet, and liquidity for xUSD remains near zero.
Want your project in front of crypto’s top minds? Feature it in our next industry report, where data meets impact.
Source: https://www.cryptopolitan.com/morpho-co-founder-illiquidity-in-defi-vault/