Why are institutions collectively shifting to Morpho for isolated markets?

Author: Bo Bo Bo Source: @bocaibocai_

“To understand why Aave lost hundreds of millions in funds, while Morpho remains almost unscathed, you first need to clarify the funding storage and operational logic of the two types of protocols.”

The underlying principles of all lending protocols in DeFi are generally similar:

• Users deposit stablecoins or Ethereum into a shared liquidity pool, from which borrowers can withdraw funds after collateralizing assets;

• A decentralized autonomous organization (DAO) votes to decide which assets can be used as collateral and the corresponding collateral-to-loan ratios.

Aave is built on this model, developing a deposit volume of up to $50 billion. For most of DeFi’s development, this has been the industry’s only mainstream approach, and its reasonableness has never truly been questioned.

However, on April 18, 2026, a hacker exploited a LayerZero cross-chain bridge vulnerability in the Kelp DAO project to forge rsETH tokens worth $292 million. The hacker deposited these fake tokens into Aave as collateral and borrowed real Ethereum. Within just a few hours, the funds utilization rate across major mainstream lending markets on Aave reached 100%, meaning all available funds within the protocol had been fully borrowed.

Over the following three and a half days, the platform lost $15 billion in deposits. Ultimately, Aave had to collaborate with various ecosystem parties to raise $160 million to cover the losses.

Although the vulnerability originated from the Kelp DAO project, the root cause of such massive losses lies in Aave’s governance mechanism. As early as January this year, the community voted to raise the collateral-to-loan ratio for rsETH to 93%, leaving only a 7% safety margin for this type of asset’s risk. This decision contributed to one of the largest bank runs in DeFi lending history.

On the same day, some forged rsETH tokens also entered Morpho, the second-largest DeFi lending protocol. But the risk exposure was only $1 million, dispersed across two small, isolated markets, and did not trigger a chain reaction.

I conducted an in-depth investigation and found that this incident was far from just a simple security attack.

Core Differences Between the Two Models

To understand why Aave lost hundreds of millions while Morpho remained nearly unaffected, you need to clarify the funding storage and operational logic of the two types of protocols.

When you deposit USDC into Aave, the funds are pooled into a single liquidity pool used to support lending activities for Ethereum, staked tokens, and all other assets approved by the community. Depositors cannot choose the specific collateral type for their funds; all rules are set by DAO voting. Therefore, when rsETH faces a collapse risk, even ordinary users who only deposit USDC or have never interacted with rsETH will find their assets frozen — everyone’s funds are in the same risk pool, and a loss affects all.

What’s more problematic is that during market halts, when users cannot withdraw tokens, Aave’s governance layer actually lowered the interest rate for the frozen Ethereum lending market to protect leveraged borrowers using rsETH. Since deposit and borrow rates are directly linked, depositors with the lowest risk and principal safety ultimately see their returns shrink further.

In traditional credit systems, the lowest-risk lenders have priority in repayment. But Aave has completely reversed this rule. The reason is that borrowers engaging in rsETH leverage trading are also the most active voters in community governance. When risks materialize, high-risk participants with governance power naturally prioritize protecting their own interests.

Aave had launched an insurance mechanism called Umbrella at the end of 2025 to address such bad debt risks. Users could pledge Ethereum, and in case of bad debt, the pledged assets would be used for compensation. But after the Kelp DAO crisis, out of 23,507 pledged aWETH, 18,922 entered a withdrawal waiting period, with nearly 80% of the insurance pool’s funds withdrawing.

This mechanism ultimately failed. On-chain insurance relies on voluntary participation, and when risks actually materialize, fund providers will inevitably choose to exit — after all, only during a crisis do their assets face real losses. This results in such insurance often existing during stable times but being effectively useless when protection is truly needed.

Morpho’s operational model is entirely different. It abandons the unified shared liquidity pool, allowing anyone to create independent isolated lending markets, with pre-set parameters for lending assets, collateral assets, price oracles, and interest rate models. Once deployed, these parameters cannot be changed. To adjust risk levels, new markets must be created.

Moreover, Morpho introduces independent risk control agencies (protocol managers), such as Gauntlet and Steakhouse Financial. These agencies set up funds, allocate capital to different markets based on their assessments, and earn performance fees; losses are limited to their own funds. Gauntlet has also provided risk management advice to Aave, but within the Aave system, its professional opinions are often vetoed by token holders seeking high yields, whereas Morpho fundamentally prevents such situations.

Hidden Costs Often Overlooked

Aave and Morpho are currently the two most widely used lending models in crypto: Aave uses a shared liquidity pool where all deposits are pooled together, and risk rules are decided by community votes; Morpho adopts an isolated market approach, with each lending transaction independent and risk managed by professional institutions.

The Kelp DAO vulnerability exposed the flaws and risks of the shared pool model. Even during stable periods without security incidents, this model has a long-term hidden cost that is often overlooked.

Aave’s three main on-chain markets (Ethereum, USDT, USDC) contribute 89% of the platform’s lending volume. In these markets, deposit interest rates are always 25% to 35% lower than borrowing rates.

The difference essentially represents idle funds in the liquidity pool, which depositors cannot profit from, while borrowers still bear the full cost of the loans.

Using a rate mechanism based on utilization, the system can raise interest rates during high-risk periods but cannot activate idle funds during low demand, causing large amounts of assets to remain in the pool without generating returns.

Just these three markets cause an annual value loss of up to $52 million due to idle capital, nearly a quarter of Aave’s quarterly annualized revenue. Even if reserve ratios are eliminated and platform fees are canceled, the problem of idle funds cannot be solved — this is an inherent flaw of the shared pool architecture.

Morpho’s interest rate model aims to keep utilization around 90%, well above Aave’s 60% to 80%. This high utilization is sustainable because deposits are not used as collateral for other loans, avoiding chain liquidations from the source and eliminating the need for large risk buffers.

When lending demand is high and funds are heavily borrowed, interest rates automatically rise to attract more depositors; when demand drops, rates fall to stimulate borrowing. The entire system can achieve dynamic balance without community voting.

Real-world data also confirms its advantages: even after deducting protocol management fees, the yield offered to depositors in Morpho’s leading USDC liquidity pools remains higher than Aave and Compound. Currently, Morpho’s loan-to-deposit ratio is 41%, Aave’s is 39%, and with a multi-billion dollar volume, the yield advantage benefits all depositors daily.

Institutional Trust: Who Is More Reliable?

Surprisingly, all of Coinbase’s crypto asset lending services are built on Morpho. The related loan volume has exceeded $2 billion, and over 100 million platform users indirectly enjoy the benefits of Morpho’s lending.

Most users are even unaware they are using DeFi services. Coinbase has not developed its own lending system nor chosen other platforms; the core reason is that Morpho’s underlying architecture allows the platform to set risk control parameters independently, select partner risk agencies, and fully control the entire product experience.

Apollo Global Management, with over a trillion dollars in assets under management and 30 years of private credit experience, recently signed a four-year partnership agreement to acquire up to 9% of MORPHO tokens, totaling 90 million tokens. The firm will use its tokenized fund assets as collateral on Morpho, with Gauntlet responsible for fund management and stress testing.

Beyond that, Anchorage Digital, the first federally licensed crypto-native bank in the U.S., has integrated Morpho liquidity pools for its billion-dollar institutional clients; France’s Societe Generale’s SG-FORGE, a licensed bank’s compliance division, is the first to deploy DeFi lending via Morpho.

These strictly regulated traditional financial institutions collectively choose Morpho, driven by a common goal: the isolated market model allows them to meet their compliance and risk management requirements without relying on DAO governance. In contrast, all of Aave’s market rules depend on community voting, making it impossible to meet institutional needs for autonomous control.

Changing regulatory environments further amplify this trend. The U.S. “GENIUS Act” prohibits stablecoin issuers from directly distributing yield, requiring stablecoin platforms to rely on neutral underlying infrastructure to activate large amounts of idle assets. U.S. forecasts suggest that by 2028, stablecoin reserves invested in U.S. Treasuries will surge from the current $120 billion to over $1 trillion. This massive capital needs a lending infrastructure that allows asset providers to independently manage risks, and Morpho is currently the most suitable choice.