Composability of DeFi

The adoption of groundbreaking technology takes time, but those who recognize its potential early often reap significant benefits. While traditional finance (TradFi) offers closed, proprietary solutions, DeFi holds the promise to completely change it.

DeFi has seen cycles of growth and retracement, and technological advancements with AI consistently push the ecosystem forward. This brief article explores how composability drives innovation, showcasing the concept of “DeFi Money Legos,” protocols building on each other, and the unique risks of this modular approach.

DeFi’s Evolution: From 1.0 to Modular Finance

The first wave of DeFi introduced decentralized applications (dApps) that utilized smart contracts on Ethereum. Early protocols like Uniswap, AAVE, and MakerDAO showcased automation in swaps, lending, and collateralized debt positions (CDPs). However, this era was characterized with inefficiencies and unsustainable yield farming practices.

With the advent of DeFi 2.0, protocols embraced more sustainable models like real yield, creating robust foundations for future innovations.

Enter the era of composability, where DeFi applications integrate to unlock new functionality and synergize with each other—marking the rise of DeFi Money Legos.

What is Composability?

Composability is the ability to combine existing DeFi protocols, apps, and platforms to create new financial products and use cases. The term “money legos” is used to describe the idea that DeFi protocols can be combined like Lego blocks to build new structures.

Every day, protocols like Aave, Yearn, Synthetix, Curve or Axelar and Wormhole in interoperability mesh together to enable, process, and deliver new financial products only possible in DeFi. To understand this point, remember that DeFi protocols are open-source, permissionless, and can be used by anyone.

The open-ended and permissionless nature of DeFi protocols allows you to stack these protocols together just as you would a Lego set. By playing with composable money legos (i.e., DeFi protocols like Yearn), you can unlock incredible yield farming returns, deploy flash loans, or take out loans that repay themselves.

For example, let's look at Kamino’s integration with Orca.

Orca is a permissionless decentralized exchange on Solana that utilizes a Concentrated Liquidity Automated Market Maker (CLAMM) model. Orca allows liquidity providers (LPs) to concentrate their liquidity within specific price ranges. This makes trades more efficient, reduces slippage, and maximizes the use of liquidity.

Kamino enhances Orca’s functionality by introducing automated liquidity vaults for SPL tokens, which streamline the process of managing and optimizing liquidity positions on Orca.

1. On-Chain Liquidity Support for $KMNO: Kamino’s vaults support the on-chain liquidity of $KMNO by deploying capital into Orca pools.
2. Yield Optimization: Depositors into Kamino’s vaults earn trading fees from Orca’s CLAMM pools.

DeFi Money Legos: A New Era

The modularity of blockchain systems gives rise to the concept of “Money Legos,” allowing protocols to stack functionalities and assets to form entirely new applications.

Examples of Money Legos in Action

1. Liquid Staking Ecosystems

Lido’s stETH exemplifies DeFi composability by integrating with various protocols to enhance utility and unlock innovative financial strategies.

Aave, a decentralized lending platform, incorporates Lido’s stETH and its wrapped version, wstETH, enabling users to utilize these tokens as collateral for borrowing other assets. This allows stETH holders to earn Ethereum staking rewards while simultaneously participating in Aave’s lending markets. Specifically, users can supply stETH on Aave V2 and wstETH on Aave V3 across multiple networks, including Ethereum, Optimism, Arbitrum, and Polygon. Users can also supply stETH or wstETH as collateral, borrow ETH against it, restake the borrowed ETH to receive more stETH or wstETH, and repeat this process to amplify staking returns. This recursive strategy enables users to maximize yields by combining staking rewards with Aave’s lending capabilities.

2. Trading Ecosystems

Automated Market Makers (AMMs) like Uniswap, Curve and SushiSwap, are at the core of DeFi composability. They allow users to trade assets directly from their wallets in a decentralized and permissionless manner by providing liquidity to pools and earning transaction fees. AMMs enable seamless token swapping across DeFi protocols and serve as essential building blocks for liquidity provisioning in decentralized exchanges (DEXs).

3. Interoperability Solutions

LayerZero is a trustless omnichain interoperability protocol designed to address the issues of liquidity fragmentation in the blockchain industry as a whole. This is achieved with a lightweight message-passing protocol that provides authentic and guaranteed delivery.

LayerZero operates at the communication primitive level, facilitating diverse omnichain applications. While exchanges are one example of applications that can benefit from LayerZero, the protocol itself focuses on enabling seamless inter-chain transactions and communication. By offering trustless messaging capabilities between Layer 1 and Layer 2 chains, LayerZero establishes itself as the first trustless omnichain interoperability layer.

Over 100 protocols are built atop and integrated with Layerzero for Omnichain solutions, including Tapioca, Stargate, and Mode Network.

Yield Optimization:

Pendle Finance is a DeFi protocol that enables users to tokenize and trade future yields of various yield-bearing assets, including Liquid Staking Tokens (LSTs) and Liquid Restaking Tokens (LRTs).

Pendle’s platform supports various LSTs and LRTs, enhancing their utility within the DeFi ecosystem:

• Liquid Staking Tokens (LSTs): Assets like stETH and rETH (Renzo ETH) can be tokenized on Pendle, allowing users to trade their future yields or secure fixed returns.
• Liquid Restaking Tokens (LRTs): With the advent of restaking protocols, Pendle has integrated LRTs, enabling users to speculate on or hedge yields from restaking activities. For instance, Pendle launched an incentivized pool for eETH (EtherFi’s LRT), facilitating yield trading and liquidity provision for restaked assets.

Money Legos amplify efficiency in resource allocation and liquidity distribution. Developers can focus on refining core features while benefiting from existing infrastructure. Users, in turn, access diverse financial services that generate sustainable returns.

Risk Section: The Flip Side of Composability

While composability enables innovation, it also introduces risks.

Interdependence Risks

Protocols relying on one another are vulnerable to failures within the ecosystem. For example:

• If a key protocol like AAVE encounters a vulnerability, it could cascade across integrated dApps.

Smart Contract Exploits

The interconnected nature of DeFi increases the attack surface. Due to dependencies, a hack in one protocol could compromise others, as we have seen on multiple occasions.

Liquidity Fragmentation

Cross-chain interoperability, while promising, risks fragmenting liquidity even more across multiple ecosystems, potentially reducing efficiency.

Governance Risks

Disputes or centralization in a single protocol could affect integrated platforms.

One of the most breakthrough innovations in the blockchain industry is Composable DeFi, which enables Ethereum’s modular ecosystem to produce an ever-growing array of financial services and products. This idea is still influencing decentralized finance even until the year 2025, spurring greater accessibility, innovation, and adoption.

As the ecosystem grows with Layer 2 solutions, cross-chain interoperability, AI and the addition of real-world assets, composability will remain at the core of DeFi's future. This will make the financial system more decentralized, effective, and open to everyone.