Written by: Val Holla
Compiled by: TechFlow
There’s no doubt that DeFi has come a long way since Compound kicked off DeFi Summer in 2020. But what’s next? What useful services can DeFi provide to users that TradFi doesn’t? Or, does DeFi have any product today that can really start to take market share from TradFi? I believe it does, and I believe that product is “Vault.”
Vaults have taken the DeFi space by storm in 2022, so if you’ve been in the ecosystem, you’re probably familiar with them. However, you may not be familiar with the ERC-4626 standard, which I believe will exponentially accelerate DeFi adoption and efficiency. Later, we’ll look at some of the protocols that are starting to drive development with these tokens. But first, let’s cover the basics about Vault and the 4626 standard.
What is Vault?
Simply put, Vaults are smart contracts that users can deposit tokens into, which then run pre-determined strategies to invest those deposits. Vaults are zero-to-one innovations in decentralized finance, and if you ask me, why are they the clearest example of DeFi adding value? Because they are available, general, and transparent across all use cases.
Available - Vault is super easy to use.
General-purpose — they are used to do a wide variety of things. Currently, Vaults can do everything from collecting option premiums, to hedging leveraged futures trades, to optimizing loan yields.
Transparent - Anyone can view holdings and performance at any time, which really differentiates them from TradFi. TradFi doesn't really have anything equivalent to Vault; there is simply nothing in TradFi right now that can run fully transparent asset management strategies with the same customization potential and ease of use.
Institutions are extremely cautious about allocating funds to crypto due to all the behind-the-scenes tricks from Celsius, 3AC, FTX, etc. The benefit of DeFi is transparency, and Vault adds usability and versatility on top of that. I wouldn’t be surprised if Vault is the key player that ultimately pulls TradFi players into the space once the dust settles on CeFi. And that’s likely where the ERC-4626 standard comes in.
What is ERC-4626?
Born out of EIP-4626 at the end of 2021, ERC-4626 has recently seen a surge in momentum as more DeFi developers and users see the huge advantages it offers.
ERC-4626 takes the Vault creation process and standardizes it. This is extremely important for the user experience, which leads to increased liquidity. If you are a crypto veteran, you remember the days when there was no ERC-20 standard for tokens on Ethereum. This made it almost impossible for DeFi to exist, and the only way to buy/sell different cryptocurrencies was through centralized exchanges. The reason DeFi cannot exist is that in order to have enough liquidity to operate a financial system, some kind of standardization (fungibility of assets) is required.
ERC-4626 brings fungibility to Vault tokens
In simple terms, this means that once you deposit tokens into a Vault, you get a tokenized version of the entire Vault strategy — kind of like an LP token for the Vault strategy.
For example, if you deposit USDC into xyzVault to earn interest, you will receive xyzUSDC in return. Ideally, you can sell xyzUSDC on a DEX or deposit it into another Vault.
When you want to exit, you must send xyzUSDC back to xyzVault and redeem your original USDC and the interest earned, minus any service fees.
ERC-4626 Brings Liquidity to Vault Tokens
Only with fungibility can there be liquidity, which is why standardization is so important.
Right now, there are so many DeFi protocols competing for a relatively small pool of liquidity. The positive side is that we are still in the early days, and an open environment breeds competition, which breeds innovation. However, the negative side is that small amounts of liquidity are scattered across a bunch of different applications that are not interoperable. This concept also applies to Vault.
Vaults are great because they allow people to invest in complex strategies without having to do all the trading themselves. However, if a Vault is not ERC-4626 compatible, your funds can’t be used for other things if you use that Vault, and DeFi fails because liquidity no longer flows.
ERC-4626 solves this problem. Going back to the xyzVault example, no matter what you do with your xyzUSDC, as long as you don’t redeem it, the USDC you originally deposited will stay in the xyzVault’s liquidity pool. If you deposit your xyzUSDC into a DEX, you’ll also add liquidity to that DEX. Alternatively, you can lend your xyzUSDC to money market applications, which also contributes to their liquidity.
Let’s take a look at three projects that use the ERC-4626 standard.
1: Rodeo Finance
Rodeo is working hard to become the premier venue for liquidity mining on Arbitrum, and they are doing this by leveraging the power of ERC-4626.
Rodeo’s Vault allows you to invest in different LP yield strategies, and even goes a step further by allowing users to take margin loans, earning you higher returns.
For example, let's say you want to earn yield by providing $100 of USDC/WETH liquidity to Uniswap. Normally, you can only invest a maximum of $100 in this strategy, but Rodeo allows you to borrow up to 10x leverage on any deposit. Of course, the more leverage you use, the greater the risk, but it provides a good option for those who want a higher APY from a "normal" LP and don't mind taking on some additional risk.
Rodeo is different in two ways: First, in order to invest in their strategies, you only need to deposit USDC, and Rodeo will take all the USDC, buy any LP tokens required for the strategy, and invest them for you. This saves you time and money that would be spent on the tedious process of purchasing tokens and depositing them in liquidity pools. Instead, all you need is some USDC.
Second, of course, all of their vaults use the ERC-4626 standard, which means it’s easy to merge new vaults. For example, due to the risk of leverage, there could be vaults on Rodeo that allow users to hedge their positions to avoid liquidation.
2023 should be an exciting year for Rodeo. As you can see, they have a ton of releases and improvements planned on their roadmap.
2: FactorDAO
Factor is a relatively new project that aims to be the liquidity hub for Arbitrum. Of course, the way they plan to do this is to make it easier to create Vaults, and their strategy revolves around the ERC-4626 standard.
Factor has a one-stop shop for creating a variety of structured products, including yield strategies, derivatives, LPs, etc. Basically, if you want to create or invest in a custom asset management strategy, you can consider it.
As I mentioned before, there is nothing like this in TradFi: anyone will be able to easily create a customized asset management strategy, which is the main advantage of DeFi. In addition, with DeFi, you get the transparency of a public blockchain, where anyone can see all strategies, transactions, etc. for each Vault.
At the same time, we again see ERC-4626 come into play here, as its composability allows for strategies to be built on top of other strategies. For example, you can create your own fund composed entirely of other ERC-4626 tokens, reaping the benefits of a variety of different strategies, paving the way for more innovative products and systems to be built on Arbitrum.
There’s a reason Factor is rapidly expanding their list of partners across the Arbitrum ecosystem (including Plutus DAO, Buffer Finance, and Camelot): the product they offer is a win-win for everyone involved.
3: Fuji Finance
Fuji Finance is a cross-chain money market aggregator that is currently integrated on Ethereum, Polygon, Fantom, Arbitrum, and Optimism. In their upcoming V2 version, they will take ERC-4626 to the next level.
Using Connext’s cross-chain service, Fuji will enable cross-chain pools that use, you guessed it, the ERC-4626 standard, which allows users to lend and borrow different assets on different chains in a single transaction.
This also furthers efficiency in the broader DeFi space; with Fuji’s new product, liquidity will be able to take advantage of higher lending rates, lower borrowing rates, liquidity mining activities, etc. on different chains. It also helps to spread liquidity across different chains; for example, if a newer chain integrates with Fuji, they can incentivize Fuji users to lend on their chain while also lending on more mature and liquid chains like Ethereum. Essentially, there is potential here to bring liquidity on-chain.
Later this year, Fuji will also expand their capabilities to become a strategy aggregator in addition to a money market aggregator. This is where the standardization of Vaults again shows its advantage: Lending Vaults will have the same infrastructure as Strategy Vaults; they are both ERC-4626. This also means that Strategy Vaults can also easily integrate Lending Vault assets on Fuji, which can be used to create more capital-efficient strategies on various chains.
Summarize
Now, hopefully you have some understanding of how ERC-4626 is creating exponential usability and capital efficiency within DeFi. This will bring a massive amount of liquidity to DeFi. TradFi has no equivalent to Vault, its interoperability, customizability, and transparency are so clear and efficient. The three protocols I mentioned in this post are just some of the many projects that are driving this space forward, and judging by the adoption rates in recent months, I believe DeFi as a whole is on the verge of a massive breakout.
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