Understanding Vaults: Your Key to DeFi
While DeFi “vaults” are analogous to the real-world kind, they play a more complex role in the DeFi ecosystem. Cryptocurrency vaults are not just for storage; they are also instrumental in various DeFi operations, including arbitraging, staking, and yield farming.
What is a Crypto Vault?
A crypto vault can be described as a smart contract where cryptocurrencies are stored. While this definition explains what a vault does, the emergence of DeFi has redefined what a crypto vault can do.
Today, DeFi vaults have become automated, self-executing strategy entities whereby users can deposit assets, and the vault executes “strategies” to invest, and re-invest in profitable investments (across chains). This way, users earn yields on assets they deposit in the vault — a process referred to as yield farming, arguably the most common use-case of DeFi vaults.
How Do Vaults Work in DeFi
In their most basic form, vaults operation can be described as follows:
- Deposit: Users deposit cryptocurrency into a vault.
- Strategy Execution: The vault’s smart contract executes a pre-defined strategy to maximize returns. This could involve lending out the assets to earn interest, participating in liquidity pools, or utilizing more complex strategies like leveraged yield farming.
- Yield Harvesting: The strategy periodically harvests yield, converting it into the vault’s base currency or reinvesting it according to the vault’s strategy.
- Withdrawal: Users can withdraw their initial deposit along with any earned interest, typically subject to withdrawal fees or conditions set by the vault.
Understanding Vaults Categorization in DeFi
Categorizing vaults in DeFi can be tricky as they can differ based on their strategy, function, and what they aim to achieve. Regardless, we can categorize them mainly into two categories: Simple “Crypto” Vaults and Complex “Strategy” Vaults.
Simple vaults, as the name suggests, are generally built with the singular purpose of protecting and holding assets, often with robust security mechanisms as an added layer(s) of protection. Beyond security, they may also be configured to execute basic tasks that are part of a broader infrastructure.
For instance, Orderly Network’s vaults are integral components of Orderly’s omnichain architecture, able to send and receive cross-chain messages (powered by LayerZero) that play a vital role in facilitating cross-chain user deposits, trading, and withdrawals across multiple EVM chains.
On the other hand, complex strategy vaults can multitask, i.e. executing one or more strategies, often to maximize user deposits across multiple DeFi protocols at the same time.
For instance, a strategy vault can simultaneously invest in yield farming protocols and lending/borrowing protocols to maximize yields for users in every possible scenario.
Common Use Cases of DeFi Vaults
- Yield Farming Vaults
These vaults seek to maximize yield by participating in various yield farming opportunities across the DeFi ecosystem. They typically move assets between different lending protocols, liquidity pools, and farming opportunities to capture high returns.
One of the most well-known platforms that introduced the concept of automated yield farming is Yearn Finance, moving users’ funds across different lending protocols like Aave, Compound, and Curve to find the best yield opportunities
- Liquidity Provider (LP) and AMM Vaults
LP vaults automate the process of providing liquidity to AMM-based DEXs. They are configured to manage the composition of assets in a liquidity pool to maintain an optimal ratio and claim trading fees or liquidity mining rewards.
- Stablecoin Vaults
These vaults focus on strategies involving stablecoins to offer more predictable returns with reduced price volatility. Strategies might include lending stablecoins on various platforms or participating in stablecoin-based yield farming.
- Liquidity Mining Vaults
These vaults are aimed at maximizing returns from liquidity mining protocols, where users are rewarded for providing liquidity to specific pools with additional tokens. Protocols like BadgerDAO and Convex Finance are prime examples here.
- Leveraged Yield Farming Vaults
These vaults use borrowed funds to amplify investment in yield farming strategies, aiming to increase potential returns. Leveraged trading can significantly boost yields but also increase risk. It is worth noting that the risk level for leveraged yield farming vaults is considerably high, due to the added risk of liquidation if the market moves unfavorably.
- Algorithmic Trading Vaults
These vaults employ algorithmic trading strategies to earn yields. Strategies may include arbitraging, liquidations, or market making, executed automatically by smart contracts. They might also engage in strategies to mitigate trading risks such as impermanent loss.
It is noteworthy that DeFi protocols can offer a combination of one or more vault use cases.
Associated Risks and Considerations of DeFi Vaults
It is essential for investors to conduct thorough research and consider the risks before investing in DeFi vaults. The DeFi space is rapidly evolving, and while vaults offer significant opportunities, they also require a good understanding of the underlying technologies and market dynamics.
Here are a few things to consider when interacting with vaults:
- Smart Contract Risks: As with any DeFi product, vaults are susceptible to smart contract vulnerabilities, which could lead to the loss of deposited funds if exploited.
- Strategy Risks: The performance of a vault heavily depends on the underlying strategy. Poorly performing strategies or unexpected changes in market conditions can significantly affect returns.
- Gas Fees: Interacting with vaults can require paying gas fees on the blockchain network, which can vary and sometimes be significant, depending on network congestion.
Whether through yield farming, liquidity provision, or leveraging advanced strategies, DeFi vaults cater to a wide array of financial goals and risk appetites. For newcomers stepping into the DeFi realm, understanding and leveraging vaults can be a powerful step towards achieving financial autonomy and maximizing the potential of your crypto assets.
