Written by: ValHolla
Compilation: Deep Tide TechFlow
There is no doubt that DeFi has come a long way since Compound kicked off its DeFi Summer in 2020. But what's next? What practical services can DeFi provide users that TradFi does not have? Or, are there any products in DeFi today that can really start to take market share from TradFi? I believe it has, and I believe the product is "Vault".
Vaults are taking 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 use these tokens to drive development. But first, let's cover some basics about Vault and the 4626 standard.
What is Vault?
Simply put, Vaults are smart contracts into which users can deposit tokens and then run predetermined strategies to invest those deposits. Vaults are a zero-to-one innovation in decentralized finance, and if you ask me, why are they the clearest example of value-add in DeFi? Because they are usable, generic and transparent in all use cases.
Available --Vault is super easy to use.
Generic - they are used for a variety of things. Currently, Vault can do it all, from collecting option premiums, to hedging leveraged futures trades, to optimizing loan yields.
Transparent - anyone can view holdings and performance at any time and this really sets them apart from TradFi. TradFi doesn't really have an equivalent to Vault; TradFi simply doesn't currently have anything that can run a fully transparent asset management strategy with the same customization potential and ease of use.
Institutions are extremely cautious about allocating funds to cryptocurrencies because of all the backstabbing by Celsius, 3AC, FTX, etc. The benefit of DeFi is transparency, and Vault adds usability and versatility to that. I wouldn't be surprised if Vault is a key player in finally pulling TradFi players into the space after the CeFi dust settles. And that's probably where the ERC-4626 standard comes in.
ERC-4626 was born from EIP-4626 at the end of 2021, and its momentum has exploded recently as more DeFi developers and users see the huge advantages it has to offer.
ERC-4626 takes the vault creation process and standardizes it. This is extremely important to user experience, which leads to increased liquidity. If you are a cryptocurrency veteran, you remember the days when there were no ERC-20 tokens on Ethereum. This makes it almost impossible for DeFi to exist, and the only way to buy/sell different cryptocurrencies is through centralized exchanges. The reason DeFi cannot exist is that in order to have sufficient liquidity to operate the 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 your tokens into the Vault, you get a tokenized version of the entire Vault strategy - kind of like LP tokens for the Vault strategy.
For example, if you deposit USDC into xyzVault to earn interest, you will receive xyzUSDC in return. Ideally, you could sell xyzUSDC on the DEX, or deposit it in another vault.
When you want to exit, you must send xyzUSDC back to xyzVault, redeeming your original USDC and the interest earned, less any service fees.
ERC-4626 Brings Liquidity to Vault Tokens
Only with substitutability can we have liquidity, which is why standardization is so important.
Right now, there are so many DeFi protocols competing for relatively small pools of liquidity. On the positive side, we are still in the early days, and an open environment breeds competition, which breeds innovation. However, the downside is that small amounts of liquidity are spread across a bunch of different applications, and the applications 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 the Vault is not ERC-4626 compatible, using the Vault, your funds cannot be used for other things, and DeFi will fail because the liquidity will no longer flow.
ERC-4626 solves this problem. Going back to the example of xyzVault, no matter what you do with xyzUSDC, as long as you don’t redeem it, the USDC you initially deposited will remain in xyzVault’s liquidity pool. If you deposit your xyzUSDC into a DEX, you also add liquidity to that DEX. Alternatively, you can lend 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 striving to become the premier place for yield mining on Arbitrum, and they are doing this by harnessing the power of ERC-4626.
Rodeo's Vault allows you to invest in different LP income strategies, and even further allows users to make margin loans, thereby earning you higher income.
For example, let's say you want to earn yield by providing $100 of USDC/WETH liquidity to Uniswap. Normally, you can only put up to $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 makes for a good option for those who want a higher APY from a "normal" LP and don't mind taking on some extra risk.
There are two things that make Rodeo different: First, in order to invest in their strategies, you only need to deposit USDC, and Rodeo will take all the USDC, buy whatever LP tokens the strategy requires, and make the investment for you. This saves you time and money that would otherwise be spent in the tedious process of buying tokens and depositing them into liquidity pools. Instead, all you need is some USDC.
The second, of course, is that all their vaults use the ERC-4626 standard, which means it's easy to incorporate new vaults. For example, due to the risk of leverage, there may 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, there are tons of releases and improvements planned in their roadmap.
2: FactorDAO
Factor is a relatively new project that aims to be Arbitrum's liquidity hub. 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 and more. Basically, you can consider it if you want to create or invest in a custom asset management strategy.
As I mentioned before, there is no such thing in TradFi: anyone will be able to easily create a custom asset management strategy, which is the main advantage of DeFi. Also, with DeFi, you get the transparency of the 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 strategies to be built on top of other strategies. For example, you can create your own fund, composed entirely of other ERC-4626 tokens, to benefit from a variety of different strategies, which paves 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): their offering is a win-win for everyone involved.
3: Fuji Finance
Fuji Finance is a cross-chain money market aggregator, which is currently integrated on Ethereum, Polygon, Fantom, Arbitrum and Optimism. And in their upcoming V2 release, they will take ERC-4626 to the next level.
Using Connext's cross-chain service, Fuji will enable a cross-chain pool, you guessed it, the ERC-4626 standard. Through ERC-4626, users can lend and borrow different assets on different chains in one transaction.
This also further improves efficiency in the broader DeFi space; with Fuji's new product, liquidity will be able to take advantage of higher lending rates on different chains, lower borrowing rates, liquidity mining activities, etc. It also helps decentralize liquidity across different chains; for example, if a newer chain integrates with Fuji, they can incentivize Fuji users to borrow and lend on their chain, while more mature and liquid on Ethereum etc. on-chain lending. 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 being a money market aggregator. At this point, Vault's standardization once again shows its advantages: the Lending Vault will have the same infrastructure as the Policy Vault; 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 idea of how ERC-4626 creates exponential usability and capital efficiency within DeFi. This will bring a lot of liquidity to DeFi. TradFi has no Vault equivalent, its interoperability, customizability and transparency are so clear and efficient. The three protocols I’ve mentioned in this post are just some of the many projects driving the space, and judging by the adoption rates in recent months, I believe DeFi as a whole is on the verge of a massive breakthrough.
https://frogsanon.neworder.network/articles/the-future-of-erc-4626
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