The Future of ERC-4626
There’s no question that DeFi has come a long way since Compound kicked off DeFi summer in 2020. But what’s the next step? What practical service can DeFi provide to users that’s not available in TradFi? Or even better, does DeFi have any products alive today that can actually start to take market share from TradFi? I’m convinced it does, and I believe that product is the “vault.”
Vaults took the DeFi landscape by storm in 2022, so if you’ve been around the ecosystem, you’re probably familiar with them. However, you may not be as familiar with the ERC-4626 standard, which I believe is going to exponentially accelerate the adoption and efficiency of DeFi. Later, we’ll look at a few protocols that are starting to push the envelope with these tokens. But first, let’s cover the basics about vaults and the 4626 standard.
What Are Vaults?
Simply put, vaults are smart contracts that users can deposit tokens into, which then run pre-determined strategies to invest those deposits. Vaults were the zero to one innovation of decentralized finance, and if you ask me, they are one of the most obvious examples of DeFi's value add? Why? Because across all use cases, they are usable, versatile, and transparent.
Usable – vaults are super easy to use.
Versatile – they’re used for all sorts of things. Currently, there are vaults that do everything from collecting options premia, to hedging against leveraged futures trades, to optimizing lending yields (shoutout to Yearn Finance for being a pioneer on the vault front.)
Transparent – anybody can check the holdings and performance at any time, which truly separates them from the TradFi pack. TradFi doesn’t really have an equivalent to vaults; there’s simply nothing out there that runs a completely transparent asset management strategy with the same customization potential and ease of use.
With all the shenanigans played by Celsius, 3AC, FTX, etc., institutions are extremely cautious about allocating their funds to crypto. The nice thing about DeFi is the transparency, and vaults add the usability and versatility on top of that. It wouldn’t surprise me if vaults are the key feature that ends up pulling TradFi players into the space after the CeFi dust has settled. And that may be where the ERC-4626 standard comes in.
What is ERC-4626?
ERC-4626 was born out of EIP-4626 back in late 2021, and recently there’s been a surge in momentum as more DeFi devs and users see the massive advantages that it offers.
Basically, ERC-4626 takes the vault creation process and standardizes it. This is extremely important for UX, which leads to liquidity. If you’re an OG crypto veteran, you remember the days where there was no ERC-20 standard for tokens on Ethereum. This made it pretty much impossible for DeFi to exist, and the only way to buy/sell different cryptos was via centralized exchanges. The reason DeFi couldn’t exist is because in order for there to be a meaningful amount of liquidity to operate a financial system, there needs to be some sort of standardization (fungibility of assets.)
ERC-4626 brings fungibility to vault tokens
Simply put, this means once you deposit your tokens into a vault, you get a tokenized version of the entire vault strategy - sort of like an LP token for a vault strategy.
For example, if you deposit USDC into xyzVault to earn interest, you’d receive xyzUSDC in return, which would be earning interest in real time. Ideally, you could then go sell that xyzUSDC on a DEX or deposit it into yet another vault to earn some sweet, compounded interest.
Whenever you want to exit the trade, you’d have to return your xyzUSDC to the xyzVault and redeem your original USDC plus the earned interest, minus whatever fee was charged for the service.
ERC-4626 brings liquidity to vault tokens
Again, in order to have liquidity, you first have to have fungibility, which is why it’s so important to have standardization.
Right now, there are so many DeFi protocols out there battling for a relatively small pool of liquidity. The positive side to this is that we’re still early, and a wide-open playing field breeds competition, which breeds innovation. However, the downside is that the small amount of liquidity up for grabs is fragmented across a bunch of different apps that aren’t interoperable. This notion also applies to vaults.
Vaults are nice because they allow people to invest in complex strategies without having to do all the transactions themselves. However, if the vault isn’t ERC-4626 compatible, by using that vault, you’re sacrificing doing anything else with your money, and DeFi loses out because that liquidity is now completely tied up. ERC-4626 fixes this!
Going back to the xyzVault example, no matter what you do with your xyzUSDC, as long as you don’t redeem it, the USDC that you originally deposit remains in the liquidity pool for xyzVault. If you then go deposit your xyzUSDC into a DEX, you add liquidity to that DEX as well. Or, you can go lend out that xyzUSDC on a money market app, which contributes to their liquidity, too.
Now for the alpha! Let’s take a look at three projects using the ERC-4626 standard.
#1: Rodeo Finance
Rodeo is gunning to be the premier spot for leveraged yield farming on Arbitrum and they’re doing so by leveraging the power of ERC-4626.
Basically, Rodeo’s vaults allow you to invest in different LP yield farming strategies, but they take it a step further by allowing you to take out a margin loan, which allows you to invest more, which earns you a higher yield.
For example, say you want to earn the yield by providing $100 of USDC/WETH liquidity to Uniswap. Usually, you’d only be able to put a maximum of $100 into that strategy, but Rodeo allows you to borrow up to 10x leverage on any deposit. Of course, the risk increases the more leverage you use, but it provides a nice alternative for people who want higher APY from “normal” LPing and don’t mind taking on some extra risk.
Now onto the fun stuff! There are two things that set Rodeo apart: First, in order to invest in their strategies, you only need to deposit USDC. Once you do that, Rodeo takes the USDC, buys whatever LP tokens are needed for the strategy, and invests them for you. This saves you time and money that would be spent on the tedious process of buying tokens and depositing them into a liquidity pool. Instead, all you need is some USDC and you’re good to go.
Second, of course, is the fact that all of their vaults use the ERC-4626 standard, which means it’s really easy to incorporate new vaults. For example, due to the risks of leveraged yield farming, vaults could pop up on Rodeo that allow users to hedge against 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 in their roadmap.
Factor is a relatively new project which aims to ultimately be the center of liquidity on Arbitrum. The way they plan to do this, of course, is by making it way easier to create vaults, and their strategy is centered around none other than the ERC-4626 standard.
Factor has a product called the creation wizard, which serves as a one stop shop to create all sorts of structured products, including yield strategies, derivatives, LP staking, etc. Basically, you can think of this as the place to go if you want to create or invest in a custom-built asset management strategy.
As I mentioned before, TradFi has nothing like this; the ease with which anyone will be able to create a customized asset management strategy is a major advantage in DeFi. Additionally, with DeFi you get the transparency of public blockchains, where all strategies, trades, etc. in each vault can be seen by anyone.
Yet again, we see the value of 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 that’s solely made up of other ERC-4626 tokens, earning yield from a variety of different strategies – in TradFi, this is known as a “fund of funds.” Ultimately, this paves the way for more innovative products and systems to be built on Arbitrum.
Factor is rapidly growing their list of partners (including Plutus DAO, Buffer Finance, and Camelot) across the Arbitrum ecosystem, and for good reason: they’re providing a product that serves as a win-win for everyone involved. They also have a public sale for their FCTR token on February 20th, and it’ll be interesting to see how much attention it draws to both the project and ERC-4626 as a whole.
#3: Fuji Finance
Fuji Finance is a cross-chain money market aggregator, and it’s currently integrated on Ethereum, Polygon, Fantom, Arbitrum, and Optimism. And in their upcoming v2 launch, they’re taking ERC-4626 to the next level.
Using Connext’s cross-chain services, Fuji is going to enable cross-chain pools using, you guessed it, the ERC-4626 standard. However, Fuji is taking this to the next level by enabling users to lend one asset and borrow another on separate chains in just one transaction (to put this in perspective, the combination of lending/borrowing in DeFi typically takes around 7 transactions).
This further improves efficiency within the broader DeFi landscape as well; with Fuji’s new product, liquidity will be able to take advantage of higher lending rates, lower borrowing rates, farming events, etc. on different chains. It also helps spread out liquidity across chains; for example, if a newer chain is integrated with Fuji, they can create incentives for Fuji users to lend or borrow on their chain while borrowing on a more established and liquid chain like Ethereum. Essentially, there’s potential here to bring liquidity to chains where otherwise it wouldn’t have gone.
Later this year, Fuji will also branch out their capabilities to become a strategy aggregator in addition to being a money market aggregator. This is where the standardization of vaults once again becomes an obvious benefit: the lending/borrowing vaults will be the same infrastructure as the strategy vaults; they’re all ERC-4626. That also means strategy vaults can easily integrate the lending/borrowing vault assets on Fuji as well, which can be used to create more capital efficient strategies across various chains.
By now, hopefully you have some idea about how ERC-4626 is creating an exponential increase in usability and capital efficiency within DeFi. This is not just a huge deal for regular users like you and me, but vaults could also be a key element of onboarding more TradFi entities into the space, which would bring a ton of liquidity. The world of TradFi has nothing like vaults, where interoperability, customizability, and transparency are so clean and efficient. The three protocols I mentioned in this article are just some of the many projects pushing this space forward, and judging by the adoption rate in recent months, I believe DeFi as a whole is on the verge of a massive breakthrough.
Published on Feb 22 2023