Crypto Vaults: Big Money, Thin Protection

Anyone who has spent time around financial markets will recognise the pattern. A new product appears, the yields look irresistible, billions pour in, and only later does anyone ask who is minding the shop. That is where crypto vaults now sit, and regulators on both sides of the Atlantic have started to take notice.

According to data group Blockworks, deposits in these vaults have passed $10bn, up from around $4bn at the start of last year. The money largely comes from holders of stablecoins who would rather see their tokens working than sitting idle, and traders are happy to borrow them.

How Vaults Actually Work

Vaults run on decentralised finance (DeFi) platforms and use smart contracts instead of banks or brokers. The twist is the "curator", who in practice behaves much like a fund manager. Curators pick the strategy, set the risk limits and take a fee for doing so.

Returns typically land between 3 and 10 per cent, which beats most other DeFi lending. The more aggressive strategies can promise 20 per cent or more. Investors connect their crypto wallet, choose a strategy, and see interest accrue almost immediately.

These are not the same thing as the secure vaults some investors use to protect passwords and assets. Those are about safekeeping. Lending vaults are about putting your money to work, and that is a very different proposition.

Who Is Putting Money In

The main depositors are not, for now, the general public. According to Adrian Cachinero Vasiljevic, co-founder of Steakhouse Financial and the largest curator in the space, they are fintechs with large stablecoin balances, digital asset treasury companies and hedge funds.

Supporters see vaults as the future shape of crypto. As shares and funds become tokenised and tradeable on blockchains, they argue, vaults give owners more ways to put those assets to use.

The Risks Nobody Reads

Having watched the industry for a long time, I find the concern here familiar. In 2022, Voyager Digital, Celsius and Genesis all failed after risky lending and a rush of customer withdrawals. Critics fear vaults are steering fresh money into the same unregulated corner, with no intermediary to step in if things go wrong.

Léopold Wenger of research firm Kaiko calls it very risky, and he points to a real paradox. Everything sits in the smart contract for anyone to inspect, yet most investors never look at the liquidity ratios or the underlying mechanics. They simply glance at the interest rate on offer.

There is also the speed of it all. Vaults generally come with automatic mechanisms that liquidate a struggling portfolio quickly. That gives investors more control over their collateral than standard DeFi lending, but in a downturn it can make a sell-off worse. Andrew O'Neill of S&P Global Ratings warns that trouble spreads far faster in decentralised finance than in traditional markets.

Hacks and Coding Errors

Then there is theft. TRM Labs reports that $972mn was taken from DeFi platforms in the first half of this year alone. Bugs in smart contracts add another layer of danger, because code can only react to situations its authors thought of.

March offered a neat example. A hack at the Resolv protocol sent some crypto prices tumbling. Its USR token was used as collateral in certain vaults, where the price had been hard-coded at $1. The vaults therefore never noticed the token had collapsed.

Complexity compounds the problem. One of the most popular vaults on the Morpho platform lends the USDG stablecoin against a mixed basket. That includes a stablecoin backed by other crypto tokens rather than sovereign currency, and a coin tracking a pool of tokenised private credit. It is hardly a simple deposit account.

Regulators Close In

The authorities are no longer standing back. In July, the US Securities and Exchange Commission said it was examining how vaults might fall under securities law. Commissioner Hester Peirce, before leaving the agency, noted that a vault holding securities could land in investment company territory, and that some might work much like unit investment trusts.

Europe is moving too. In September, the European Securities and Markets Authority proposed regulating "gatekeepers", meaning firms that facilitate or intermediate between clients and DeFi services. Esma told the Financial Times those proposals are relevant to lending vaults where crypto service providers arrange access.

Lawyers see the curators as the likely focus. Jonathan Galea, a partner at Cahill Gordon & Reindel, says those who fine-tune parameters and watch the movement of assets day to day look most like traditional fund managers, and so are the most likely to face rules.

A Sector That Likes Being Left Alone

Unsurprisingly, an industry that has thrived outside regulation is not eager to change. As Kaiko's Wenger puts it, a curator's biggest risk is waking up tomorrow and being told to comply.

For investors, the lesson is an old one. A high yield is always paying you for something, and with vaults, that something is risk.