A new cryptocurrency market promising high yields while concealing significant risks is coming under the microscope of regulatory authorities in the US and Europe. Over $10 billion has been deposited into so-called crypto vaults, up from $4 billion early last year, according to figures from data firm Blockworks. Holders of digital assets seek to secure high returns on their stablecoins by lending them to traders.
How crypto vaults operate
Like other forms of lending across decentralized finance (DeFi), vaults operate on decentralized platforms via smart contracts without intermediaries. However, each vault features a so-called "curator" acting similarly to an investment fund manager—selecting investment strategy, setting risk parameters, and collecting fees. The standard strategy involves lending or staking tokens to secure returns between 3% and 10%, higher than other forms of DeFi lending. Certain higher-risk strategies can offer returns of 20% or more. However, some industry figures voice concern that following the high-profile collapses of lending firms Voyager Digital, Celsius, and Genesis in 2022 due to bad loans and mass client withdrawals, the expansion of lending vaults is drawing capital into one of the most hazardous and least regulated sectors of the crypto market. Within this space, investors lack a protective market intermediary while their positions can face automated liquidation. "It is very dangerous," stated Léopold Wenger, head of digital assets at research firm Kaiko. "One of the greatest paradoxes is that everything is public because everything is encoded in the smart contract. Yet none of the investors read or understand the metrics, the liquidity ratios. They simply look at interest rates," he added.
The risk of mass liquidations
Lending vaults—which differ from secure digital vaults utilized by certain investors to protect passwords and assets—enable users to connect their crypto wallets and deposit tokens into a strategy of their choice, earning interest almost immediately. Proponents maintain they represent a new era for cryptocurrencies. As more traditional assets such as equities and investment funds become tokenized and tradeable via blockchain, advocates argue vaults provide additional ways to utilize them. Currently, main depositors in vaults consist of financial technology (fintech) firms maintaining large stablecoin balances, digital asset treasury management firms, and hedge funds, according to Adrian Cachinero Vasiljevic, co-founder of Steakhouse Financial, the largest vault management firm. Although vaults provide investors greater control over collateral used compared to conventional DeFi lending, they typically feature automated mechanisms capable of rapidly liquidating distressed portfolios. This dynamic can worsen a market sell-off. "In a severe stress scenario, things can change very quickly," stated Andrew O'Neill, lead digital assets analyst at S&P Global Ratings. He added that within decentralized finance, problems can spread "much faster" compared to traditional financial markets.
Cyberattacks and smart contract bugs
Cyberattacks constitute another risk. According to TRM Labs, $972 million was stolen from decentralized finance platforms during the first half of this year. Furthermore, coding bugs in smart contracts can trigger issues when unforeseen situations arise. For instance, in March, a cyberattack on decentralized protocol Resolv caused certain cryptocurrency prices to collapse. The USR token was used as collateral in certain vaults where its price was hardcoded at $1. Consequently, the vault failed to recognize that the token's real price had collapsed due to the cyberattack.
Complex strategies and low-liquidity collateral
Investment strategies available through vaults can be complex and involve using low-liquidity tokens as collateral. For example, one of the most popular vaults on decentralized platform Morpho extends loans in USDG stablecoins using various tokens as collateral. These include a stablecoin backed not by fiat currency but by other cryptocurrencies, alongside another digital asset tracking the value of a portfolio of tokenized private credit assets.
SEC examines application of securities law
Regulatory authorities have already begun examining whether these activities require oversight. In July, the US Securities and Exchange Commission (SEC) announced it was evaluating ways vaults could fall under securities legislation. "A vault holding securities or allocating assets to securities investments could fall within the scope of investment company laws. Certain vaults may operate in a manner similar to investment trusts," wrote SEC Commissioner Hester Peirce prior to stepping down from the agency. "Lending strategies can also carry significant implications regarding federal securities laws," she added. In September, the European Securities and Markets Authority (ESMA) proposed regulating so-called "gatekeepers"—entities facilitating transactions or acting as intermediaries between clients and decentralized finance services. The proposal aims to curb risks concerning consumer protection, system operations, and smart contracts. ESMA informed the Financial Times that its proposals "are relevant to lending vaults" in cases where cryptocurrency service providers facilitate access to them.
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