On-chain vault products have become popular as the cryptocurrency equivalent of a savings account, allowing users to easily deposit some assets, earn a return by automating the claiming of rewards and compounding them to generate additional profit. DeFi vaults were first popularized by Yearn Finance several years ago, but since then, many new types have enjoyed success, such as options vaults.
The benefits of vaults are clear. With investment strategies brought on-chain, they offer way more transparency as compared to asset managers in traditional finance. Investment banks of the future will not be staffed by thousands of people, but can be made to be more efficient by utilizing a set of smart contracts that automate the process for users (which is exactly what yield aggregators do).
Nevertheless, there are some challenges to overcome, as many DeFi vaults have relied on token distributions to deliver a decent yield. What happens when incentives dry up or the return is diluted by more people depositing into the strategy?
Sky-high yields can still be found, but come with elevated risks (such as requiring you to hold highly illiquid assets or face a high risk of impermanent loss). In the search for sustainable yields in DeFi, more and more vault products exploring a variety of different approaches have been launched in recent times.
In this article, we’ll compare the most popular types of vaults to assess the advantages and disadvantages of each. Since each type makes a particular trade-off, there is no single vault that can be ranked as ‘the best’. Many DeFi protocols do a good job of highlighting the risks of their vaults (such as Beefy’s safety score shown below) and exponential.fi also assess the risks of individual pools.
It’s important to understand where the yield is coming from as well as the benefits and risks of each vault. By the end of this article, you should have a better understanding of cryptocurrency vaults and be able to make an informed decision.
Vaults Overview
The table below shows the yield, risk level, whether the principal is protected, as well as the advantages and risks for popular types of vaults.
There are also some important considerations when it comes to crypto vaults not mentioned in the table above.
All vaults have market risk related to the quality of assets utilized in the strategy. For example, if you deposit WETH into a strategy, then you are exposed to market risk as the price of WETH may drop sharply, reducing the value of your investment. Similarly, if you use a stablecoin vault, then you have to assess the risk of depegging and losing parity with the dollar (or fiat currency it is pegged to). Another risk common to all vaults are smart contract bugs or exploits which can cause the protocol to act in an unexpected way and is amplified if more than one protocol is utilized in a vault.
Finally, there’s the risk of yield dilution. Vaults with the largest total value locked tend to have more reliable and stable yields. More depositors and more funds flowing in will not significantly impact your yield, since these deposits are unlikely to be a large share of the existing TVL. However, for vaults with a low to moderate TVL, your yield could be affected and decline as more depositors show up and add more capital to the vault.
The trade-offs of each vault type are discussed in more detail in the following sections. There are benefits and drawbacks for each type, but the simple principle to keep in mind is the risk-reward profile: the higher risk you take, the more you can earn. But if you’re more conservative, you’ll want the lowest risk strategy that delivers a steady return.
Money Market Vaults
Money market vaults are one of the simplest types where you can deposit an asset, for example DAI, to earn more of that asset. Deposits are pooled together and put to work in lending protocols like Aave to earn interest (and sometimes token rewards too). The interest payments are automatically claimed and reinvested into the strategy to generate returns in the same token you deposit.
An example of a money market vault is the WETH vault on Optimism for Reaper Farm. Users deposit WETH to passively earn more WETH.
Benefits
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Earn yield from interest payments, which are compounded automatically.
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Principal protected meaning you’ll always be able to withdraw what you deposited (or more).
Risks
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Liquidity risk: if the utilization rate becomes high enough and approaches 1 (meaning funds borrowed almost equal the funds supplied to a pool), then withdrawals may become unavailable. Since almost all of the funds in the pool have been borrowed, depositors will have to wait for some loans to be repaid before they can access their funds.
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Counterparty risk: loans may not be repaid and losses may occur under extreme market conditions. If the price of the asset lent out relative to collateral suddenly jumps sharply, the loans may become undercollateralized.
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When the borrowing demand is low (such as during bear markets), interest rates will adjust lower, meaning a smaller return for lenders and for the strategy too.
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Returns may be highly dependent on token emissions.
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For non-stable assets, money market vaults are not delta neutral.
LP Vaults
LP vaults, like money market counterparts, also employ a simple strategy but the complexity goes up a notch as instead of a standard token like USDC or WETH, tokens that represent your share of a liquidity pool are used instead. There are also single-asset liquidity vaults (such as GLP) where you take on counterparty risk in exchange for high yields.
An example of an LP token vault is the LUSD-ETH vLP vault on Beefy Finance. Users deposit their Velodrome LP tokens into the vault to earn Velodrome’s governance token. The earned tokens are swapped to acquire more LP tokens for the LUSD-ETH pool and added to the farm to earn even more rewards in the next cycle.
Shared liquidity vaults have also enjoyed high returns, such as GLP and gDAI, in which depositors are essentially passive market makers. However, the risk relates to traders' PnL, which if it turns positive then depositors can realize a loss. Since trader profits are paid from these vaults, their performance may suffer if enough traders position long and there’s a strong bullish move.
Another drawback of these vaults is without scaling these platforms and bringing in more traders, it’s prone to dilution as more people buy into GLP or gDAI to earn a yield. There are also restrictions on the gDAI vault for example to prevent bank runs, where withdrawal delays of up to 9 days are utilized depending on the vault’s collateralization level. So unlike some of the other vault types mentioned, it’s not always possible to withdraw your funds whenever you want.
Benefits
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LP vaults provide high returns when there’s a lot of interest in a particular asset or high trading volume. As more trades are facilitated in the pool, the more you’ll earn from LP token or shared liquidity vaults.
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The source of yield for the wide range of LP vaults is from real market activity based on supply and demand, making it sustainable as long as traders continue to use these pools/protocols.
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LP token vaults auto-compound your trading fee income and farming rewards.
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High returns can be found for stable-stable pools, with a much lower risk of impermanent loss (e.g., USDC-USDT pools or stETH-ETH pools) although you still have to consider the liquidity and security of the asset in these pools. Providing liquidity to a pool that pairs a low market cap, low liquidity stablecoin with USDC is much riskier than a USDC-DAI pool.
Risks
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Risk of impermanent loss: you might be better off just holding one of the assets for the pool you’re LP’ing into. Impermanent loss occurs when the value holding just one asset in the pool exceeds that of your LP deposits. For example, if you LP into an ETH-USDC pool, you’ll deposit both tokens and receive an LP token to represent your share of the pool. If the price of ETH increases a lot, then your LP position will be swapping ETH for USDC. If you started with 1 ETH and 1,500 USDC, when the price rises you’ll have less ETH. In this case, you’d have been better off if you just held 1 ETH and 1,500 USDC.
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If the trading activity for the pool you have LP tokens for or provided liquidity for drops dramatically, then so will the amount of fees or token rewards you collect, reducing the returns. A long-tail event in the markets could cause a LP vault to become unprofitable and put your funds at risk.
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As with money market vaults, the yield for LP token vaults may also be highly dependent on token emissions.
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Not all LP vaults are delta neutral, so you have to hedge price exposure yourself.
Leveraged Vaults
Increasing the complexity event further, now let’s look at leveraged vaults.
What they essentially do is to allow borrowers to leverage their LP tokens for even more LP tokens, which amplifies their yield farming positions and LP rewards. Basically these are the same as money market or LP token vaults, except that they utilize borrowing pools to allow depositors to apply leverage. However, if the borrow fee outweighs the yield for a leveraged LP position, then the lending pool will have a negative APR.
Some examples of protocols that offer leveraged vaults are Alpaca Finance, Alpha Homora, and Tarot Finance.
Benefits
- As well as the benefits of money market and LP vaults mentioned in the previous section (such as automating the yield farming process), the primary advantage of leveraged vaults is the prospect of much greater returns.
Risks
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Leveraged vaults bear all of the same risks as money market or LP vaults, but also have the additional risk of liquidation. Since users of these vaults rely on borrowing pools to boost their farming position, their collateral is always at risk and may be liquidated under certain circumstances. When liquidation occurs, there are also penalties that apply.
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The impermanent loss experienced for these types of vaults built on LP strategies becomes amplified with leverage.
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Not delta neutral, so you have to hedge price exposure yourself.
Multi-strategy Vaults
Multi-strategy vaults, such as Yearn’s yVaults, execute advanced strategies that capitalize on opportunities across many different protocols. yVaults can execute up to 20 strategies, with guardians and strategies overseeing the performance and taking action to improve capital management or act on critical situations.
Benefits
- Higher returns can be achieved by utilizing multiple strategies. As shown below, the APR for Yearn’s WETH vault (right) has consistently been greater than just depositing into Aave (left), since profitable strategies are allocated more capital, while capital is diverted away from strategies that become less profitable.
- The permissionless nature of multi-strategy vaults such as yVaults means anyone can submit a new strategy to improve the vault’s performance.
Risks
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There’s additional smart contract risk compared to simple strategy vaults. An issue with a single protocol used impacts the security of the entire vault.
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Not delta neutral. You have to hedge the price exposure yourself.
Decentralized Options Vaults (DOVs)
Decentralized Options Vaults (or DOVs) allow you to deposit capital, which is then collateralized to sell options contracts. Most options vaults offer two simple strategies: the covered call and put selling. The pool of capital earns the premiums from the sale of options contracts and any returns are distributed to the depositors. The strike price is selected to minimize the risk of exercise while earning yield from the premiums.
Some examples of protocols that offer DOVs are Ribbon Finance, Dopex, Thetanuts and Friktion. Vaults like Opyn’s Crab strategy differ from typical DOVs in that it goes short on volatility rather than taking a directional bet (however, drawdowns are still possible when volatility is high enough).
Options contracts allow traders to express their views on the likelihood of events and transfer the risk of these events from buyer to seller in exchange for a premium. However, if options are priced correctly and accurately reflect the risk of rare events, the expected value of buying or selling is close to zero.
For typical DOVs, if the options that are sold expire in-the-money, then the market makers earn the difference between the strike price and current price, resulting in a loss for vault depositors. For covered call vaults, there’s a risk that depositors lose out on the gains in an asset’s price when the options expire in-the-money and the price increases above the selected strike price. Similarly, for put selling vaults, depositors incur a loss when the price of the asset ends up below the strike price of the put options minted by the vault.
Passive ‘set-and-forget’ strategies are only likely to break even or provide very low returns for simple strategies like covered calls and put selling. For example, three of the vaults listed on this Ribbon Finance dashboard have essentially only ever lost money, and for vaults that have displayed a better performance, the yields have varied widely.
However, a highly active strategy has the potential to increase returns by depositing and withdrawing at the right times. So unlike many other vault types mentioned here, it’s not necessarily more profitable to leave your funds in a DOV for as long as possible. While DOVs are an exciting avenue to create a decentralized way to take on directional risk, some of the current strategies are not suitable for the average person as stable investment products.
Benefits
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DOVs have become popular for generating a sustainable yield from real market activity and they have a lower reliance on token rewards to generate returns.
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Options trading provides a variety of income generating strategies through earning the premiums from the contracts that are sold, with covered calls and put selling being just two examples.
Risks
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Options may expire in-the-money when there’s high volatility. In this case, the case covered call vaults have an opportunity cost (you could have earned more profit by simply holding the underlying asset), while put selling vaults are theoretically exposed to unlimited losses.
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Some DOVs have third-party dependence (others do not). Specifically, the market makers may default, although unlikely, it is still a risk to be aware of.
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Most DOVs are not delta neutral, so you have to hedge market risk yourself.
Hot Tub (Arbitrage Vaults)
Arbitrage vaults automate a trading strategy that takes advantage of price differences across different trading venues for a particular asset. For example, Hot Tub generates profit from mispricings in the ETH-USD market across decentralized exchange spot markets and Perp on Optimism.
As the closest thing to a risk-free trading strategy, arbitrage offers a sustainable and reliable yield and the performance is not as affected by market conditions as compared to other vaults listed above. The longer your funds are put to work in the Hot Tub, the more you’ll earn over time as more arbitrage opportunities will arise when there’s highly volatile market events.
Benefits
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Like DOVs and LP vaults, the yield earned from arbitrage vaults like Hot Tub is more sustainable than other types of vaults, as it isn’t dependent on token emissions but on real market activity. In fact, Hot Tub does not rely on any token emissions at all!
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Returns are generated whenever there are profitable arbitrage opportunities. As a result, there’s a very low likelihood of drawdowns and a steady return can be generated over time.
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Delta neutral: the strategy hedges price exposure so the performance isn’t dependent on the market conditions.
Risks
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Although the strategy is highly sustainable, Hot Tub is not principal protected since the main risk lies with the funding rate. Given that a delta neutral position is maintained at all times using a combination of spot holdings and perpetual swap positions, then an unusually high or low funding rate may impact returns in extreme market conditions.
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A market that becomes illiquid under extreme market conditions may affect the performance of arbitrage vaults, as it reduces the ability to execute these opportunities. However, this is very unlikely for the highest quality crypto-assets such as ETH.
Conclusion
The key takeaway is that depending on the vault you use and the strategy implemented, there are different trade-offs being made. Higher advertised yields usually means you have to be comfortable with taking on risk, while lower yields imply lower risks and more peace of mind.
Apart from the risk-reward profile, sustainability is another important factor to consider. Will the yield you actually earn still be the same in months or years ahead? Many simple or advanced strategies utilizing money markets or DEX liquidity pools are usually highly incentivised with token rewards to generate a return or face dilution as more investors pile in.
By now it should be clear that arbitrage vaults satisfy the conditions that make them suitable as a crypto savings account. When compared to other vault types that generate returns from real market activity, Hot Tub’s upside is that it is more sustainable, delivering a stable stream of returns while having much lower risk.
There’s also the added benefit of arbitrage directly contributing to improved efficiency in the DeFi markets on the Optimism network! In contrast to the zero-sum nature of many vaults, where a trader’s losses are the LP’s gains (and vice versa), Hot Tub is positive sum. Different ecosystem participants will directly benefit from it: LPs earn more fees when arbitrage trades are executed, DeFi participants benefit from better price discovery and enhanced market efficiency, while vault depositors earn a return for helping to facilitate all of this.
Turn up the heat on your crypto game and be one of the first to soak in arbitrage profits by joining the Hot Tub! 👇