How do vault strategies work in DeFi?
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How do vault strategies work in DeFi?
DeFi vaults can be considered as a pool of funds held in a smart contract, which optimizes returns on invested assets by employing one or more strategies.
Navigating Web3 tides with focused insightsWritten by: Okoye Modestus
Compiled by: TechFlow
What are vault strategies in DeFi? I've read many whitepapers about using vaults to maximize returns for users, but what exactly are these vaults?
Let me break it down in a way that's easy for beginners to understand.
Literally speaking, a vault can be thought of as a box holding assets set aside for a specific purpose.
In TradFi, assets such as gold, cash, diamonds, and valuables can be stored in a vault for future use or safekeeping. You could also compare a vault to a piggy bank at home where money is saved for future use.
However, a DeFi vault can be seen as a smart contract-managed pool of funds that optimizes returns on deposited assets by employing one or more strategies.
You can think of it as a box where users store their assets, but with added strategies (or methods) designed to generate yield on the deposited assets.
The strategies used can be simple—such as depositing assets into a vault to earn the best APY across different protocols, or providing LP tokens to a vault to automatically compound fees.
For example, imagine a pool where users deposit DAI every epoch (a time period, say 8 hours), and must manually claim rewards (say, additional DAI).
A vault can be built with a strategy to automatically compound the DAI rewards each epoch by re-depositing them back into the pool, continuing until the user decides to withdraw.
Moreover, there are vaults that employ complex strategies, which we see in structured products, leveraged farming, yield aggregators, and more. The core mechanism involves leveraging pooled user assets to generate better, consistent yields by identifying higher-yielding protocols.
Examples of such vaults can be found in DeFi Options Vaults (DOVs), like Polysynth DOVs. Let's illustrate how a DOV works on Polysynth using an ETH weekly call options vault:
- Users deposit ETH into the vault;
- Polysynth determines the optimal strike price;
- Polysynth uses the ETH as collateral to sell call options on the options market;
- Polysynth collects the premiums and distributes them as yield to depositors;
- If the expiry price < strike price, the call buyer loses;
- If the expiry price > strike price, the call buyer receives ETH from the vault at a discount. However, depositors only incur a loss if the amount of discounted ETH they have to deliver exceeds the premium received;
That's a simple explanation of how vaults work.
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