The decentralized finance (DeFi) ecosystem has been transforming into something more capable of addressing real-world problems with the growing interest in World Asset tokenization. Even though RWAs accelerated this transformation, technical obstacles still need to be addressed. With infinite possibilities and opportunities within the scope of tokenization, ERC-4626, a critical standard designed to smoothen the management of yield-bearing tokens, has the potential to become much more extensive than its use cases today.

In this piece, we’ll explore the current need for tokenized vaults and the current use cases, not just in current DeFi applications but in a broader context — how they can be leveraged to tokenize asset-backed securities. We must realize that ERC-4626 unlocks new opportunities for financial instruments that are stuck within the constraints of TradFi but can find a much more efficient place within DeFi’s liquidity and efficiency. At this point, ERC-4626 also offers solutions to the constraints of DeFi that have been slowing down the onboarding of the next billion users, such as composability, interoperability, and creating a more connected system for risk exposure and enhanced liquidity. Let’s dive in more to see why we position ERC-4626 as a fundamental building block for the future of decentralized finance.

The need for ERC-4626

In the wake of contractionary fiscal policies post-COVID, tokenized money market funds have emerged as an efficient option for collateral and margining purposes. As DeFi continued its transformation, the need for a standardized protocol to manage and connect the yield-bearing assets has emerged. Even though the concept of tokenized vaults did not introduce itself with ERC-4626, earlier vault mechanisms lacked interoperability between protocols. While the issue of liquidity fragmentations with L2s is a hot topic that builders have been addressing for the past years, the lack of composability between protocols is a significant constraint on the growth of yield-bearing assets in DeFi, as liquidity keeps fragmenting and making portfolio management tricky for the investors. From the investors’ standpoint, especially traditional investors, adopting and integrating financial instruments into DeFi has always been challenging. Still, the constant fragmentation of protocols has made it worse. Unfortunately, the decentralized, automated ecosystem we have been bragging about has become much more manually overloaded, time-consuming, and inefficient than Tradfi over the years.

In the wake of these challenges, the ERC-4626 standard optimizes and unifies the technical specifications of yield-bearing assets, creating a cohesive protocol for all types of yield-bearing tokens. ERC-4626 allows developers to implement vaults through a single API. The mission behind the standard is to connect the fragmented liquidity of yield-bearing tokens that are ERC-20 compatible. Functioning as an extension of ERC-20, vaults can store the yield-bearing tokens, creating share tokens for representative investors in return for their deposits.

In extension to the basic functions of ERC-20, vaults work with specific strategies to automate the management of assets inside. These strategies rebalance the deposits to reach maximum returns from yield-bearing assets without user interaction. The strategy inside these tokenized vaults and how they are decided and implemented on-chain are also new topics for the future of DeFi in portfolio and investment management, which is not the topic of this piece.

For investors, this connectivity enhances capital efficiency by skipping complex stages of managing their various assets in various protocols. Vaults automate the process of compounding and reinvesting, removing the need for repetitive manual tasks and saving time and transaction costs. Beyond typical DeFi applications, the standardization that ERC-4626 introduces prepares DeFi for more complex financial instruments, such as asset-backed securities, to benefit from enhanced liquidity, diverse risk exposure, and portfolios, which we will talk about later.

How does it work?

So, how exactly do the vaults work?
First, we must understand that every vault can store and manage a single type of ERC-20. After investors deposit, vaults create a share token that represents your deposit proportion in the vault. These share tokens are ERC-20 compliant, broadening the earning opportunities by concentrating liquidity even further.

The vaults are responsible for querying the total assets and supplies within. It also manages the fees and slippage in rebalancing while implementing strategies, saving investors the burden of these complex steps. The key functions are to convert these shares to assets, and of course, withdrawal can be redeemed after regarding calculation from the 4626 contract.

So, let’s talk about the fun part: strategies. The vaults contain specific strategies that are shown to investors prior inprotocols. This specific strategy is planned and calculated precisely to gain maximum returns for all share holders. The allocations of the ways inside the strategy can rebalance itself to reach the optimal return, usually in every epoch in the current protocols.

Throughout the investment period, functions like convertToShares and convertToAssets inform users of shares’ value regarding representative underlying assets. But of course, according to the changes in the deposits, withdrawals, and states of yield-bearing assets, the values of share tokens change over time. In a completed withdraw function call, the contract burns the share tokens and returns the underlying asset with rewards similar to how every other pool works.

To sum up, vaults offer a system to connect your desired portfolio of investment to automate risk management so that you do not have to take the burden of many seamless manual and complex steps. Instead, the vault actively curates a risk exposure for all deposited assets, optimizes your investment for maximum returns, and links you to the best possible options in the market with strategies.

Current Use Cases of Tokenized Vaults

Many protocols have integrated the ERC-4626 standard into their protocols for various strategies since its foundation. We will briefly discover the current use cases of the tokenized vaults.

1. Lending Protocols: In decentralized lending markets, users lend their assets and receive vault tokens representing their earnings. ERC-4626 ensures these vault tokens are consistent and interoperable across different platforms, simplifying the user experience for those engaging with multiple lending services. For example, when users deposit stablecoins into a lending vault, the vault allocates the funds to the most profitable DeFi protocols, earning yield, and pre-determined routes. Rather than finding the best possibilities in lending markets and investing in them with various networks, protocols, and stablecoin on your own, there is only one entry point in the tokenized vaults to do it all. As profits accumulate, the value of the vault tokens increases accordingly, offering a seamless way to grow returns. This use case can be expanded to any reward-giving protocol, where vaults can efficiently manage assets to maximize returns, which we will mention.

2. Yield Aggregators: In yield aggregators, tokenized vaults automate and optimize the process of yield farming. Users deposit their assets, which the vault uses to provide liquidity across various DeFi protocols. The rewards generated can be automatically reinvested via strategies, boosting the overall returns. Basically, the vault aggregates underlying deposits to supply liquidity in various pools without users needing to manage multiple transactions themselves. This unified approach streamlines capital allocation and enhances liquidity, maximizing returns with minimal user input.

3. Staking: For staking, vaults allow users to deposit their assets, which are then staked across different protocols. The vault automates distributing and reinvesting staking rewards, saving users time and reducing gas fees. Users enjoy higher yields without manual management as the vault compounds the rewards over time. This efficiency not only increases returns for investors but also creates promising demand and participation for protocols.

4. Complex Strategy Vaults: Complex strategy vaults are designed to manage multiple strategies simultaneously, offering users flexibility in capital allocation. When users deposit assets into these vaults, the vault distributes these deposits across various protocols using the various strategies discussed above. For example, a single vault might divide its strategy between yield farming and staking, or any other combination, to optimize returns under different market conditions. By employing multiple strategies simultaneously, these vaults allow for more sophisticated capital management, protecting investors from dangerously dynamic conditions of the market. Additionally, complex strategies of ERC-4626 vaults can open up further possibilities for Real World Asset (RWA) tokenization. Users can simultaneously invest in tokenized assets like real estate or invoice-backed securities, earning yields through other DeFi strategies that can divide the risks of on-chain portfolios. This multi-strategy approach can attract investors that require more diverse portfolios from a single entry point.

Possible Use Case: Vaults for Asset-Backed Securities

So, what is next for 4626? It is very clear that every defi protocol needs interoperability to address real-world problems and possibilities. Onboarding the next billion users can only be achieved by creating a more efficient environment than traditional ways. At this point, the ERC-4626 standard can be an entry point for more real-world asset tokenization via tokenized vaults. As we have dived deep into the struggles of SMEs post-COVID in the piece before, we should consider possibilities in financing and asset-backed securities for businesses. With the Fed rate cuts, we can now expect that investors may look for higher yield opportunities. From a DeFi investor standpoint, keeping in mind that DeFi investors tend to have more risky investment portfolios, this could be a shift towards tokenized asset-backed securities and private credit opportunities for SMEs. This can be a great match between DeFi’s high-risk tolerance investor and struggling SMEs post-covid.

It has now been years since we have been able to invest in tokenized real estate and tokenized government funds, but the DeFi space still has not stepped up to real-world finance problems, such as the 5 trillion credit gap of SMEs in emerging markets.

One of the main problems for private credit solutions for SMEs in DeFi was that they needed to be more cohesive and have more liquidity to address compliance concerns. Current tokenization and financing solutions for SMEs in DeFi are structured primarily around off-chain arrangements that benefit from DeFi’s liquidity. 4626 creates a potential to make real on-chain tranches for asset-backed securities. As the tokenized vaults can invest and aggregate underlying assets through more than one end, private credit pools for businesses in defi can be implemented through these vaults to create real on-chain tranches and bridge them to the liquidity these possibly low-volume pools need. Of course, this is just a potential use case that has considerable flaws at first thought, such as the different approaches that have to be taken towards every scale of business. However, the potential to use more than one tokenized asset/collateral in one single investment portfolio can open a new dimension to the new world of finance.

Finally, there is no doubt that the ERC-4626 standard currently provides a very efficient way of aggregating investments for DeFi protocols. However, the interoperability behind the standard means that it can and should be more than just an aggregator standard.

Written by Karan Kayaturan.