A growing segment of the cryptocurrency market known as stablecoin lending vaults has attracted more than $10 billion in deposits, raising concerns among US and European regulators about the associated risks and the need for increased oversight. According to data from Blockworks, this marks a substantial increase from $4 billion at the beginning of 2023, as digital asset holders seek higher returns by lending their stablecoins to traders through decentralised finance (DeFi) platforms.
Stablecoin vaults operate through smart contracts on decentralised platforms but differ from traditional DeFi lending by incorporating a “curator” who manages investment strategies, establishes risk parameters, and collects fees. Borrowers can expect returns typically ranging from 3% to 10%, with some riskier strategies offering even higher yields, sometimes exceeding 20%. This blend of decentralisation and managed oversight presents a hybrid model that appeals to investors looking for attractive earnings on stablecoin holdings.
However, this emerging sector has raised alarms following earlier market disruptions. Last year, several prominent crypto lenders including Voyager Digital, Celsius, and Genesis collapsed due to risky loans and sudden customer withdrawals. Experts warn that lending vaults may channel funds into similarly risky, largely unregulated areas of the crypto market where investors lack traditional intermediaries and face swift automatic liquidations.
“It’s very risky,” said Léopold Wenger, digital assets director at research firm Kaiko. Wenger pointed out that despite the transparency offered by smart contracts coding, many investors do not fully understand the financial ratios or liquidity risks, focusing primarily on interest rates.
Lending vaults enable users to link their crypto wallets, deposit stablecoins into chosen strategies, and receive near-instantaneous interest payments. Major participants include fintech firms with substantial stablecoin reserves, digital asset treasury companies, and hedge funds, according to Adrian Cachinero Vasiljevic, co-founder of Steakhouse Financial, one of the largest vault curators.
Nonetheless, these vaults carry significant vulnerabilities. Automatic liquidation mechanisms that act quickly during market stress could exacerbate sell-offs, as Andrew O’Neill, digital assets analytical lead at S&P Global Ratings, noted. Additionally, DeFi platforms remain targets for hacks, with TRM Labs reporting $972 million stolen in the first half of 2023. Coding errors in smart contracts further increase risk. For example, a March hack at the decentralised protocol Resolv led to a collapse in the price of certain tokens that were hard-coded in vault collateral valuations, resulting in mispriced assets and losses.
Some lending strategies involve complex and illiquid tokens as collateral, such as stablecoins backed by other cryptocurrencies or tokens representing private credit assets, adding layers of opacity and risk.
Regulatory authorities have started to scrutinize the vault model. The US Securities and Exchange Commission (SEC) indicated in July it is assessing whether vault operations fall under securities laws, especially when vaults manage assets akin to investment companies or unit investment trusts. Meanwhile, in September, the European Securities and Markets Authority (Esma) proposed rules targeting intermediaries facilitating access to DeFi services, which could include vault curators. Esma emphasized concerns around consumer protection, operational risks, and vulnerabilities inherent in smart contracts.
Legal experts suggest that vault curators who actively manage and adjust strategies on a daily basis may be classified similarly to traditional fund managers, potentially subjecting them to established financial regulations. Jonathan Galea, a partner at Cahill Gordon & Reindel, warned that such developments could create compliance challenges for those involved.
The prospect of tighter regulation is likely to face resistance from a sector that has largely evolved outside conventional oversight. For curators, adapting to new compliance demands poses a significant risk, said Kaiko’s Wenger, who remarked that the most pressing threat could be the sudden requirement to become regulated participants.