Optimizing Yield and Risk: Designing Smart Stablecoin Vaults

Fantastic. Okay, let me kick this off. Uh, we've had essentially a big shift in DeFi where rather than having users go into essentially managing their own positions or going into static position managers such as your vault, we've gone into more u essentially deriving the sorry delegating that responsibility to active managers. Uh so we have essentially uh curators running vaults uh for different strategies. Uh particularly the USD based or stablecom strategies have been the ones that seem to have the most growth.

We've had uh earlier today Machina presenting uh their solution but essentially every single liquid fund in existence have has created their own vault infrastructure. So my first question is uh what do you think that is and what benefits or uh issues you see with this uh trend? Uh we can go sequentially. If anyone wants to speak over each other, please feel free. I can start.

Um I think Yeah, sure. Um so I think stable coins obviously are the building block of the vault ecosystem. As you said, I think of stable coins as the fundamental unit of onchain credit. they are um rehypothecated T bills and money market funds that are then lent out against other credit instruments. So basically you have people doing looping trades and uh rehypothecating credit all over the place and it turns out that doing that onchain is it's actually pretty good like it generally works.

Um and you can squeeze a lot of juice out of those trades and make them really efficient. Um it where it gets hairy is when um you're getting too cute with your LTVs and um you are not necessarily pricing the risk of the underlying asset. Let's say it's a uh private credit fund that you know on the surface looks all fine and dandy but um maybe is not the quality asset that you thought it was. And I think that's where um the part that I love about um the vault model that's taken DeFi by storm is you do have professional risk managers that are curating these vaults. Yeah.

So um first of all I apologize if I say something stupid. For once I blame it on jet lag. Um vaults are really taking by storm. I think uh the best way to to summarize it is every day we're straying a bit further from God because what's happening is we started with T bills which are basically HQLA so very liquid asset and we're progressively adding into the backing more and more esoteric collateral more and more riskier things which is not bad per se but it's exactly what happened in 2008 the difference is that that it's more transparent we can have an idea of what's in it uh but It's basically the quality of these assets. Can we even call them stable coins?

I think it's disingenuous and uh regulator legally speaking, we actually can't call these stable coins. Um what's actually happening is we're going further onto the risk curve because there's more and more offer and because people in DeFi like to chase yield, which is normal, uh we're starting to have a growth of the risk again of the risk curve that's being pushed further and further back. And uh it means that the most important thing you should look for when you're actually looking at a vault is basically the risk management process can be either internal uh like a is doing for example or external like the morpher model is but at some point if no one is doing the risk management is going to go to zero very fast. So there's a lot of different risk I think uh look touch on on one of them. You got uh of course the risk that gauntlet for instance would look at the the the risk creator of this vault but there also new risks that are coming with a new type of asset that are coming in.

So we have private uh credit private funds private equity uh there'll be more and more of those coming from also world staking and restaking and royalty. So that's the interesting part of vault right you have all those different type of investment that become available and you can have strategy with vault of vault that will just adapt but uh one of the vault that will have to be looked at for all those that involve LWA real world asset is the actual credit risk of of the underlying token. Yeah, I mean I I think this kind of highlights a a growing problem uh over the last few years and essentially a few years ago, right, uh you had some stable coins, you were like, "Oh, let me just lend them out on a you kind of understood where the yield was coming from." You had an idea of the types of risk that you were taking, right? you know, AB could get hacked or, you know, AB could maybe onboard a collateral asset that that is not very high quality, right?

And could potentially, you know, uh have such exposure, right, that maybe they could become insolvent, right? Um not not to say, right, that the you know, A is bad or or that would happen, right? But as a user, right, choosing to to earn yield, right, you you could kind of understand the source of the yield and contextualize this risk. Um, what I think we're seeing now with these vault strategies is that like as yields have kind of compressed, um, people, you know, are chasing the the, uh, chasing the yields and stepping out on the risk curve. And I don't think they're necessarily understanding what's what's happening under the hood, right?

And the riskadjusted return may actually be quite poor. Um, and and the the issue here, right, is that you don't see this in a, you know, uh, degradation of performance. You know, you see this play out as a binary event, right? Everything is fine. Everything is fine.

Everything is fine. And then one day, right, like it's completely worthless, right? And so um I I'm I'm not going to say that you know we we need oh we need more regulation and we need standards right of of course those those elements will be introduced. Um but I I I don't see a lot of self policing uh in in the ecosystem right now. It's very much a growth at all cost type of type of mentality and and that's that's a bit concerning but we we need the standards.

That's the whole point. uh what you're describing is just human behavior. People don't do the work and that's why you have intermediaries. Uh for those who were there when we started DeFi, the whole point was we're going to do finance without intermediaries. And I think no one is saying that anymore because we realized it's a terrible idea because you're never going to reach noninancially savvy like non-institutional people because they're always going to do the mistake and get wrecked.

That's why even the most decentralized protocols, things like liquidity, you can even set someone else to manage your interest rates. You need interminaries. You need someone who's going to build a standard. You need an SMP that's going to say this is a bad idea. You should not put money into this.

What's up? No, Luke, do you want to say it? I wanted to shout out very quickly um Credora Network and I know S&P Global actually invested in these guys, but I think last week they released their platform to individual DeFi users and you can go on there and you can look at every Morpho Vault, every stable coin and see like a Tradfi equivalent uh credit rating for that opportunity. And you can also see like a probability of default or a probability of significant loss for that vault. And I think some of those numbers if they were more widely um circulated and known would would kind of blow people's minds.

Like a lot of the stable coins that people look at as money good like safe sleep at night risk are effectively junkrated uh debt masquerading as you know a one for$1 We something we had a problem like one or two years ago especially around standards and credit rating was there's a new asset and a new stable coin every day. How do you follow and how do you rate this right now? We have LLMs. So we could actually have like an SMP credora model that could actually rate this would never be perfect but it's better than nothing. Please do it.

Uh thanks and thanks for the shout out on on Creda. So um yes so we started to create product in the field right so we created I mentioned it before a product specifically for stable coin and so we assess the risk of some of the biggest name you know and some others and uh well some got better scores than others uh it's freely available you you can ping me or just Google stable coinp global you probably find the stable coin stability assessment now uh we're always looking at what type of new product we could create and we're needed. So we've been asked to do all type of stuff, right? like can you assess the risk of uh of wallet of token of stable coin we did it uh of um staking operators and well now there's more and more conversation around vaults and how could vaults be rated but uh the idea here would be to focus maybe not only but a lot on the overall credit risk right when when you look at rating or scoring from S&P you're always looking at something that tell you in general probability of default which is basically what is the risk you don't get your money back and then you have to look at all the risks that are involved in that so the risk is not the same based on the protocol you use the blockchain you're in but also yes all the underlying uh tokeniz said that there'll be my belief and our belief is that um and again opinion on my own um I believe in the tokenization of everything so I think everything will eventually be tokenized there's a lot appetite for yield that are not correlated to uh what is in trai. So when you start to have well staking yield in involved restaking royalty stuff that can be also intangibles uh well you'll have more and more interesting use cases in vault and in tokenized asset uh but then you you'll need this visibility on risk.

So yes uh I'm thinking about product around that. So clearly risk is uh currently mispriced in DeFi. I think that's the nicest way of saying it. Uh yeah and I think right now we talked about risk quantification which is important but there's also the opposite the counterpart which is risk mitigation. Um if you look at a traditional bank the reason why people continuously deposit capital is the bank have a balance sheet.

If they have a problem and they lose first the first losses on the balance sheet then they have a surplus buffer theoretically that's also counted in the balance sheet that's mandatory from the basil tree requirements then they have an equity buffer also mandatory from basil tree requirements and then they're insured by the state because they have a banking license. How many protocols have this much protections? The reason the answer is zero because even the ones who have a surplus buffer usually are not at 2.5% of cash bounds maybe a but then again I think it's you forgetting about sky the ultimate it's not 2.5% that at some point it was it was capped but you're right because it's not necessary 2.

5% is overkill right these are things we're trying to incorporate in our protocol but one you need a lot of capital to be able to do it and two I think the question that people are not asking themselves enough uh when you look at the banking regulation I'm sorry I'm coming back a lot to this because it's not just bad things. uh most of the collaterals are always what they call HQLA which is basically cash deposits uh treasury bills and re reverse repo right so how do we build cryptonative HQA otherwise we're always going to do centralized things because these are the safest assets and that's what we haven't done today and that's my white whale but but the reason why well it exists in advi is also regulation and so regulation is coming right so we got mika I I touched on that this morning but the the regulation coming in the United States is a gamecher. So we have it for stable coin but then the next one they they have is a clarity bill right the the market structure and all which might address a lot of those aspect uh maybe not in the first version I don't know but but through this regulation that will be done which at the end of the day is to well with the target uh at least of of protecting um well you'll have this mechanism that will be put in place and again it depends who you're targeting right are you targeting retails or are you targeting institutions s uh they won't have the same risk profile or understanding of risk. So I think you started answering my question which is what what solutions we have in the market of this. So I want to talk to you Luke about uh on the insurance side of this how difficult is to get people to actually accept the correct pricing of assets.

Uh and I'll jump to Nick with the implementation of oracles which we've seen is not as easy as people think it is. Exactly. So this is what we're building at Cork. So, like I said earlier, onchain credit default swaps and it's relevant for individual stable coins, but it's also relevant for vaults. So, if you think about uh a yieldbearing stable coin that, you know, people take for granted, it's, you know, a one for one pegged asset.

We've seen tons of DPEG events in crypto over the years. Um, and so Cork is a way for um, anyone to take a view on the probability of default, significant loss, a DPEG event, what have you, and have a transparent risk pricing for that asset. There's going to be a pegged asset, and then there's going to be uh, an underlying collateral asset or a redemption asset that gets posted by the liquidity providers who are effectively providing the cover for that trade. So, they're going to earn premiums from um the insurance or protection that they're selling. And then what we like to do is we like to use a yield bearing stable as the collateral asset to make it more capital efficient.

So that could be like USYC from Circle, it could be staked USDS, depends on what the LPs want to do. Um and then for vaults we'll do a similar type of trade but it's more about helping um risk curators and vault managers to have certainty of um backs stop liquidity or a buffer of liquidity in the event that there's a run on the vault. So, if you have uh you're running a a loan book, that's your vault, and you have, you know, 20 to 30% in liquid assets that you can use to service redemptions at any given time. If you have half of your depositors click the withdraw button at once, you're not going to be able to service those withdrawals. And so having a cork market in place and owning a number of swaps allows you to take your vault token plus the swap, go to the cork market and redeem at any time for a liquid underlying that you can then come back and service those redemptions with.

And so you think about the game theory of that if your users know that there's a cork market, they know that it's that much less likely for there to be a run on that vault. And then you actually reduce the likelihood that that happens. you reduce the risk of um of losses or of that liquidity leading to problems with your vault. Nice. So now Nick, let me uh get your take on so the last few I'd say not necessarily like this uh association vaults but a lot more the credit vaults of like morphiler have had issues where uh we can call them hacks but in general has been misconfiguration or misspecifications of oracles that have led to uh let's say less than desired uh outcomes.

Yeah, I mean I I think uh oracles were playing on easy mode for uh a number of years uh right crypto assets were are crypto native right there were there were native kind of uh liquidity solutions and it was quite apparent right where volume was happening uh how much liquidity there there was right and it was really easy to kind of aggregate all of all of these sources together to construct um a reasonable pricing model um with these vault strategies and and also you know touching on tokenized assets right um it's becoming much more esoteric and I think the uh the Oracle space is kind of going through a a coming of age uh kind of process now right we've we've seen what happens uh when it's done uh inappropriately right and is it's a function of you know Garbage in, garbage out, right? Um, uh, you know, we I I I think we got kind of like a a uh teaser of this, right, when it came to the LSTs and the LRTs, right, where we weren't necessarily pricing them based off of the market price, uh, but more on the underlying, right, which we knew ultimately had some redeemability uh, guarantees or at least like eventual uh, redeemability guarantees. Right now with the extension into private credit um this becomes a much more uh esoteric and difficult uh problem. Right? You can you know price these things.

Um but there are extra kind of risk considerations where price is not necessarily the um the only identifier you you want to use right when when assessing risk. And this is kind of what I what I alluded to earlier in my presentation of, you know, uh the more esoteric these things become, the more you need data infrastructure that is reporting on more than just uh than just price. Uh because if we're waiting on, for example, a rating agency to to downgrade, um it's already too late, right? Uh there's a race condition here and uh um you might be the last one out the door, right? And that's a good point.

One of the things that we know will happen is uh at least two. One is ratings and and scorings will come on chain. Absolutely. And they'll they'll have to become more real time. I think um some part we haven't covered yet in the panel uh which is our optimizing it's optimizing yield.

It's also optimizing the whole stack. Um DI only works if it's better than its counterpart. Um what we have to understand is purely on the banking industry. The banking industry operates at a very large leverage. Something that would look absolutely crazy in crypto.

Traditional funds operate on average at a 7x uh leverage. Banks operate at something like 12 to 13x and they're allowed to go depending on the size of the bank. I think something around 30. I'm not saying. Um so we are playing DeFi on easy mode.

You're 100% right. It's going to get 10x the leverage. Lending protocols are going to make 10 times more money, which is great if you own part of it or if you're building one. Uh but also means we're going to have to automate a lot of the credit uh rating. We're going to have to automate a lot of the processes and we're going to have to automate a lot of the risk understanding.

Um, when you're building a risk uh stable coin vault, it means that you're basically going to have to be extremely risk averse or extremely good at managing risk and there's going to be no in between. something can look at the mo if you look at the most successful companies today in crypto tether circle coinbase they have one point in common they take very little risk or they're able to hedge it out or pass the storm because some of them did take risk but they were able to push it in under the rug before it cut back to them so the more each risk you take is basically bad depth that at some point you're going to have to fix it's what you mentioned before I think this uh this problem is called the Thanksgiving turkey, which is you look at the life expectancy of a turkey and you look how many turkeys actually die for Thanksgiving. Right. Exactly. So the whole point is um one of my good friends had his protocol hacked not once, not twice, but three times.

Uh most people quit at the first hack. They're actually still paying back the bad debt. They've been doing that for almost two years. Kudos to them. Uh and when you talk to him, he used to be very hand wavy about risk management.

Now he tells you it's not about how do I reduce the risk. It's how do I accept that at some point we're going to lose money and we need to minimize the consequences of this. This is why I talked before about surplus buffer about all of these. This is why things like cork are very important because u optimizing yield is not going to be just how do I get the best APR on that specific block. So how do I get the best average yield over the next 10 years?

Because if you want to be there on the long term, there's going to be huge opportunities in the industry, but you have to survive and survive means managing the risk. No, I think uh you know risk management is the name of the game and it's you know uh woefully inadequate at the moment in in DeFi, right? Uh and uh it it may be a case of you know we we learn by by failing, right? And I would not be surprised, right, if um any of you know what we think of like the blue chip, right, uh DeFi lenders, if if one of them were to just uh blow up, right, just because they uh they they have too much exposure and uh and and they didn't uh they didn't do their homework. Um it it's still very early days and uh we're we're going to, you know, uh you know, crawl, uh walk, run.

uh but we can't just go straight to running. Well, I actually bring this back to I think you guys also mentioned the introduction of per credit into DeFi as well as let's say more DeFi uh owned practices uh of having uh uh building on like money legos. I think my question here would be more um on do you think it you can run a protocol that successfully merges both of them at the same time or you're basically going to have a situation where the DeFi experts are going to mess up on the on the private credit and then the traffic experts are going to mess up on the DeFi side of things and maybe Charles I'll put you on the spot because I'm interested in bringing from your perspective on SMP how do you guys see how DeFi has been operating until now? Yeah. So it's been an evolution for sure.

Like when I I started this team in 2022, uh I remember speaking with a lot of protocol that's on many that do not exist anymore and bring the idea of looking at the risk of this and that and there was not a crazy interest in 2022 2021. Um but it's been evolving of course since. Now to your question specifically there's a lot of something that is often said is um DeFi is not reinventing everything. There's a lot of things that exist in in trfy that are very similar. There are some new things but um the tools that already exist to manage the risk in trfy uh can can also be used in this field.

So I think that what what Cork is doing is very interesting the for the the the risk of uh private credit there are tools and ratings etc for that now also what need to be real time is not necessarily everything you when you have vault like they probably will have to have a risk evaluation that is real time uh but if the risk evaluation of the I don't know the TBL or the tokenized money market fund that are part of the overall strategy is you know less uh with a lower uh a bigger latency than than issue. So I I think there's definitely a path forward. The the good thing is that people now care about it just the fact that we have panels speaking about risk now again go back to 2020 the defi summer you didn't have that. I mean most of the people here uh maybe with the exception of cork would not even be talking maybe no S&P2 would not be talking about risk a year ago. uh it's because there's an evolution uh the fact that we have uh marketplaces that uh create an intermediary to manage this and it's not just internal teams who are doing it uh creates new market opportunities on on one end and the other is there's a lot of demand for more sophisticated product not just the T bill rapper uh one because some people not a lot unfortunately realize that T bills is not a great backing especially in the current geopolitical context uh but the second one is people want more yield.

So all of this is to enable to access more capital and the pro the more basically rewards. The problem is uh is the cost of the risk management worth the extra reward and I think only time will tell and just quickly like if you want like most people most protocol are not all but are interested in getting the money from the institution on chain. I mean, you know, we've been hearing about the institution accommoding 2017 and 20, but but now they are like now they are for real and and risk management and how is the risk being looked at is is a very important thing that they look at. Yeah, I actually wanted to touch on that as well and just shout out Maple Finance, which is where I worked for the past couple of years and was there in 2022 when we lost 60 odd million dollars uh in our loan book. And I was actually pretty adamant throughout that period that that was somewhat okay.

like it wasn't a crazy um default rate for a high yield, high-risk, uncolateralized crypto loan book. We did like $3 billion of originations up until that point. And yeah, we lost some money, but the default rate was in line with the credit that was being created out of the Maple engine at the time. And if you look at Maple now, um they have like $2.5 billion of TBL.

They're getting allocations from Cancer Fitzgerald, uh, from Sky through the the Spark liquidity layer. Um, so the largest allocators in DeFi and then in Tradfi, you have legitimate Wall Street banks allocating dollars into Maple for cryptobacked lending to crypto counterparties. Um, I mean that's a very real success story that like I I sat on the investment committee at Maple for the last year plus and like we didn't shy away from taking risks. We were very calculated in the risks that we took and ultimately that led to where the protocol is today and and the success that they've seen. Well, I mean I I absolutely echo that that sentiment.

Um I was at Maker uh or Sky formerly known as Maker Dow at the time, right? And I can tell you out of the first five or so instances into uh kind of like private credit uh we had four defaults right we had like an 80% default rate and uh you know we I I think uh you know were uh not necessarily naive but inexperienced. Um we recognized how inexperienced we were right and made sure that the uh the exposure right we had was uh you know we we kind of assumed it would all default and uh you know we we wanted the to be fine right in terms of solveny. Um but no I I I think still you know we were quite uh you know we we considered ourselves smart people right you know we were one of the original you know DeFi OGs and I think we got a little bit too too all up in our own uh our own ego right and and this stuff is difficult and I I do worry though uh about right not going through this walk crawl uh sorry crawl walk run right uh type of flow rather and and just you know uh someone just full sends you know half a billion or something right and it's a it's it's it's a binary kind of a insolveny event if that you know it's too big to fail in in that sense right um one of the other things I'm concerned about is you know uh without getting too uh um too directional about monetary policy right but eventually um monetary policy will come down And uh those kind of juicy T- billill yields that um people are have gotten used to, you could even uh say have have gotten drunk on, right, are are going to disappear and they're going to step out on that risk curve and you know you'll you'll see kind of an explosion of of private credit, right? And the risks that those users will be taking taking on are you know a completely different ballgame to the uh to to you know what what is the current meta right of of just okay it's T- billills it's issued by I don't know by black rockck or it's issued by byo or it's issued by by superstate um and uh you know I I I feel like every point I I make comes back to like we need to be careful I I um you're saying something super important um it's a race against time uh right now we're at over $250 billion of stable coins It's the greatest vector of uh the US United States dollar ever.

Uh 79% of all stable coins are backed by T builds. So that's 78% of the backing is just T bills. And at some point, you're right, the pendulum is going to come back and we're going to go more into private credit because this is always what happens when you look at the allocation of traditional financers. The problem in my mind is that tokenized private credit right now, the biggest the best comparison you can do is basically with crowdfunding. Crowdfunding is for people who can't raise funds with venture capital.

Is tokenized private credit? It's an honest question. I' I'd love to have your opinion uh here. Uh is it for people who can't raise on traditional markets? And if so, why can't they raise on traditional markets?

How many ICO projects are still around? No. So, you're talking about ICO. I'm going even a step further. Think about web two companies crowdfunding.

Yes. It's a total adverse selection problem. you're getting assets that can't get financed offchain and they're just coming on chain looking for liquidity. That's how it's been for the past number of years. I mean, hopefully over the longer term, you start to see the better assets coming on chain as the capital markets get deeper and more liquid and there are real benefits to be had from doing that.

But up until this point, that that hasn't been the case. I I also just wanted to push back on and I think it's an interesting point around like monetary policy and easing. The beauty of crypto yields up until this point has been when monetary policy eases, then crypto prices rip and then people want to borrow against their crypto and then the onchain risk-free rate, if you can call it that, of a or Morpho or wherever those vanilla money market lending uh protocols, those rates get very attractive and that's also priced off of where basis is at. So, I mean, do those trades go away? Do those get crowded?

Is there like more capital allocated onchain today so that if cryptos ripping um those rates aren't, you know, 500 basis points wide to T bills at any given point in time? I don't know. Just on the quality of the asset, I think we'll see more and more interesting assets. So, there's private credit, there's private equity. You saw that Apollo tokenized several fund at one.

I think they're doing another one. So I think Trafi is coming through this angle also and you'll have more and more interesting investing opportunity for looking for the liquidity you have in DeFi. And it's always a a chicken and a heck issue, right? Do do you have the product first? Do you have the liquidity first?

But now you got evolution on both side and and you see where it's going. Is there more liquidity? because I consider crypto to be the second biggest liquidity market in the world after the American market. I I hope it's a fair assessment. Um the problem I see today uh with this is basically that all of this um thing what's the argument for private credit to come onchain outside of we can't find access access it's it's when you when you speak with KKR and and Hamilton Lane and and all that they did for for tokenization in general getting in in in one of their fund is really painful for high net worths and not even accessible to the average uh person.

So, so there is a a real access component just the way they did it. When uh if you're one in one of their phone, it's really painful to get in, then you want to get in another one, it's painful again. Now, when you were in their tokenization platform, you could move from one to the other after doing it just once. So, there is an access angle, an accessibility angle to well, you cannot easily get uh to invest in an Apollo fund just like that. Now you'll have the vault to do that and the liquidity.

So there's um a lot of fintexs that are looking at vaults morpho like and centrifuge etc. And um what they're interested in is the yield that they can get in DeFi. So uh as they'll get and you can imagine just custodians etc. And also you have more um let's say shops that have clients with a lot of bitcoin. they're all looking for some type of yield.

So you have these these demand for yield and and and solutions that are being built on chain. So you got the yield from from from staking etc. So there's a lot of different yield that they are trying to uh provide to their customers through through v. The last one I think is really important as well is just it should be lower cost for the issuer because if you think about all the human beings who have to sit there and punch in the cash flows of the coupon payments from those companies that are getting paid out to the lenders, that should all just be programmatic. All right, guys, we're going to wrap up.

Uh thank you for the conversation. Thanks for all the panelists and everyone here uh coming to listen to us. Have a good day.