Vaults vs. Indexes

Industrializing the Yield Farming Landscape

Summary:

• Conventional vaults and indexes in DeFi have important distinctions in terms of gas and service fees paid, and the amount of assets held in a ‘basket’.
• A vault automates yield farming on a limited number of assets while an index allows its holders to have an exposure to a larger number of assets in a single basket with a periodic rebasing function. Vaults tend to be more expensive to maintain than an index.
• Recognizing these differences, the Formation FI team plans to provide a unique blend of indexes with vault-like features containing cross-chain assets to simplify portfolio construction while keeping the fees low.

Vaults transformed the yield farming landscape in 2020 when they launched — suddenly, farming your favorite digital veggies scaled up, becoming altogether easier, more predictable and a lot more profitable. Building on that success, indexes are letting users diversify their assets in a more structured and curated way and take a longer term view. Both mechanisms have their limits, however.

Vaults usually collateralize few stable-coins or reserve assets and attempt to maximize yield by collecting reward tokens (i.e. liquidity mining) when those assets are lent or borrowed. They also earn a pro rata portion of trading fees from an LP token when the collaterals are staked. The essence of their charm comes from concentration, automation and accumulation. They often automatically collect and reinvest the target reward token continuously without any human involvement. Their focus, therefore, is short-term yield maximization. Their drawback can be relatively high fees (gas + management).

Indexes usually include (or track) a wide variety of assets in a single basket and attempt to capture an enhanced aggregate price appreciation of those assets through diversification. Their attraction comes from diversification and curation. They automatically add or remove an asset and rebalance the relative weight ratio across all assets in a basket periodically without requiring human intervention. Each portfolio is usually constructed around a certain theme or style. Their focus is to isolate and capture the growth of the top performing players in a target sector. Their drawback can be concentration risk, which we will explain below.

Now, we are entering into the new era of the internet of multiple blockchains. That necessitates these traditional vaults and indexes to adapt to this new fast-moving environment.

They are failing to capture much of the growth across the broad range of developing DeFi projects and are leaving investors unprotected from many negative events in the market. Formation Fi is working on the next generation of industrialized yield farming, to introduce a more sophisticated form of index-based investment fund that solves the problems with both approaches.

Vaults

Vaults were introduced in 2020 by Andre Cronje at Yearn Finance as a way to automate the optimization of his personal crypto portfolio. As well as automation, they introduced relative ease of access and higher returns to what was a very complex and precise manual process that scared many potential users away.

Getting technical, a vault can be thought of as a container for holding DeFi tokens. Each container has algorithms attached (aka strategies) that have control over the tokens within. The algorithms make use of token composability to call 3rd party Web3 services to, for example, swap tokens for others, invest in liquidity pools, lend/borrow and stake. Most vaults are hosted on a platform such as Yearn and thus are limited by the functionality/reach of their platform (e.g. only Ethereum blockchain access).

Vaults resulted in famously high, attention-grabbing yields (sometimes 100%+) by combining multiple farming strategies such as staking liquidity pool tokens. This produced more predictable returns with easier access to a wider range of coins and techniques, without human biases or mistakes.

However, there are pitfalls too. Vaults are usually very specific in what they do and which coins they use on which blockchain, so users have to consider how many to enter. Because the algorithms actually go and stake or pool coins, the gas fees can be very high for entering and exiting. The APY can be very volatile, attracting users at high rates but then falling dramatically. When this happens, the user has to consider moving to another vault (and incurring more gas fees) or to stay with a less than ideal APY. So although vaults are automated, the user still needs to monitor performance.

In conclusion, vaults offer easy access to specific yield farming strategies but with high fees. Expect to change vaults to chase the best APY, incurring yet more fees. In practice, vaults are only really viable for high-value amounts.

Indexes

A DeFi index is a token that tracks the value of a collection of other tokens that are usually curated into themes or styles to produce an aggregate expected return over a longer time horizon. They are similar in many ways to vaults but generally give exposure to a higher number of coins without access to yield farming. For example, the well known DeFi Pulse Index (DPI) tracks the top DeFi projects, weighted by market capitalization. Depending on the theme of the collection, they can be more highly diversified and so offer more protection against market dips. Indexes are often hosted on a platform vault, such as TokenSets, with an algorithm that runs the index and rebalances it regularly. The index tokens can themselves often be traded on DEXes, avoiding most of the gas fees of entering/exiting directly.

Indexes have the same advantages, such as automation, as vaults above but with lower ongoing gas fees as they don’t yield farm (but they do swap tokens for which there are fees). They are designed for longer-term returns.

Their current design can also be a disadvantage, however. Two design problems are high correlation and concentration risk. Firstly, themed indexes will have a high correlation of assets. That means, they all move in the same direction when an environmental change occurs. That defeats the purpose of diversification. Secondly, as Roberto Talamas at Messari pointed out in his article, ‘Rethinking Indexes in The DeFi Ecosystem’, a simplistic price-to-market-capitalization based weight ratio method (e.g. DPI), creates a situation in which a few top assets in a portfolio contributes the majority of the risks derived from the entire portfolio. In other words, their expected returns do not match their risks, creating low protection from crashes/bear markets.

In conclusion, indexes will be better than simple vaults for longer-term investors and the exposure to a wider number of assets means more chance of catching growing coins, but if the whole theme drops then there is no protection.

Risk Parity Index

Both the above mechanisms suffer from a high correlation and low diversification of overall risks. This ultimately means little protection against loss over the long term. It is common for DeFi strategies to focus on just the potential returns and not calculate the risks being taken. Formation Fi is introducing a suite of new, more sophisticated, cross-chain indexes, aided by custom bridges, bots and statistical optimization software, which will take DeFi investing to the next level. We are taking experience from traditional Wall Street fund managers, learnt and refined over decades, and applying it to DeFi. Our first strategy is called Risk Parity.

The Risk Parity DeFi strategy does three ground-breaking things: 1) cover a wide range of tokens and yield farming assets, across all the main blockchains; 2) classifies and groups tokens systematically into uncorrelated Alpha, Beta and Gamma indexes; and 3) constructs a portfolio by adding and assigning the indexes with appropriate weights in a Parity index. This Parity index has vault-like features, based on correlation matrix data from a statistical optimization tool running on and off-chains, to fight against fundamental environmental risks such as low economic growth or inflation. The end user experience for Risk Parity by Formation FI will be a hybrid of index and vault. Read more about how all these indexes work together in a portfolio in upcoming articles.

Formation Fi’s Risk Parity strategy is engineered to catch the fast-moving, high growth coins and aggressive yield farming tactics that make the space so exciting, track the big infrastructure projects that will underpin DeFi in the future, provide consistent returns in phases of low growth and also protect against the times when it seems everything is going down. A Risk Parity portfolio will be productive for the long term, through good times and bad.

Find out more about the plans for next-generation DeFi at https://formation.fi, on Medium and on Telegram.