How ERC-4626 Could Fuel the Next Wave of DeFi

By Sujith Somraaj

If you know NFTs, you know token standard ERC-721. But are you caught up on ERC-4626?

The TVL (total value locked) across all DeFi protocols stands at nearly $193 billion, according to data from DeFi Llama. Since the explosion of decentralized finance in summer 2020, a concept called “yield farming” emerged. Users deposit funds to a platform, such as the lending protocol Compound, and get rewarded with a share of the profits as their deposits are loaned out, reminiscent of a traditional bank’s interest payments.

But yield farming was less attractive to individual users without significant capital or knowledge of the concept, which led to the introduction of “yield aggregators”—sets of smart contracts that pool user funds and optimize yields. These quickly became known as vaults.

However, these vaults lacked implementation standards, which led to multiple complexities. Yield aggregators, vaults, lending markets, and native yield tokens were always implemented with slight variations. It was difficult to build apps on top of the vaults, and it created the potential for security vulnerabilities. Scaling was also limited.

With vaults operating on smart contracts, general users couldn’t directly interact with them, which only increased the importance of potential decentralized apps (dapps) that could be built atop the vaults.

The vault standard

An Ethereum Improvement Proposal (EIP) created on December 22, led by Fei protocol founder Joey Santoro, set out to change that. Enter ERC-4626.

While the proposal’s main goal was to establish robust implementation standards for the vaults, it also outlined the potential security implications of vaults lacking a specific standard.

EIP-4626 was approved on March 18. Since then, a large number of DeFi protocols—Yearn Finance, Balancer, Rari Capital, and mStable among them—started implementing ERC-4626 in their vaults. (Approved EIPs are called ERCs, or Ethereum Requests for Comment.)

All applications built on top of ERC-4626 vaults work with all other yield-bearing ERC-4626 vaults, so with these contracts now easy to integrate, new innovations sprung up around yield strategies.

With ERC-4626, vaults are now classified into two main categories: transferable and non-transferrable.

In transferable vaults, a representative ERC-20 token is issued to the user. This token would represent the fraction of the vault pool owned by the user. Non-transferrable vaults don’t use tokens.

Of course, liquidity pools are still going to have challenges.

On April 30, for instance, Rari Capital’s liquidity pools were hacked, and the attackers were able to drain $80 million in crypto. Fei protocol, backed by Santoro, was a major liquidity provider to these pools.

But Santoro told Decrypt the exploit was "a bit unrelated. The hack was partially because of using native ETH with an external call."

Establishing standardized vaults open up new possibilities for interoperability between different protocols. This could also pave the way for increased compatibility of protocols across multiple blockchains.

Editor's Note: This article has been updated to reference the Rari Capital hack.

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