What is a Vault?
A vault is a supply of crypto assets that are underpinned by a smart contract that outlines the terms under which those assets are traded, and executes the trading of those assets according to the terms in the smart contract.
If this sounds a lot like how liquidity pools are described, it’s because at first glance, liquidity pools and vaults are quite similar. However, there are a few key characteristics that set vaults apart from liquidity pools as more complex investment strategies, and this article will outline those differences.
Differentiating between Liquidity Pools and Vaults
First, it is true that liquidity pools and vaults are both baskets of assets that collect yields for users as a reward for contributing liquidity to the basket. The differences emerge when considering what your assets do while in a liquidity pool versus a vault, and the unique role of the smart contract for each type of protocol.
In a liquidity pool, deposited assets passively collect interest & token rewards from that same liquidity pool for as long as they stay deposited. In a vault, deposited assets are actively moved around between protocols associated with the vault to maximize yields earned by the user who supplied the assets to the vault.
The mechanism facilitating these frequent swaps is the smart contract underpinning the vault’s protocol. Whereas a smart contract associated with a liquidity pool outlines the terms in which users automatically receive passive income, a smart contract associated with a vault outlines a complex strategy for how a user’s assets will earn the maximum possible yield by being automatically swapped between different pools as yield rates change.
How do Vaults Work?
So, what does a vault strategy look like?
Say you deposit assets into a vault that has a goal of earning users maximum interest in lending and borrowing protocols. That vault protocol would be executed by a smart contract that automates swapping your assets between lending protocols like Aave, Compound, or Rari depending on which protocol has the higher return for its users at a given moment.
For perspective, manually maximizing yield on your assets by swapping them between Aave and Compound whenever interest rates changed would be nearly impossible, since rates go up and down on each protocol countless times each day. Vaults automate this lending strategy for users, ensuring that interest earned over time on a basket of assets is the highest it could possibly be.