S&P Global Ratings Launches New Risk Assessment for DeFi Lending Vaults

Andrew O'Neill (0:00)

We had some pretty large exploits earlier in the year. In DeFi, which has shone a light on some pretty loose risk parameters in some of the major protocols, in some activities within vault lending, parts of the industry have really come to a reckoning now in terms of setting those parameters in such a way as to limit risk.

Jennifer Sanasie (0:24)

Digital asset vaults offer transparency, but what about the risks behind the returns? S&P Global Ratings' new vault risk assessment delivers independent forward-looking insight into vault credit quality, governance and risk management. Move beyond transaction transparency to risk transparency. Learn more at spglobal.com.

Digital assets are becoming a bigger part of the financial system, and institutional investors are taking notice. But as stablecoins, tokenized funds and on-chain lending grow, so do questions about risk. Just because transactions are transparent doesn't necessarily mean the risks are easy to understand. S&P Global Ratings is looking to change that with its new vault risk assessment. It offers an independent assessment of the risks associated with on-chain lending vaults. Joining me now to explain how it works is Andrew O'Neill, Managing Director and Digital Assets Analytical Lead at S&P Global Ratings. Hey, Andrew.

Andrew O'Neill (1:16)

Hey, Jen. Thank you for having me.

Jennifer Sanasie (1:17)

Thanks for being here. Now, I know that this was announced at Token, so I'm assuming you were in Singapore, as was I. How are you doing? Are you feeling like you're back on the right time zone? Are you jet lagged? What's going on?

Andrew O'Neill (1:32)

I'm about to go on holiday, so looking forward to some recovery time. But yes, it was a pretty hectic week in Singapore.

Exciting announcement for us. It feels like you're getting to an end when you announce something like that, but actually you're really only getting to the beginning. So now we've got a future ahead of us in terms of assessing risk in the vault market.

Jennifer Sanasie (1:52)

That's exactly it. I mean, after the announcement, we see what happens on the roadmap. We get to see how this evolves, but just lay a foundation for us. Talk to us about what a lending vault is, how it works and why it's growing so fast.

Andrew O'Neill (2:07)

So vaults are analogous to funds. They allow to aggregate investor deposits and to deploy those deposits according to an investment strategy that's set out in a smart contract.

The rules of that smart contract are established by a protocol as well as a curator that sets the risk levels of a specific vault, which is analogous to perhaps a portfolio manager in a traditional fund context. And that curator is then held to account against those rules and its ability to manage risk in a way that's consistent with depositor expectations, often by an independent party referred to as a guardian or sentinel, which performs a similar oversight role to say a trustee in a traditional context. Now, vaults are extremely promising in terms of the transparency that they bring, but bringing that transparency isn't really the same as understanding the risk that is there to be observed. That's hopefully the piece of the puzzle that we can help the market to observe, showing a structural view of risk in these products.

Jennifer Sanasie (3:09)

Dig into that a little bit deeper for me. When we're talking about understanding the risk associated with these products, what exactly are we looking to understand and how do you evaluate that risk?

Andrew O'Neill (3:19)

We start looking at the portfolio of investments that a vault can allocate to.

You can look on chain at where funds are deployed as of right now, in terms of eligible investment markets, but also what could be invested in. What markets have been listed as eligible for investment? Look at two vaults today that may allocate to exactly the same markets. One of those may actually have an extra three markets that are significantly riskier that currently have an allocation of zero, but that could change very quickly to the extent that more funds are made available to the vaults or a curator decides to reallocate to riskier markets. And to helping investors to understand that differential in terms of not only where vaults are investing right now, but where they might is key to helping build an understanding of structural risk in a vault. The next piece is then looking at how difficult or easy it may be for a investor to withdraw from a vault given liquidity mismatches. So in many vaults today, investors may expect that they're able to withdraw instantly.

Whereas in reality, those funds have actually been invested in lending markets, which have some limitations in terms of the available liquidity to withdraw. Again, that's a matter of degree and helping investors to understand what may have higher liquidity risk versus something else in the vault space. And then we have other aspects. We look at the curator themselves and what their risks and policies are. Because ultimately, there is also a human element to this in terms of how risk is managed and how it might be changed. So we look at the curator and we look at a range of operational security factors as well from the underlying blockchain to the protocol that is used to create the vault smart contract. And last but certainly not least, the use of timelocks and government's rules to keep the vault in line with investor expectations in terms of risk.