Could Some Vaults Trigger Securities Law? Yes, but It's Case by Case

Transcript

What people need to understand though is it's really important that people know the level of risk that they're taking. It's not critical in my opinion that there's no risk at all. Right? The whole point of finance is is moving risk and trading off things like liquidity and yield. And I think we want to support a large universe of interesting um assets. It's just users need to understand they shouldn't think they're having some safe, you know, insured savings account and suddenly they're getting exposure to basically an onchain hedge fund like stream finance. Hi everyone, welcome to Unchained, your no hype resource for all things crypto. I'm your host Laura Shin.

Thanks for joining this live stream, though heads up, this was pre-recorded a couple weeks before publication. Now, we'll take a quick word from the sponsors who make the show possible. This episode is brought to you by Cape, America's privacy first mobile carrier. Same premium service you'd expect from any other carrier, but designed so your number, your location, and your data actually stay yours. Get 33% off six months at cape.co/unchained. Today's guest is Sun Ragupathi, co-founder and CEO of Veta. Welcome, son.

>> Thanks for having me. So, we booked this podcast a week or two ago and now suddenly there's a lot more chatter about vaults than there was even at that time and they're already a big business about $67 billion in TVL and vaults and um why don't we just start with the basics because we've never had a deep dive on them here on the podcast. So, VA is an onchain vault infrastructure provider for institutions but let's just start with the question what is a vault? >> Yeah, great question. So vaults are basically onchain vehicles for giving users exposure to onchain markets, right? The general problem that exists are defi markets are diverse and complex

and very hard for normal people to use and vaults have emerged as this primitive that sits on top of DeFi markets that allow users to get simple exposure um to these underlying markets. Another way to think about this is vaults are infrastructure for creating financial products on top of onchain markets. Um those can be lending, it can be baskets of RWAs, um trading vaults, there's a huge spectrum. So vaults are a word that everyone uses to mean different things, but the thing that sort of unifies all of this is this layer for giving users exposure to onchain markets.

>> Okay. Yeah. You know, it reminds me a little bit of um some of the things that were bubbling up during DeFi summer like year or even I think like InstaDap might have been another one. Um but I'm curious to hear like how you even got into crypto and came to launch Veta. >> Yeah, my my journey's been sort of uh securious and wrong and long. Um I've been building in DeFi for the last five years. Before that, I was actually enrolled in a PhD in computer science, machine learning. um had nothing to do with crypto or DeFi. I'd heard of Bitcoin, but nothing beyond that. Uh and a friend of mine from college was actually joining a startup in the Cosmos ecosystem back in the day. Uh before my PhD, I was starting to wonder if maybe

entrepreneurship and doing startups was a better fit. And so I deferred my PhD and uh joined DeFi. What I found was an industry that is in many ways very interdisciplinary, right? you can have you get whatever your academic interest is whether it's game theory, economics, cryptography, computer science, there's a place for you in the crypto world where you can do something interesting. So that was the thing that sort of initially nerd sniped me. Over time what I started to understand was that the things we were building today are the infrastructure and foundations for a new financial system that is going to touch billions of people. And when I joined in 2021, the space was basically dens like yield farming was crazy. Um there were

all kinds of interesting game theory experiments being run on chain. And um a perspective that I adopted then and I still think is true is that eun are kind of like the beta testers of the onchain world. Like we needed people who were willing to take massive amounts of financial risk with their own assets to test all of the infrastructure that we've been building. uh without that these things these systems would never get battle tested at scale and would never be adopted. And so that's been really fun. I've seen crypto and DeFi evolve from what was effectively a onchain casino with crazy experiments being run to now what we see is an ecosystem of really strong and diverse onchain primitives that are being adopted by enterprises and institutions

globally. >> Okay. Yeah. And I think what's really interesting about vaults is um this is sort of the solution to what most people kind of think they want for all their money, which is just to get yield and to have it be sort of automatic and you know they don't have to think about it. Um but I know it's not really simple to deliver that. So talk us through what vaults look like on the back end and how they work. >> Sure. So there are three sort of dimensions that are really important for vaults. Uh one is access. So users want access to the widest range of onchain primitives and markets. Again that can be across multiple chains. It can be

across multiple asset types whether those are stable coins or other sorts of crypto assets. Um and diversity of strategy type, right? Trading um lending RWAs. So that's one thing that vaults need to solve for. They need to be able to give users access to whatever sorts of onchain products that they want. The second dimension is control. So vaults need to be able to impose very strong guard rails over what can happen to assets. Um when you think of the evolution of DeFi and the onchain world, these products are increasingly being distributed through fintex as opposed to direct consumers who are creating their own wallets and coming and experimenting on chain. And what fintexs need when they're underwriting these products is

an ability to impose their own compliance policies and risk controls. So vaults need to do that for them. And the third most subtle but probably most important feature of vaults is they need to give users verifiability into what can happen to their assets. Right? That means multiple things. It means users need predictability into when and how they can withdraw from these products. They need to understand what sorts of strategies and risks these products are going to be taking on their behalfs. And finally, what this is really important, but it's sort of taken for granted. Users need to see where their assets are at all times, right? This is sort of the big promise of DeFi in the onchain world where you don't get the like FTX, BlockFi issue where um there's centralized intermediaries who are

taking uh basically unaccountable risk with your assets and you have no idea what's going on. The beauty of this technology is that you can actually see exactly what the health of your portfolio is, what sorts of risk you're exposed to. there's a separate question of understanding it, but the vault's job is to ensure that all of this is very transparent for users. >> Yeah. I mean, after what was really a just traumatic year of 2022 for crypto, I could imagine that for anybody who lived through that, that last quality you talked about is super important. Um, but also, you know, in terms of that back end, explain like where the yield um comes from, like what are all the different buckets? Um yeah, just how is this being generated?

>> Yeah, I would say there's a couple different categories. Um some are are more dominant today, but I expect the industry to evolve. So when we talk about vaults today, the thing that the largest fintexs are doing today is mostly onchain lending, right? That's what Robin Hood, Coinbase, Kraken, MetaMask, and a number of these other companies are building today with vaults. getting exposure to protocols like Morpho, a on the Salana side, Camino, Jupiter, this universe of sort of peer-to-peer lending protocols which is looks they look very different than you know primitives that you see in traditional finance but increasingly as more assets move on chain through things like tokenized funds, tokenized equities that increases the universe of products

that can be built. And so increasingly what we're seeing is demand for vaults that do things that are beyond just simple lending, right? Things like maybe I want access to tokenized treasuries and money market funds. Maybe I want baskets of tokenized equities. So vaults are really this very flexible primitive that today have found significant PMF in the onchain lending world. But my view is longterm that this will evolve and we're already seeing that from uh some demand in the market. And so, you know, there's a lot of different ways to get yield in DeFi. So, when people um get yield via a vault, how is that different from other ways that people get yield in both DeFi and also how they get yield in Trafy?

>> Yeah. When you think of DeFi, you basically have two choices to participate in the system. You can either onboard directly to these underlying peer-to-peer protocols, right? think of staking primitives, lending protocols, exchange decentralized exchanges like unis swap and others. So you can go and use those products directly. The problem is that those are really meant for expert users, right? Not just people who understand risk at a level at a smart contract level and a protocol economics level, but even the interface, right? Creating a wallet, managing private keys, um knowing what to use these protocols for.

So that's the mode that we've seen dominate for most of DeFi's life. This is a function of the user base being very DeFi native and crypto native. Again, we call them dgens. Uh but over time and where we are today, most of the distribution in DeFi today and going forward, most of the net new people who are actually getting exposure to these markets and protocols are coming through fintech platforms, right? Platforms where they already live their financial lives. Maybe they're holding stable coins and the next question they have is how do I put these to work? How do I make money on my stable coins, right? Or how do I access financing against my crypto assets? So, these are user needs that exist beyond a user base that is cryptonative. And this is really where vaults enter the picture and are seeing

a lot of traction. Uh what vaults do is they provide a very simple interface, right? You don't need to deal with the complexities of interacting directly with all of these various peer-to-p peer protocols. You can just express a preference, right? Like look, I want to earn yield. I want most of my assets to be withdrawable 247. I have a low risk profile, right? I don't I don't know much more than that, but I don't want to take crazy risk, right? Maybe these are my my savings and I don't want to go crazy far on the risk curve. And then the fintex and the parties that come together to build these vault products can solve that user preference and offer them a product that abstracts all the complexities of DeFi. Um, so I wouldn't characterize this as vaults are doing something fundamentally different from the onchain world. They're just

packaging up the markets that many different parties have created on chain and creating a userfacing product that's very easy to consume and to understand. >> All right, so in a moment we're going to talk a little bit more about VETA's um role in all this, but first we'll take a quick word from the sponsors who make the show possible. If you hold crypto on your phone, your biggest vulnerability isn't your wallet, it's your carrier. AT&T, Verizon, and T-Mobile have been breached again and again, and SIM swaps are still one of the easiest ways for attackers to drain accounts. That's where Cape comes in. America's privacy first mobile carrier. Same premium service, but Cape rotates the identifier

on your SIM every 24 hours, deletes your call and text metadata after a day, and protects against SIM swaps with a 24word recovery phrase that only you control. You also get two middle toend encrypted secondary numbers for banking and signups, so you stop handing your real number to every app that asks. Go to cape.co/chained and use code unchained for 33% off your first 6 months. Back to my conversation with Sun. So, as you um as we discussed, Veta offers infrastructure for these vaults. So, what exactly does that mean?

and break down what VAT's role is versus like for instance curators. >> Mhm. So vault this is really important. There's a distinction between the actual risk management that's happening at an economic level and what the infrastructure needs are. So VA is an infrastructure provider primarily. Our job is to build a platform that allows curators and distributors and users to get access to whatever forms of onchain markets and onchain products they want. Right? Our goal is to make this as wide as possible. Meaning we want to support the widest range of range of chains and assets and protocols and markets. And doing that in a way that's secure, right? That that turns out to be a really hard problem. How do you integrate things quickly while ensuring

that um you know you don't compromise on security. Once we establish that universe of products that can be built on our platform, this is where a role like a curator comes in who's basically solving that user preference and packaging up these different markets that we've made available um to fit that fintech or that user's need. Right? So if that's determining what collateral to lend against, right, there's a risk management question there of how do we underwrite different forms of collateral? If it's managing a liquidity buffer so that users always have a guarantee to be able to withdraw up to x% of their portfolio, that's a curator decision. So how we like to think about it at VETA is when you deploy and create a vault, there's really three parties that come together to make this happen.

There's the vault infrastructure provider that's creating that platform and the smart contracts that actually hold and deploy the assets. There's the curator that's doing the risk management and then selecting collateral types and things of that nature. Uh and then there's the distributor who typically owns the user relationship and they have views on what their users want. They may have strategic needs for these products. So all three of these parties come together to deploy an instance of a vault that meets a very specific product need. >> Okay. So now let's talk about um one of the aspects that people should definitely know about because even though you know in the comparison to the centralized lenders that we had seen you know BlockFi and Celsius there is of

course still risk when it comes to vaults and DeFi. Um so one aspect would be that uh potentially the curators are taking on risk to get the yield. So, if something goes wrong and um let so let's say we'll we'll go to kind of the end of a you know potential event here. Let's say a user put some money into a vault and the end result is they didn't get some or even all of their money back. What are the different possible things that might have happened to uh you know cause that result?

>> Yeah, this is so this is a question of risk, right? when a user puts their money into this kind of system, what are the layers of risk that they're accepting? Because there are different layers. So there's one level of risk which is just raw smart contract risk, right? At the end of the day, all of these things, whether it's the vault itself or the underlying protocols themselves or the assets, they're all built on chain in code that's running on the blockchain, which we call smart contracts. And those can have inherent risks. In fact, the sort of uh exploits that we saw back in 2021 for over that time period, those were actually mostly smart contract based exploits where there's some flaw of logic in the code that allows for someone to, you know,

basically steal funds. So, that's one form of risk. That's something that could go wrong. One one just side comment is that what we've seen in recent history over the last six to 12 months is smart contract risk has come way down as we've converged on much better coding practices, better auditing tools, better cyber, you know, capabilities. But what's gone up is actually um key management risk or operational risk where you have layers of different protocols that have some governance functions that do things like upgrade the protocol or allow the whitelisting of new markets. And that's actually turned out to be the layer where risk is now consolidated. This was true of kelp, the kelp incident. It's true of um you know uh uh drift.

Basically many of the major exploits that we've seen over the last six months were operational failures. So that's a form of risk that customers might be take or users might be taking, right? Um you really have to look at the supply chain of D5 protocols, assets, vaults and look at the governance risk in those. And then the final one is economic risk and collateral risk. Right? Even if you're doing something very simple like a lending strategy, uh what's really important is that the value of the collateral that is securing the loan doesn't drop more quickly than um it can be liquidated and actually used to repay users. So an example of this is where collateral just gets exploited and you know instantly wipes out all of its value. So that's sort of

the spectrum of risk. It goes from smart contract to operational to economic risk. Different parties are involved in securing different parts of the stack. Like I said, smart contract risk, we've we've gotten we've made a lot of progress over the last 5 years to the point where, you know, very few exploits today at scale are a result of smart contract risk. Now, I think the industry needs to solve the operational layer and that's one of the um you know, the most important areas. >> Okay. And so in that scenario I painted, it assumes that the user lost some money or didn't get all their money back. Um, but are there situations where when a vault has a loss that it isn't necessarily the user who eats that loss?

And if so, what might those scenarios be? >> Yeah, one one thing that there's a lot of interest in is insurance. Um I think especially as these products become more mainstream and are adopted by traditional fintex and normal consumers um insurance becomes really compelling. So this is an area where there's a lot of work going on and we've actually started to see insurance programs go out. We haven't seen a major claim be processed yet. So that's always something that people should be skeptical of. Right? it's easy to look at the marketing of insurance programs, but until we see a major event where we actually see what happens to claims. Uh it's it's really hard to know. So that's one sort of way of answering this question. It's, you know, insurance is

sort of this category of transferring risk between players or people. Um on the other hand right when you think of the large brands that are now building these products right there are there are scenarios I can imagine where if someone loses money it's in the interest of the various businesses that are involved to cover that loss right whether that's a distributor of fintech whether it's an underlying protocol whether it's a vault provider um so these are sort of the people that are available to cover losses either you transfer risk via insurance or someone who's constructed the product um has just you again chosen to to cover those losses or the user has to eat them um if they've accepted the risk.

>> And one other thing is, you know, after the RS ETH attack, a lot of people talked about how when you're vetting partners, you're not always vetting certain aspects of their work, right? Like, you know, how how do they manage those keys? Um, and I wondered um if there's some kind of like checklist that you think either um you know the different providers in this world should use to vet their partners or even for like a user who's considering do I want to put my money in this vault? Like what are all the different ways that you kind of vet uh who you might be working with?

>> Yeah, this is a really complicated and and deep question. The first thing I'll say is that we absolutely need operational standards that make it easy for end users to actually understand what kind of operational risk they're taking. We can't expect end users to be able to do the diligence to look at the supply chain and see which keys have which roles. It's just not practical. But what you can do is rely on um credible third parties who do this for a living like you know rating agencies who can evaluate the risk of these financial products all the way down the stack. And we're actually starting to see that category form both with cryptonnative players like what Credora is doing within you know Redstone uh and even some large traditional players like SNP are starting to get interested in rating

vaults. So that that's one flavor of of things that are important. It's that users should not be expected to do this assessment. It should come from experts who who do this u as their core business. As far as like best practices, obviously, you know, VETa, we have our own diligence process. When we when we think of product construction and we work with partners, it's really important that people like key management, best best practices for key management are really important here. Do things like um important keys should be secured by multi-igs with time locks um where every signer is using hardware keys. These are some of the basic best practices that get you there. How you sign transactions, right? um are you blind signing in devices that aren't isolated? So there there are definitely

best practices that are forming. What's not obvious to users of the product are are those best practices being followed across the whole chain? >> Yeah. Yeah, that's that's definitely a much harder question to resolve. Um so now let's also talk about an incident last November with Stream Finance. It blew up and created about $285 million worth of exposure in vaults. And that especially happened for vaults where the curators had chased high yields. And I wondered if you have seen an evolution in the vault space uh since then. Like do you think um you know from that time that you would say you think that potentially is less likely to happen

again or do you still see curators taking risks that you think could lead to a similar situation? I definitely think post stream um around this is around the 10-10 time uh there has absolutely been a scaling back of risk-taking on chain right the dynamic that everyone's talking about today on Twitter is this idea that uh the only way to juice yields on these products is to continue going farther down the risk curve and as curators compete to offer the higher yield the highest yield there's this tendency to just do that on behalf of users um even if users aren't aware of the risk that they're taking.

But I think we've definitely seen that sort of practice start to scale back significantly uh after the events of stream and other similar incidents. Um I think this is natural, right? Like users are becoming smarter. They were they there was a a general like pulling out of funds from these kind of products in general across the board, right? And so that I think made made participants like curators a little bit more conscientious. Now, do I think that this will never happen again? I don't think so. I think the I think it will happen at some point in the future. Um, in the sense that one of the points of DeFi is that this is an open financial system where any sort of longtail asset can move on chain and be composable with the

broader universe. Right? So, enabling financing against complex longtail assets, that's one of the core value props of DeFi. Right? And when you accept that, what it means is that there's going to be risk in the system. What people need to understand though is it's really important that people know the level of risk that they're taking, right? It's not critical in my opinion that there's no risk at all. Right? The whole point of finance is is moving risk and trading off things like liquidity and yield. And I think we want to support a large universe of interesting um assets. It's just users need to understand they shouldn't think they're having some safe, you know, insured savings account and suddenly they're getting exposure to basically an onchain hedge fund like stream finance.

>> Okay. So then from the users perspective, I'm sure that when they're looking at the different vaults that they'll definitely be, you know, evaluating the curators, you know, um these so these firms are, you know, tasked with mapping out the risk, with choosing the market, setting caps, they're we're rebalancing all those things. So when you think about evaluating curators, what are some of the main metrics that you think are important to look at? Yeah, there's there's very basic ones like how long has this curator been operating in production? Um what kind of track record do they have? Um what kind of assets have they curated? Right? I think that's that's really important. So operating history is just one very basic

thing that I think um it is a huristic but it's a really important one. Beyond that, when you look at what curators need to be able to do, it is a very complex and technical problem of both being able to underwrite different forms of collateral and assets, which is a very like traditional riskmanagement capability, but also really understand technical risk within DeFi and the nuances um and idiosyncrasies of risk within, you know, crypto assets. Um so that's again smart contract risk, governance protocols. Curators actually need to be able to do both of those things. Um, so that that's sort of a way to evaluate. It's like how long and how big are these curators? How long have they been around and how big are they?

And what sorts of expertise and technical capabilities do they have to be able to safely navigate onchain markets? >> Okay. So, we are recording shortly after SEC Commissioner Hester Purse released a statement saying that when it comes to vaults, some of them could potentially u implicate federal securities laws. She wrote, quote, "A vault, for example, could be a common enterprise in which users invest money with a reasonable expectation of profits to be derived from the vault deployers and curators entrepreneurial or managerial efforts.

I'm sure for anybody who's been in crypto for any number of years, they will recognize that this line comes from the quote unquote how we test, which you know is uh what uh in the US they use to determine whether or not an investment is subject to securities laws. How did you read her statement? What were your takeaways? >> Let me zoom out a bit and first just contextualize this with what this means for the market. So the first important point is that this was inevitable and I think a lot of people understand that it was inevitable but why it's happening now like why regulators are paying attention now as opposed to over the last 5 years is because these products are finally becoming mainstream right

it's no longer just these very sophisticated whales or dgenss who are using this technology it's now being distributed again through fintech to real normal people and businesses um who don't fully understand uh the onchain world and so that's happening as we speak, right? Robin Hood launched their earn program a couple of weeks ago and I imagine many of the users of that product have never touched DeFi in their lives before. So that's one thing, right? It's very it was inevitable that this would get the attention of regulators precisely because these products are finally becoming successful. The second thing I'll say is that it's actually good like that regulators are paying attention and engaging with this category. Um you know VETA has been engaging with regulators for the last couple months. Um, you

know, Tongv Lee, who's FedEda's general counsel, Laura, you know very well. Um, she's been an expert on this and has been working really closely to educate regulators on what vaults are, what the design space looks like, different trade-offs. Um, so that's one thing I'll say. Now, in terms of uh Commissioner Pers's statement today, I think she's touching on something that many of us in the space have been saying for a long time, which is you can't just call 20 different things a vault and pretend that they're all the same thing and carry the same risks and the same regulatory implications. Um what Commissioner Purus is saying is that different aspects of a vault design inform whether these products should be

regulated uh under securities law or should not be. And so it's a really nuanced question, right? You have some vaults that don't take exposure to securities. And our view at VA is that you know D5 protocols and markets like A and Morpho are not securities. That's a view that that we we have pretty strongly. And so vaults that do onchain lending there are questions right this is a product that's not actually taking exposure to underlying securities. Um on the other hand as more securities move onchain we are increasingly going to see faults that take direct exposure to securities and those clearly do implicate securities laws in various ways and then it's a question of what does that structure look like in what way do they implicate laws. Um so that that's just my quick read of the

situation. Uh there's many people on the timeline who are viewing this as like you know the end of vault or something. I actually think it's the opposite. I think there's so many players out there, financial institutions and fintexs who are really excited about this technology and they're just dipping their toes in. But what's preventing them from jumping all the way in is a lack of clarity and uh guidelines for what what these products are and what the laws are that surround them. >> Yeah. I didn't read it as um being some kind of uh warning shot to vaults. It was more like she was saying it's very much like the Howie test where facts and circumstances matter and you know all the little details around how any

individual vault is structured is what's going to be the determinant. So um yeah it definitely felt like she was just saying pay attention to what you're doing you know don't don't make it like that famous line from the howy test which is why I think she you know modified it for this statement. Um so as you mentioned vaults are just becoming more popular and in January you launched um as the infrastructure partner to Kraken DeFi earn and I wondered how that partnership has been going and if there's any you know surprises from it or anything about it that has influenced um you know how you think the space will grow. Yeah, Kraken um Kraken has I think confirmed beyond any sort of doubt that

enterprise distribution is the right way to export DeFi to the world, right? Taking these products and these onchain markets, packaging them up in a simple format that normal people can use and putting it into a re into a distribution channel that already has millions of users. That's very obviously now the way that DeFi can be successful. And in terms of our partnership with Kraken, this has been it's even exceeded my expectations in terms of growth. Uh so we launched in January with three stable coin products and a couple months later, you know, that partnership expanded to BTC earn. And across all of these products that we've grown to over 600 million in assets across over 80,000 users, many of whom may have never used

DeFi before. Um, so it just shows you there's a huge amount of latent demand for access to these products. When you package them in the right way and embed them in these interfaces with the right UX, it's very clear why these things are taking off and growing. And I think a lot of people are paying attention to the category off the success of products like what Kraken has done, Robin Hood, Coinbase, and a number of others. >> All right. So as you mentioned this is a very competitive space right now and I wondered how you think about how to compete amongst uh you know all the different players there's centur metamorpho era there's just a number of them so what are you you know what do you think will be the differentiators

>> yeah one one thing is that there's when you look at the construction of these products right there's so many different ways that so many different layers that come together to make a vault um so centur is a curator right and we work with Centura. In fact, they're uh they're the curator for the Kraken products. Um Morpho has their own vault protocol that's specific to Morpho's markets. Um but many of our vaults, we're one of the largest users of Morpho. Many of our vaults take exposure to Morpho. So one just thematic thing here is that the market is growing so quickly that it's much more fruitful to just work with people and grow the pie than it is to sort of too aggressively compete with each other. Um it just

doesn't make sense to be knives out in a category that still has a thousandx to go from here. Um and now in terms of VA's value prop where why we think we're differentiated, we're one of the oldest uh vault providers. My team's been building vaults for five years. Um, which there's a lot of things you learn through different market conditions and cycles that are just impossible to learn a priori from a textbook. Right? On top of that, we're one of the few that are actually tested at enterprise scale. Right? We're at billion dollar scale. We've never had a security incident. Um, and enterprises buy unprecedented, right? Nobody wants to be the first one to integrate some net new piece of infrastructure and take additional risk in what's already a fairly risky offering. Um, so I think maturity of go

to market, maturity of operating history, uh, in addition to having the best technology stack, these are what I view as our core differentiators. >> All right, Sunwell, it's been a pleasure talking with you. Thank you so much for coming on Unchained. >> Thanks for having me. >> Thanks everyone for joining this podcast. We will catch you next time. Bye. Nothing you hear on Unchained is investment advice. This show is forformational and entertainment purposes only, and my guest and I may hold assets discussed on the show. For more disclosures, visit unchainedcrypto.com.