Author: cryptographic

Compiled by: Block unicorn

Introduction

Nature is cold and ruthless; it has no emotions, no feelings, no attachments. It only conducts an endless test: is this design worth surviving?

The financial market is no different. Over time, it will eliminate weak designs, fragile architectures, and strategies that fail to adequately consider risks, integrating those that are effective. This is the essence of natural selection—a brutal, relentless test that ensures the survival of the fittest.

DeFi is no exception. After years of experimentation and thousands of protocols, a pattern has become clear: each extinction event is less of a "black swan" event and more a case of natural selection eliminating the weak, ensuring that only the strong can survive.

Aave is a typical example.

Despite experiencing multiple industry extinction events, such as the Luna collapse, FTX, and the most notorious abuse of customer deposits by effective altruists in cryptocurrency, the Aave lending market still boasts hundreds of billions in deposits, with v3 consistently leading in DeFi lending TVL.

Aave's survival and dominance are not coincidental; they stem from conservative parameters, compounded returns, and a culture that assumes counterparties will fail and plans accordingly.

This leads us to Stream Finance and the latest round of natural selection.

Stream Finance

Stream Finance positions itself as a yield primitive, issuing synthetic assets (xUSD, xBTC, xETH) that users can mint with deposits and then deploy the newly minted synthetic assets into DeFi. These synthetic tokens are widely used as collateral and embedded in lending markets and curated vaults.

When an external manager responsible for overseeing part of Stream's assets reported a loss of $93 million, Stream was forced to suspend deposits and withdrawals, xUSD decoupled from the dollar, and YAM had linked $285 million in loans and stablecoin exposure to collateral associated with Stream, covering derivative stablecoins like Euler, Silo, Morpho, and deUSD.

This was not a failure of smart contracts but a failure of architecture and design, stemming from a lack of transparency and:

• Funds entrusted to external managers

• xAssets used as collateral in multiple places

• Curated "isolated" vaults integrating these xAssets, along with aggressive re-staking loops, leading to multiple claims on the same underlying asset.

What should have been a completely isolated system was, in fact, tightly coupled. When Stream's entrusted funds disappeared and xUSD decoupled, the losses did not remain isolated but spread to various markets and platforms built on the same underlying collateral. The originally independent vault + custodian model failed, and a single point of failure that should have been isolated evolved into a systemic issue.

Isolated Vault + Custodian Model

Stream exposed the vulnerabilities of the current isolated vault + custodian model, which operates as follows:

1. A permissionless lending primitive (like MorphoLabs) serves as the base layer.

2. Above it is a custodian layer, where custodians operate "isolated" vaults, set parameters, and promote "curated" yield paths.

In theory, each vault should have an independent isolation layer, custodians should be experts with the necessary experience and domain knowledge, and finally, risks should be transparent and modular.

However, the reality is different. Stream's bankruptcy revealed three main flaws:

1. Synthetic assets carry issuer risk: accepting synthetic assets like xUSD in isolated vaults exposes them to upstream risks at the issuer level.

2. Misaligned incentives: custodians compete through APY and TVL, with higher APY = higher market share = higher custodian rewards, and without the first loss (where custodians' interests are tied to market interests), all downside risks are borne by liquidity providers.

3. Cycles and re-staking: the same synthetic asset is reused and deployed as collateral in lending markets, packaged into another stable asset composition, and then recycled through curated managed vaults, leading to multiple claims on the same underlying collateral. In short, during times of stress, redemption amounts may exceed available collateral, and the "isolated vault" suddenly becomes non-isolated.

Natural Selection

Nature is the best teacher, and its lessons are clear: isolation based on shared interests is an illusion.

Stream Finance is the result of natural selection at its best, eliminating weak designs that prioritize growth over resilience, yield over transparency, and market share over survival.

The isolated vault + custodian model itself is not wrong, but for now, it cannot pass the most basic test… can it survive? When issuers fail, collateral evaporates, and chain claims reveal that "isolation" is merely a marketing tactic, can it survive?

Aave survives because it assumes failure; Stream collapsed because it assumed trust.

The market, as always, expresses its views through the brutal laws of natural selection—the laws of the effective and the ineffective. Those protocols that externalize risks, leverage opaque collateral, and pursue annualized yields over survivability will not get a second chance; they will be liquidated, and their total locked value will be redistributed to truly effective protocols.

DeFi no longer needs endless hype around yield mechanisms; it needs more rigorous designs, more transparent collateral, and decision-makers to bear more risk. The protocols that can survive will be those that can handle counterparty defaults, assume market stress rather than stability, and turn conservatism into dominance.

Nature does not care about your TVL or your APY; it only cares whether your design can survive the next extinction event.

And the next one has already arrived.

Recommended Reading:

$1 billion stablecoin evaporated, what’s the truth behind the DeFi chain explosion?

MMT short squeeze event review: a carefully designed money-making game

Under the savage harvesting, who is looking forward to the next COAI?

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