The natural selection of DeFi: survival of the fittest

null

Author: cryptographic

Compiled by: Block unicorn

Preface

Nature is indifferent and ruthless; it has no emotions, no feelings, no attachments. It only conducts an endless test: whether this design is worthy of survival.

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 work effectively. This is the essence of natural selection—a brutal, relentless, ongoing 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: rather than being a “black swan” event, each extinction event is more akin to natural selection eliminating the weak, ensuring that only the strong survive.

Aave is a typical example.

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

The survival and dominance of Aave is not by chance, but rather a composite return of conservative parameters and a culture of assuming that counterparties will fail and planning accordingly.

This brings 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 into lending markets and curated vaults.

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

This is not a failure of smart contracts, but rather a failure in architecture and design, caused by a lack of transparency and:

Funds entrusted to external managers

xAssets are used as collateral in multiple locations.

The selected “isolated” vault integrates these xAssets, along with an aggressive re-staking loop, to enable multiple claims on the same underlying asset.

It was originally supposed to be a completely isolated system, but in reality, it is tightly coupled. When the delegated funds of Stream disappeared and xUSD became unpegged, 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 has failed, and a single point of failure that should have been isolated has evolved into a systemic issue.

Isolation Vault + Custodian Mode

Stream exposes the vulnerability of the current isolated vault + custodian model, which operates as follows:

A permissionless lending primitive (like MorphoLabs) as a foundational layer.

Above it is a custody layer, where the custodian operates an “isolated” vault, sets parameters, and promotes “selected” yield paths.

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

However, the reality is not so. The bankruptcy of Stream exposed three major flaws:

Synthetic assets carry issuer risk: Accepting synthetic assets like xUSD in a segregated vault exposes oneself to upstream risks at the issuer level.

Incentive Misalignment: Custodians compete through APY and TVL, where a higher APY = higher market share = higher custodian rewards, and all downside risks are borne by liquidity providers without any initial losses (where custodians' interests are linked to market interests).

Recycling and Re-staking: The same synthetic asset is reused and posted as collateral in the lending market, packaged into another stable asset portfolio, and then recycled through a carefully managed vault, resulting in multiple claims on the same underlying collateral. In short, during times of stress, the redemption amount may exceed the available collateral, and the “isolation vault” suddenly ceases to be isolated.

natural selection

Nature is the best teacher, and it gives us a clear lesson: isolation based on common interests is an illusion.

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

The isolation vault + custodian model itself is not wrong, but for now, it cannot pass the most basic test… Can it survive? When the issuer fails, collateral evaporates, and chain claims reveal that “isolation” is just a marketing tactic, can it survive?

Aave survives because it assumes failure; Stream collapses because it assumes trust.

The market continues to express 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 returns instead of survival capability will not get a second chance; they will be liquidated, and their total locked value will be redistributed to those truly effective protocols.

DeFi no longer needs endless hype around yield mechanisms; what it requires is more rigorous design, more transparent collateral, and decision-makers taking on more risk. The protocols that will survive are those that can cope with counterparty defaults, assume market pressures 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 time has already come.

Recommended reading:

$1 billion in stablecoins evaporated, what is the truth behind the DeFi chain explosion?

MMT Short Squeeze Incident Review: A Carefully Designed Money-Making Game

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

Click to learn about the job openings at ChainCatcher