The Rise in Ethereum Liquid Restaking Protocols
White Star Capital Digital Asset Fund - newsletter #161
The Rise in Ethereum Restaking Protocols: A Market Overview
White Star Capital Digital Asset Fund - newsletter #161
By Robin De Baets, Associate
On September 15th 2022, after years of testing and development, The Merge led Ethereum to successfully transition from proof-of-work to proof-of-stake, the most efficient consensus mechanism by any metric. This shift has allowed DeFi to have its own, crypto-native yield-bearing instrument - ETH - which can now be staked (put in escrow) to secure the chain in exchange for yield. Yield-bearing assets in traditional finance (e.g. bonds) have entire industry verticals built around them, thus having a crypto-native equivalent could be a major inflection point for the industry.
Staking
Participants in blockchain networks need to reach consensus about the correct ordering of transactions in the chain, i.e., they need to agree on a shared, single version of history. In Proof-of-Stake, nodes validate blocks (rather than the ‘mining’ described in proof-of-work), by committing and locking up a stake to prove ownership and vested interest in the blockchain’s success. A randomized process selects which nodes become validators for each new block, and the vested interest mechanism disincentivises participants from undermining the system.
So, in the proof-of-stake consensus mechanism of Ethereum 2.0, the chain is secured through people (validators) locking up (staking) their ETH. In exchange, they receive staking rewards in ETH in proportion to the quantity of ETH tokens initially staked. These nodes function as the security mechanism for Ethereum transactions. Each of these nodes is required to deposit 32 ETH as collateral; this is called staking. If the nodes behave as they should, they will be rewarded. If they do not behave as defined in the protocol specification, they can lose (a part of) their deposit. This is called slashing. This could either be intentional (e.g. a malicious attack) or unintentional (server downtime, technical issues in the implementation). Through this mechanism, Ethereum enables a global, trustless, and programmable transaction network. The stakers in this case are those driven by economic incentives to ensure this network is honest and stable.
Statistics
Ethereum has 945k validator nodes, run by institutions (e.g. Figment, Blockdaemon), protocol operators (e.g. Lido) and individuals
30.3mn ETH (=$85bn) is currently staked, constituting 25% of the supply
The yearly staking return has averaged out at 3.9% annually
On Ethereum alone, there are $3bn of staking rewards per year
There are three main downsides to becoming a validator node:
Users have to run and manage their own server, which brings a significant amount of complexity and risk with it, so multiple players have emerged to tackle this with delegated staking.
Staking requires a minimum of 32 Eth, which equates to around $90k in today’s prices
Once a user has staked, they have locked away their ETH and cannot use it for anything else.
Delegated staking
Delegated staking protocols were developed to reduce barriers to entry as they let ETH holders stake without running a validator node. In this model, users commit their ETH to a pool of a protocol, which then takes care of running the node. Essentially, users deposit their ETH into a third-party app which then deposits it into the Ethereum deposit contract for them through their own validators. The user will usually pay a small commission to the node operators. This allows users to stake less than the 32 ETH deposit required for running a single node. This also spreads out the risk of a faulty node operator across the protocol’s users, reducing individual user risk. Large players in this arena include Figment, Consensys, Blockdaemon, and others, and they are essentially infrastructure providers and operators.
Liquid staking
Many delegated staking protocols will issue a liquid token on Ethereum that functions as a receipt for your deposit. The protocols give derivative tokens called Liquid Staking Tokens (LSTs) in exchange for staked Ether on the proof of stake network. An example is Lido’s staked ETH token stETH. These derivative tokens are fungible and freely transferable, so the user can trade with stETH while earning yields from the staking contract. They can be transferred, stored, spent or traded as one would a regular token, thereby maintaining ETH liquidity whilst earning rewards. This is called liquid staking.
This token can be used at a later time to retrieve back your deposit and any accrued yield. Due to their inherent value, they are interesting primitives to use across different protocols, such as money markets and exchanges. The leader in the liquid staking space is Lido DAO (which has a current AUM of $27bn), and Rocket Pool, Frax Finance, Ankr, and Stakewise are the other major decentralized players. Some centralized players like Coinbase and Binance, will offer both liquid staking and regular staking using the company’s custody solution.
Landscape
Around 13.5mn (=$38bn) of all staked ETH is being held in protocols with liquid staking, representing around 44%.
Risks
Staking Yield Compression: As more ETH gets staked over time, staking yields will compress unless the Ethereum network demand goes up, raising fees.
Centralization: As seen in the landscape, certain staking protocols manage a significant portion of all staked ETH. This centralization causes risks, as any security or operational issues in a specific protocol could affect a large part of the ETH supply.
Liquidity Constraints: To start and stop being a validator, there are rate limits enforced by the network. This causes validators to join an entry and exit queue. For a validator to recover their deposit, they need to go through the exit queue first. This could cause a liquidity crunch in the event that tons of validators want to exit the network. This also poses a risk for liquid staking as the inherent value of a liquid staking token is based on its ability to retrieve the underlying ETH deposit. Due to this rate limit, it could take a significant amount of time to retrieve the ETH deposit, making the liquid staking token temporarily less valuable due to the time cost of money. See the below simulation by Figment:
Restaking
Restaking enables staked ETH to be used as crypto-economic security for protocols other than Ethereum, in exchange for protocol fees and rewards. This means that existing ETH stakers can opt-in to validate new software modules built on Ethereum. These applications are called actively validated services (”AVS”) and include many types such as consensus protocols, data availability layers, virtual machines, keeper networks, oracle networks, bridges, threshold cryptography schemes, and trusted execution environments. Think of restaking providers as an index of these AVS’s expected transaction fee returns. The idea of restaking is similar to Ethereum: node operators pledge their staked ETH to help validate and operate an AVS. If they operate by the rules of the AVS, they will be rewarded, if they do not, their pledged stake ETH can be slashed.
AVS (Actively Validated Services)
For AVSs, restaking is a valuable primitive, as it allows you to bootstrap a protocol more easily by relying on the deep liquidity and security of ETH. As a practical example, think of a decentralized oracle that fetches prices of assets. To guarantee that nodes in the oracle network behave honestly and accurately (and return the correct price), a mechanism is necessary to punish those that don’t. To solve this, the protocol could tap into the extensive ecosystem of existing ETH validators and the deep ETH liquidity. If node operators were forced to put up some staked ETH as collateral (i.e. restaking), they could be slashed if they don’t behave well. The fees of the oracle could be paid out to node operators, allowing them to earn a yield on their restaked ETH.
To guarantee an AVS’s security, the concept of Cost-of-Corruption (CoC) is introduced. Imagine the above oracle has a set of node operators that pledged a combined $10mn of staked ETH. For the oracle to return incorrect prices, at least 50% of the node operators (weighted by stake) would have to behave maliciously and the cost of corruption is $5m. As long as the value of what the oracle is securing (such as a DeFi protocol, money market) is less than the cost of corruption, the application is considered crypto economically secure, as it would cost more to corrupt the application versus the value that can be stolen. The value at stake is called Profit-from-Corruption (PfC).
Node operators can pledge their staked ETH to multiple AVSs at once, allowing them to earn yield from different sources (harken back to our index example above). This increases security, as liquidity is not fragmented and the cost of corruption per application increases. It does pose another challenge, however, as an attacker could try to corrupt multiple applications at once with the same pledged ETH, potentially increasing his payout. Imagine for example that there are two different oracle AVSs with each a $5mn profit-of-corruption and $8mn cost-of-corruption. By itself, these AVSs are secure, since an attacker would lose $8m in order to make $5mn. If however, an attacker can pledge the same $8mn in both AVSs and conduct both attacks at the same time, he stands to gain $10mn, while only losing $8mm due to being slashed.
EigenLayer
EigenLayer (raised $164.5mn) is the biggest player focusing on practical implementations of restaking. Right now, 2.6mn ETH (=$7.3bn) is being restaked through their protocol, representing 8.5% of all staked ETH and 2.16% of all ETH. As of now, many AVSs are being developed on testnets. Some of the major ones include:
As of right now, many AVSs are being developed on testnets. Some of the major ones:
EigenDA (developed by EigenLayer, competing with Celestia): a data availability solution for layer-2 rollups, a framework that reduces the data load on the mainnet blockchain and helps reduce fees for layer-2s.
Espresso (raised $32mn including Blockchain Capital and Polychain): a decentralized sequencer and data availability system connecting layer-2 scaling solutions, allowing layer-2’s to scale, decentralize and operate.
AltLayer (raised $7.2mn including Polychain, trading at $3.4bn marketcap): a decentralized protocol that facilitates the launch of native and restaked rollups with both optimistic and zk rollup stacks.
Blockless: provides a standardized networking framework for applications built on EigenLayer.
Ethos: Ethos leverages EigenLayer to create a validator protocol for Cosmos chains. Ethos will act as a central source of restaked ETH, from which Cosmos chains can borrow to bootstrap their trust layer with low cost.
Restaking protocols
Restaking protocols are analogous to delegated staking. They help users restake their ETH without the complexity of running nodes. In the case of restaking, this complexity is significantly elevated, as users have to choose which AVSs to run nodes for, potentially running many in parallel with different yields and risk profiles. Different restaking protocols can implement different strategies with different yields, risks, and liquidity, which is a major difference from traditional staking protocols, which all do the same thing at the end of the day.
Liquid restaking
Liquid restaking is quite analogous to liquid staking: a user restakes ETH with a certain restaking protocol and receives a token in return, which can be used to retrieve the staked ETH at a later point and accrue yield. This token is called a Liquid Restaking Token (LRT).
Some protocols offer both a liquid staking token and a liquid restaking token. Most restaking protocols will also accept liquid staking tokens coming from other protocols to be restaked with them.
Landscape
Also, see this dashboard.
1.18mn ETH (=$3.38bn) is currently held in Liquid Restaking Tokens, representing 45% of all restaked ETH.
Risks
Accidental slashing: Similar to Ethereum validator nodes, operator nodes in AVS have to behave honestly and accurately. Downtime, cybersecurity or technical issues could all lead to a node malfunctioning and being slashed incorrectly, even if intentions were honest. As a measure against this, EigenLayer will allow a certain slashing event to be vetoed through governance.
Unknown liquidity constraints: It is not yet clear how nodes will enter and exit AVSs and the potential rate limits that will be set. Similarly to Ethereum unstaking, this could lead to liquidity concerns for those that have restaked ETH with a specific AVS. This could then lead to liquidity issues on liquid restaking tokens that have restaked (part of) their ETH with a specific AVS.
Complex attack angles: As discussed before, the crypto economic security of an AVS can be quite complex, as it depends on the cost of corruption, profit from corruption and also which of its node operators have restaked the same ETH across different AVSs with different risk values. This brings rise to a whole new class of potential exploits and attack angles. The majority of the risk here will lie with the AVS and its users.
Restaking yields: To make restaking attractive, node operators and thus users will receive rewards from the AVSs they are securing. To make this a sustainable model, the yield operators can make will need to be sufficiently attractive to outweigh the additional risk versus traditional staking. As of right now, $7.3bn of ETH is restaked. To make restaking yields at least 5%, AVSs would need to pay a combined minimum of $365mn per year to node operators.
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