01.05.2024
DeFi pioneers are disrupting traditional financial institutions with new technologies and regulatory workarounds, but financial innovations bring unexpected risks.
I. Understanding Staking and Restaking.
The origin of the modern banking system is traced to the rise of merchant cities in Italy, particularly Venice and Florence. The Grain Office in Venice (not an official bank) was an early testing ground for financial instruments and banking. Usury, a practice banned by the Catholic Church, didn’t stop the Italian Christian merchants from developing innovative techniques in response to religious restrictions on lending at interest. The banking families created a new type of contract (Contractum trinius), which, instead of charging interest against the “loan,” fixed an insurance fee in case of repayment risk.
The way the merchants joined the ranks of Jewish moneylenders, cleverly circumventing their religiously imposed limitations, resembles how DeFi ecosystems are disrupting the power of traditional financial institutions. DeFi aims to recreate traditional financial services (lending, borrowing, trading, etc.) on decentralized blockchain networks instead of relying on banks or other financial institutions.
Finding flaws around usury restrictions is similar to how DeFi developers have created new financial instruments to navigate still-evolving regulatory spaces. Nevertheless, if we look at historical examples of defaults and banking failures, we must remember the risks inherent in any financial system, especially in the emerging DeFi ecosystem.
The process of staking in DeFi resembles a bank fixed deposit, where funds are locked for a specific period and earn interest or rewards. Liquid restaking, on the other hand, is analogous to securitizing a fixed-term deposit into a tradable bond, allowing for liquidity, potential collateral use, and increased accessibility for smaller investors.
Nevertheless, liquid restaking has its limitations. While traditional deposits may come with insurance up to a certain amount, liquid restaking involves risks associated with the cryptocurrency market and smart contract protocols. Additionally, both securitization in traditional finance and liquid restaking technologies can have a steep learning curve for the average user (mostly retail users).
II. Mechanism and Functionality.
Traditional staking involves locking up your cryptocurrency assets for a specific period to contribute to the security and validation of a blockchain network. During this lock-up period, your assets are essentially inaccessible, and you cannot use them for any other purpose. Besides securing the network, staking aims to earn rewards for staking your assets, such as a share of the network's transaction fees or newly minted cryptocurrency. On the other hand, liquid staking solves the illiquidity issue associated with traditional staking. With liquid staking, users can stake their assets while still maintaining liquidity. This is achieved through liquid staking tokens (LSTs) or liquid staking derivatives (LSDs), representing the staked assets and any accrued rewards.
For example, the underlying process to stake in Lido Protocol:
Depositing ETH: You deposit your ETH into the Lido protocol.
Pooling and staking: Lido pools your ETH with deposits from other users and distributes it to a diverse set of professional Node Operators for staking on the Ethereum network.
Receiving stETH: In exchange for your deposited ETH, you receive an equal amount of stETH.
Earning and using stETH: Your stETH balance updates daily to reflect staking rewards.
Use stETH in DeFi: Trade it on exchanges, use it as collateral, or participate in various DeFi protocols for additional yield opportunities.
Redeeming ETH: When Ethereum withdrawals are fully enabled, you'll be able to redeem your stETH back to ETH, potentially with some premium based on accrued staking rewards.
Liquid staking offers several advantages over traditional staking. Mainly, it provides liquidity, allowing users to access their assets and engage in other DeFi activities while still earning staking rewards. It also eliminates the need for users to manage their staking infrastructure, making it more accessible and friendlier. As a result, liquid staking has gained popularity and traction in recent years. Liquid staking protocols, such as Lido, Rocket Pool, and Mantle, have amassed more than $47 billion in Total Value Locked.
Source: DefiLlama
III. EigenLayer and its LRT Implementation.
Liquid restaking tokens (LRTs) are a form of Liquid staking tokens (LSTs) deployed from EigenLayer, the protocol that makes the liquid restaking implementation possible. To put it simply, LRT is a specialized form of LST, but instead of securing the Ethereum network, it reinforces external systems such as oracles, bridges, or rollups deployed from the EigenLayer system.
In essence, all LRTs are LSTs, but not all LSTs are LRTs. LRTs introduce the extra element of restaking, which opens up the potential for higher yields and carries added layers of complexity and potentially more risk.
EigenLayer is a protocol that facilitates restaking by allowing staked ETH to be further utilized to secure other services (AVSs or Actively Validated Services, such as oracles, rollups, or bridges). This is achieved through a design in which restaking is essential to secure the network, enabling staked ETH to be used as collateral for securing AVSs.
Problem solved by LRTs (is LRT solving something or creating new problems?)
The EigenLayer protocol security framework is designed to be efficient and scalable and its final purpose is to bring more security layers to Ethereum through the AVSs. Its critical aspect is to be compatible with existing Ethereum staking and liquid staking infrastructures, make it accessible for validators and developers to adopt, and provide them with additional rewards.
The protocol has many advantages for developers, users, and validators: It can boost ETH and liquid ETH staking profits, prioritize network security, and handle multiple validators and AVSs. Basically, it helps AVS developers to save time and resources in developing their own security infrastructure and outsource it on Eingenlayer’s restaking.
EigenLayer's introduction of restaking has sparked the development of innovative DeFi solutions like KelpDAO, Renzo Protocol, Puffer, and EtherFi, revolutionizing Ethereum staking. EigenLayer's Mechanism:
EigenLayer protocol deploys diverse restaking methods with different profile risks. The more intricate the method is, the riskier it becomes:
Deploy staked ETH in the EigenLayer protocol with a Native restaking method and stake it directly through the Beacon chain.
Restake liquid ETH of currently staked ETH (for example, stETH, the token that is the liquid form of staked ether in the Lido protocol) in a liquid staking pool such as Lido, Rocket Pool, Mantle, etc.
Restake liquid ETH of currently staked ETH in EigenLayer’s ecosystem, such as Renzo Protocol or EtherFi.
The EigenLayer protocol embodies a series of contracts to enable users to restake ETH or LSTs to secure que AVSs. The Delegation contract is disposed to manage the process of delegating the user’s restaked tokens to validators (operators in charge of running AVS software built on top of the protocol, who also are tracked in an Operator Registry contract) and handles rewards distribution. Slashing contract enforces the penalties conditions for validators that don’t follow the protocol conditions.
IV. Weaknesses of the LRT ecosystem.
DeFi complexities arise when investors are more interested in searching for the most attractive yield offer than the most secure ecosystem and robust infrastructure. This approach to DeFi has prioritized short-term rewards over long-term sustainability, leading to risky strategies like over-leveraging or investing in sketchy assets. These practices, which finally have become a part of the DeFi agenda of many investors, have amplified potential losses and destabilized the system.
Systemic risks are another concern associated with restaking. Ethereum relies on staked ETH for consensus, so any faults in restaking mechanisms or underlying protocols could jeopardize Ethereum's security and stability. Malfunctions or vulnerabilities would undermine the network's integrity, causing potential downtimes or security breaches. These risks could also affect the DeFi ecosystem, heavily reliant on Ethereum's stability.
Liquid Return Tokens (LRTs), often used in restaking, are susceptible to decoupling from the underlying value of staked assets. This deviation can cause mispricing, liquidity challenges, and losses for LRT holders. In DeFi protocols, inaccurate valuation of LRTs can introduce additional risks when used as collateral. Incorrect collateral assessments may trigger liquidations or compromise the stability of DeFi lending platforms.
V. The Renzo and ezETH depeg as a systemic risk example:
Renzo Protocol, a LRT self described as a Strategy Manager, and one of the most important DeFi platforms built on EigenLayer, being the second biggest by capitalization (with 1 million ETH staked, it accounts for 30% of the market share), lost its peg to Ethereum (ETH), leading to a deviation from the expected 1:1 ratio between ezETH and ETH.
Source: DEXScreener
The depeg was triggered after the developers disclosed the protocol's tokenomics, plan, and schedule for token distribution, including the airdrop plan for its REZ token. The controversy erupted following the publication of a pie chart by the team. Was this an unintentional design error or a deliberate attempt to deceive holders?
Source: Renzo Docs (model has been updated after backlash)
The pie chart has several issues. Not only are the proportions of 30% and 31.56% incorrectly represented as 50%, but the proportion of the 2.5% plus 2.5% pie chart is also misrepresented as 20%. The main problem, and likely the primary reason users are transferring their funds away, is the allocated tokens for the community and airdrop. A mere 5% of all tokens are allocated for this purpose.
Nevertheless, Renzo's internal reserve fund automatically covered any liquidation losses incurred by the protocol itself. While the peg has fully recovered, the depeg event highlighted the fragility of LRTs and the potential for cascading liquidations across DeFi. We must acknowledge that depeg is an inherent risk for all LRTs. When vesting periods expire, and withdrawals are enabled, temporary imbalances in DEX liquidity pools can lead to a divergence in price between LRTs and their underlying staked asset.
Crucially, this incident highlighted the significance of transparency within the LRT ecosystem. There's ample room for improvement in token distribution strategies across all LRT projects. To ensure full disclosure and promote transparency, token airdrops should provide clear details about their token distribution and allocation, incentivizing investor interest and building trust.
VI. Final thoughts.
In a time when Christians faced religious restrictions, Jewish merchants emerged as trailblazers in the realm of lending at interest. Unbound by these constraints, they ventured into uncharted territories, finding opportunities, especially in financing European farmers. The Jewish used a practice known as "two-handed trade." They offered financing against future crop yields and traded "grain debt," which allowed them to diversify their risk and maximize their profits. This practice showcases the utilization of early forms of futures contracts and securitization, concepts that modern finance still actively employs.
Early modern bankers, like their contemporary counterparts, were not immune to financial setbacks. One early form of securitization, known as "grain debt," resembled modern derivatives. In this system, farmers guaranteed the delivery of crops to the credit loaner, and in case of failure, the loan was insured by the "grain debt." This mechanism functioned similarly to present-day put options or insurance contracts designed to mitigate specific market risks. However, loaners must carefully evaluate borrowers' ability to repay and the risks associated with their underlying activities.
The crucial step to enhancing market liquidity and efficiency lays in comprehending the risk-to-reward ratio of the underlying crop loans, which were susceptible to variables such as weather and political circumstances.
The historical parallels are no coincidence. While technical jargon, technology, financial instruments, and the historical landscape have changed, the core nature of human behavior remains largely unchanged. DeFi protocols, like their historical counterparts, innovate by circumventing conventional financial regulations and offering groundbreaking services to new users. Their ultimate goal is to provide sophisticated services to those traditionally excluded from financial systems.
When considering DeFi and LRTs investments, evaluating the underlying protocols' risks and the possibility of protocol failures is essential, similar to traditional lending. Recent events in the DeFi ecosystem serve as cautionary tales. The stETH depeg in 2022, triggered by the UST/Luna collapse and exacerbated by the Celsius catastrophe, is a prime example. These unforeseen circumstances highlight the importance of careful assessment and risk mitigation strategies in the DeFi space. Acknowledging the inherent risks of the model is essential for sustainable growth. The future of LRTs depends on balancing innovation with a focus on risk mitigation mechanisms, user education, and transparency.