In the past month alone, billions of dollars have poured into new Ethereum-based liquidity re-collateralization projects such as Ether.Fi and Puffer. These emerging platforms are vying to replace Lido’s collateralized ETH (stETH) token as the asset of choice for decentralized finance (DeFi) traders.
At the heart of the entire trend is the development of a new protocol called EigenLayer, which debuted a brand new “re-staking” system last June. The platform is building a solution that lets blockchain applications and networks borrow Ethereum’s security system, and it attracted more than $1 billion in new deposits in a 24-hour period this month. The total amount now exceeds $7 billion, which according to DefiLllama means the platform alone has accumulated more than 1.5% of circulating ether (ETH).
Re-staking provides a way to secure the blockchain protocol and network using security borrowed from Ethereum’s proof-of-stake network. ETH deposits in EigenLayer can be "re-staking" into other protocols, meaning they don't have to build their own proof-of-stake networks.
Investors are flocking to EigenLayer because it promises higher interest than traditional ETH staking. However, the platform’s recent growth is largely due to a group of third parties – “liquidity re-staking protocols” such as Ether.Fi, Puffer and Swell – which claim to streamline the re-staking process on behalf of users.
These liquidity re-staking platforms act as intermediaries between users and EigenLayer: these platforms "re-stake" users' deposits to EigenLayer and deliver corresponding newly generated LRT in exchange so that users can re-stake even when their deposits are used to re-stake You can continue trading at any time.
LRT represents user deposits in EigenLayer, meaning they accumulate mortgage interest and can be redeemed back to their underlying value. LRT can also be used in DeFi, meaning people can borrow and exchange LRT for greater returns.
Aside from the convenience of LRT, the real appeal of recent liquidity restaking platforms is “points” – rewards that may qualify users for future token airdrops. While the monetary value of points is unclear, they have spawned a whole new ecosystem of add-on platforms, such as Pendle, which allows users to maximize their points through trading strategies that often involve high leverage.
This complex points system, high-yield and high-risk trading strategies are reminiscent of 2021 - "yield farms" and the pursuit of high returns triggered the boom and bust of DeFi, and the industry has yet to fully recover . While some experts are wary of the risks of liquidity recollateralization, proponents of the technology insist there is real substance beyond the hype.
1. Staking 101
Liquidity re-staking builds on two years of growth in the Ethereum staking industry.
Ethereum is run by over 900,000 validators, which are addresses where people around the world lock ETH Tokens on the network to help secure the chain. Collateralized tokens accumulate steady interest, but once they are used to run the network, they cannot be used for other purposes, such as loans or other types of investments.
This restriction prompted the rise of “liquidity collateral.” Services like Lido allow users to stake on their behalf and give them a “Liquidity Staking Token” (LST) that represents their underlying deposit. Like Lido’s Collateralized ETH (stETH) Token, LST earns interest like regular collateralized Ethereum (currently around 3%), but they can also be used in DeFi – meaning investors can borrow these tokens , to obtain additional income.
The liquid mortgage industry has boomed over the past few years. Lido, the largest liquidity staking protocol to date, has over $25 billion in deposits. Its collateralized ETH (stETH) token regularly sees higher transaction volume than regular ETH in the largest lending protocols on the network.
2. From liquidity staking to liquidity re-staking
Now, a similar liquidity staking trend is taking off with EigenLayer, a high-profile new protocol that introduces re-staking to Ethereum.
"EigenLayer basically built a tool that allows other networks to leverage Ethereum's security for bootstrapping," explained Austin King, CEO of Omni Labs, which is building a bridge protocol powered by restaking.
Investors have turned to EigenLayer to receive additional rewards on their ETH: on the one hand, the interest earned for protecting Ethereum, and on the other hand, for protecting the so-called AVS (Active Verification Service) that uses EigenLayer to borrow Ethereum’s security. Interest earned on the remortgage.
According to EigenLayer, these AVS will eventually include Celo, a layer-1 blockchain that is transforming into a layer-2 network based on Ethereum; EigenDA, EigenLayer's own data availability service; and Omni, which is building a bridge Infrastructure that helps different blockchain networks communicate with each other.
But the system also has shortcomings, one of the key issues is that tokens re-hypothecated through EigenLayer cannot be used in DeFi after depositing. This lock-in mechanism is a major disadvantage for investors looking to maximize returns.
As a result, liquidity re-hypothecation came into being, which is essentially a liquidity mortgage designed for EigenLayer.
The Liquidity Recollateralization Protocol accepts deposits (e.g. stETH), recollateralizes them through EigenLayer, and then issues "liquidity recollateralization tokens" such as pufETH, eETH, and rswETH, which can be used in DeFi to earn additional points and other rewards.
The person involved explained: "Basically the value proposition of staking ETH is that you can get the benefits of staking ETH without having to bother setting up a validator node. Not only that, but you can also be compensated for any rewards brought by these AVS networks."
3. Motivational games
Puffer’s pufETH, Ether.Fi’s eETH, Swell’s rswETH, and other Liquidity Rehypothecation Tokens (LRTs) are competing with Lido’s stETH to become the next big asset in DeFi. To do this, they have turned to the current incentive model in DeFi: points.
Although EigenLayer has accepted billions in deposits, its AVSs have not yet launched, meaning depositors have not received interest on their deposits. Currently, the main incentive for depositing tokens into EigenLayer is re-staking points, a vaguely defined count by which investors hope to earn future confirmed EigenLayer airdrops.
"EigenLayer has not launched yet and it has not had any re-collateralization," Puffer Finance CEO Amir Foruzani noted in an interview with CoinDesk last month. " "Their only incentive now is points, which is basically a guess at the future value of those points. "Major liquidity restaking protocols (including Puffer) have begun offering their own points as an additional incentive for early investors.
New services have also emerged around points exchange, promoting high-risk trading strategies that involve repeatedly staking the same token - increasing exposure to the protocol at the expense of higher future returns.
One such protocol is Pendle, which splits a liquidity recollateral token into two separate tokens - a yield token and a principal token - to unlock leveraged trading. One of Pendle's products accepts deposits of Ether.Fi's eETHToken and, according to the site's advertising, can earn 45x Ether.Fi points and 15x EigenLayer points.
While points remain highly speculative, they appear to have had a positive impact on liquidity rehypothecation of deposits. According to DeFiLlama data, market leader Ether.Fi now has $1.2 billion in deposits, five times what it was a month ago. Puffer Finance follows closely behind with $970 million in deposits, a 10x increase in the past three weeks alone.
4. Punishment risk
The risks of this trend are increasing as liquidity rehypothecates deposits.
On the one hand, there is the general risk associated with EigenLayer that comes with investing money in a complex system of layers of protocols: as the complexity of interconnected AVS networks increases, errors will inevitably become more likely.
The biggest risk from these errors will be “penalties,” which are financial penalties to the mortgagor due to violating network rules or using defective software to connect to the network. Liquidity recollateralization protocols often mention “penalty-proof” features in their marketing, but until AVS starts running, these promises will not be verified in practice.
In the context of EigenLayer restaking, penalties occur at the AVS level: each AVS will set its own penalty rules, and liquidity restaking providers will be able to choose which AVS protocols they want to validate for their users. If a liquidity recollateralization platform chooses to validate a network with malicious (or flawed) penalty parameters, it puts users at risk of having their deposits slashed.
“We will build similar reputation systems in the broader rehypothecation ecosystem,” Riad Wahby, CEO of critical management services firm Cubist, predicted in an interview with CoinDesk. “If I were to put money into an operator, I would probably choose one that gives me the right balance between risk and reward.”
5. Speculation risks
The most obvious risk with liquidity rehypothecation is that, despite billions of dollars in deposits, the practice is currently highly speculative.
AVS may not be able to provide depositors with the interest returns they expect, which may cause investors to leave the system in search of more profitable betting opportunities. Amid all the excitement about Points, there is also some possibility that the accompanying airdrop could fail or never happen, making the Points and the new markets built on top of them virtually worthless.
The reason the risk of this outcome is amplified is that points are typically not issued on the blockchain but are tracked directly by the issuer. This means it’s difficult to know how many points of a particular type are in circulation, making it difficult to determine their value.
The speculative appeal of liquid rehypothecation points is reminiscent of the days of yield farming. In 2021-2022, when the DeFi industry is at its peak, money is pouring into projects like Olympus and Terra, which promise to provide users with market-leading returns in exchange for trust in their complex systems. Critics accused these projects of creating worthless tokens and printing them indiscriminately to artificially prop up revenue numbers, and these criticisms were ultimately proven correct after the platforms collapsed.
Whatever the superficial similarities, EigenLayer has entered the minds of Ethereum developers in a way that the worst actors of yield farming have never done, and supporters of liquidity restaking say it has the potential to support applications Programs and infrastructure develop beyond the narrow realm of points and gamified speculation.
