Mastering Restaking Yields: Amplified Returns Through Incremental Risks
Introduction
Restaking has proven itself to be a core DeFi narrative in 2024 largely due to how it has supercharged yields on relatively blue chip (i.e established) assets such as ETH. By taking on incremental risks, users are able to generate returns that were previously limited to only exotic tokens with much higher overall risks.
With the advent of restaking, yield tokenization also gained significant traction as it ushered in a yield trading market whereby stakers could get fixed returns by selling off claims to the yield accrued by their restaked tokens. In other words, stakers could not only get increased returns through restaking but also fixed returns if they are willing to go through the additional process of yield tokenization.
This educational piece dives into the various yield sources associated with restaking strategies and their associated risks:
- Native Staking: Stake ETH and earn rewards for securing Ethereum (e.g. Ethereum PoS).
- Liquid Staking: Delegate your ETH stake for greater flexibility (e.g. Rocket Pool, Lido).
- Restaking: Get additional rewards by sharing the economic security of your staked ETH (e.g. EigenLayer, ether.fi, Kelp, Renzo).
- Yield Tokenization: Get fixed returns or leveraged yield exposure by separating the principal and yield portions of the yield-bearing restaking token (e.g. Pendle).
- Leverage Strategies: Take advantage of yield tokenization mechanics to amplify fixed returns (e.g. Factor).
ETH is chosen as the sample asset due to it having the most developed and well-known restaking market. It is important to note that restaking mechanics apply to any network that utilizes Proof-of-Stake mechanics. Additionally, yield tokenization can be applied to any yield-bearing assets.
Native Staking
At the very base of this yield stack is the Ethereum Proof-of-Stake consensus mechanism whereby ETH holders earn staking rewards for securing the network.
Returns
- Consensus Layer Rewards: By staking ETH to secure the PoS network, stakers get rewarded for the honest sequencing and validation of new blocks. These rewards take the form of attestation, block proposal, and slashing rewards.
- Execution Layer Rewards: ETH stakers may also generate additional yield through Priority Fees (tips) or MEV Rewards.
Risks
- PoS Slashing Penalties: The staked ETH is liable to being slashed whereby a portion of the staker’s ETH is lost to the network if the staker behaves dishonestly. This happens when a validator contradicts something that it has previously advertized to the network.
- Validator Downtime: ETH stakers only earn PoS rewards if they are available when called upon for block validation or proposal. In cases whereby the staker’s validating node fails to respond to a certain % of requests, a penalty will be applied whereby a small amount of the stake is loss.
Expected APR (Jul 2024)
- ~3.2%
Liquid Staking
Through delegating staked ETH to a service provider such as Rocket Pool or Lido, stakers receive a LST, liquid staked tokens, (e.g. rETH, stETH) which can be freely traded without any lock ups. The LST represents the share of the liquid staking protocol’s liquidity that is owned by the staker and accrues all staking rewards.
By wrapping LSTs with the same ERC20 interface, it enables such tokens to be traded freely on decentralized exchanges. Moreover, LST holders gain the underlying yield without any of the operational overhead required for maintaining validator nodes.
Returns
- Execution Layer Reward Compounding: Liquid staking protocols such as Lido reinvests accrued Ethereum execution layer rewards (i.e. priority fees and MEV rewards) into setting up more validators, increasing yield for token holders.
- Additional Protocol Incentives And Revenue Sharing: Liquid staking protocols may implement incentives that are external to the mainnet PoS rewards thereby increasing the returns for holding their liquid staked equivalents (e.g. Rocket Pool RPL rewards).
Risks
- Liquid Staking Fees: Liquid staking protocols collect a proportion of the staking rewards/deposit as a protocol fee.
- Vote Centralization: As the validator’s voting power is delegated to the liquid staking provider, it is up to the provider to ensure validator diversity therefore increasing centralization risks at the network level.
- Liquidity And Market Depth: LSTs circumvent the stake withdrawal lack period as it can be easily traded for the underlying ETH on exchanges. This means that a LST holders ability to quickly swap their LST for the underlying is dependent on the current market liquidity.
- Redeemability And Depegs: Depending on the protocol, the ability of LST holder to redeem their LST for the underlying token may be constrained by the protocol. This means that LST holders must trust that the service provider has mechanisms in place that enable withdrawals. Without a trustless mode for redemption, LSTs, which represent the underlying asset plus accrued yields, may see its price depeg significantly from the underlying asset.
Expected APR (Jul 2024)
Restaking
By sharing the cryptoeconomic security of native/liquid staked ETH with restaking applications, users can earn additional yields by taking on incremental slashing conditions on their staked assets. Instead of having to bootstrap a trust network from scratch, applications can instead choose to pay a fee to restaking protocols to benefit from pooled security.
Restakers receive a LRT, liquid restaking token, that represents the underlying staked ETH as well as any yields accrued through liquid staking and restaking yields. Some example of LRTs are weETH, rsETH, ezETH, etc.
Returns
- Restaking Yields: Depositors earn additional restaking yields as underlying ETH is used to secure other applications in exchange for a fee. Many restaking protocols also simultaneously unlocks the liquidity of locked ETH on EigenLayer which has a 7 day withdrawal period.
- Additional Protocol Incentives And Revenue Sharing: Restaking protocols may implement incentives that are external to staking rewards thereby increasing the returns for holding their restaked tokens (e.g. EigenLayer Points, ether.fi Loyalty Points, Kelp Miles).
Risks
- Additional Slashing Rules: Restaked ETH adopts the AVS-specific slashing rules. Any dishonest behaviour by the AVS (i.e. application which the staker had chosen to secure in exchange for application layer rewards) will result in the staked amount being slashed.
- Restaking Operator Overhead: Restaking operators are required to run additional software which requires proper infrastructure uptime, key management, as well as security risks.
- Redeemability And Unbonding Period: Depending on the protocol, the ability of LRT holder to redeem their LRT for the underlying token may be constrained by the protocol. This means that LST holders must trust that the service provider has mechanisms in place that enable withdrawals. Moreover, restaking protocols may have an additional unbonding period.
- Liquidity And Depegs: While the restaking market is rapidly growing, it’s total size is still small relatively small. Moreover, liquidity is split between various LRTs resulting in shallower market depth which could result in significant slippage and price impact. Hence, LRTs may experience higher volatility with the possibility of price cascades especially if its redeemability is called into question.
Expected APR (Jul 2024)
*Does not take into account points.
Yield Tokenization
As the yields on liquid staked and restaked ETH (LST & LRT) are variable and dependent on market conditions, stakers can choose to tokenize the principal and yield portions of their yield-bearing token via Pendle. This enables the trading of yields whereby stakers can choose to earn a fixed yield by holding Principal Tokens (PT) to a specified maturity date or speculate on the variable ETH yields via trading Yield Tokens (YT).
Fixed yield seekers will receive PT tokens when tokenizing their yield. The fixed return is represented as a discount on PT (i.e. locked in at acquisition) which enables holders to claim the accounting asset at a 1:1 ratio on the maturity date.
Returns
- Discounted Principal Tokens: Pendle splits the principal (PT) and yield-bearing portion (YT) of LRTs thereby enabling depositors to acquire the principal portion, PT, at a discount relative to the maturity date.
*Note that points accrues to YT holders and is therefore indirectly accounted for as an additional discount to PT (i.e. holders that do not want the uncertainty of yield and points just hold PT) - Market Making Fees: PT liquidity providers receive swap fees in Pendle’s TKN/PT-TKN pool. The TKN/PT-TKN pool enables the trading of yields with minimal impermanent loss due to PT value approaching the underlying asset value on maturity.
- Pendle Protocol Emissions: Receive boosted liquidity incentives as staked PENDLE (via Penpie) is used to direct Pendle weekly emissions (weekly emission as of Oct-2022 is 667,705 with a 1.1% decrease each week until April 2026).
Risks
- PT Opportunity Costs: While PT can be traded prior to maturity, the fixed returns at the point of PT acquisition can only be realized on maturity. This means that any exchange of PT prior to maturity will have varying effects depending on market conditions. As such, there is an opportunity cost involved as PT will have to be held until maturity.
- Redeemability: The ability to redeem PT on maturity is crucial to ensuring the functionality of the yield trading market. PT redeemability ensures that PT price always approaches that of its accounting asset as maturity date thereby expunging any fears of a depeg.
Expected APY (Jul 2024)
Note that the expected returns are quoted in APY due to the rolling nature of PT. APY range is dependent on the selected maturity period.
Leverage Strategies
By lending PT-TKN and borrowing TKN (i.e. Long PT), the fixed income nature of PT ensures that the value of the collateral (i.e. PT-TKN) is always increasing relative to debt (i.e. TKN). Barring any black swan events, this ensures that the position never becomes undercollateralized.
The additional TKNs borrowed can then be swapped for more PT-TKN and supplied to the lending pool thereby increasing exposure to the PT’s fixed returns on maturity (i.e. you are holding more PT based on the initial portfolio value). This process can be repeated with the fixed returns being “locked in” with each TKN to PT-TKN swap.
To ensure a sustainable lending and borrowing market, lending pools specify both a Supply APY and Borrow APY. PT-TKN supplied will earn a Supply APY while TKN borrowed will incur a Borrow APY. As a PT leverage strategy depositor, the Borrow APY is the cost of maintaining leveraged exposure to PT-TKN.
Returns
- Amplified Fixed Returns: Fixed yields are secured at the point of adding leverage thereby enabling stakers to hold more discounted PT. All of the PT can then be redeemed for the accounting asset on maturity to realize leveraged fixed returns.
- Factor Protocol Emissions: Factor enables community-directed protocol emissions of up to 100,000 FCTR weekly to Factor Scale vaults. FCTR stakers can vote on the distribution of Factor emission rewards which is distributed amongst strategy depositors.
- Direct Liquidity Incentives: Factor strategy depositors can also receive direct liquidity incentives via Factor Boost. Anyone can allocate any ERC20 token as additional rewards for depositors in a target strategy vaults.
Risks
- Borrowing Costs: Leveraged PT strategies are made possible by taking on debt during the PT holding period (i.e. from acquisition to maturity). Leveraged PT strategies are profitable as long as the Fixed APY at which PT was acquire is greater than the average Borrow APY during the maturity period.
- Shallow Market Depth: Market depth decreases at each layer of the strategy (ETH →LST → LRT → PT-LRT → DEBT) hence stakers are increasingly selling into a shallower market which can result in greater volatility. If the leveraged PT position size is large, PT fixed returns and borrow rates can shift significantly due to its market impact.
- Forced Liquidations: If a leveraged position becomes undercollateralized, the position is at risk of becoming forcefully liquidated by the lending protocol. While PT collateral value should increase relative to the debt asset, short term market fluctuations can result in sudden spikes in the opposite direction.
Expected APY (Jul 2024)
Note that the expected returns are quoted in APY due to the rolling nature of PT. APY range below is based on the 26SEP2024 maturity with maximum leverage. The below does not include protocol
Conclusion
The combination of restaking and yield tokenization generates much higher guaranteed returns for stakers. Unsurprisingly, this combination of factors have attracted significant liquidity into the space in a few short months. While there are significant profits to be made, it must be noted that we are still in uncharted territory given the maturity of this niche.
Stakers are able to realize additional rewards with each incremental risk that they are willing to take. This aligns closely with DeFi’s composability whereby financial primitives are continously being built on top of each other with users being able to choose the combination that suits them the best.
By recognizing the yield sources as well as their corresponding risks, we hope that this piece has helped you to navigate the complex world of restaking yields better so that you can choose the DeFi strategy that works best for you.
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