Carbono Insights | #94 The state of staking explained in six levels of difficulty

From the ABC of consensus mechanisms to the LRT of Liquid Restaking Tokens, the new hottest trend.

Spot Bitcoin ETFs went live, and the price dropped for a few days due to massive sell-offs from miners, FTX, Grayscale, and even the US Government. Now, they seem to be recovering. Perhaps the sell-off mania is fading out, or people already feel the positive vibes of the next FOMC meetings, which could bring good omens regarding interest rate decisions.

But we said we would not talk more about ETFs, and we’ve already failed. What we want to do now is what we do best: the impressive maneuver of explaining technical concepts to those in a hurry and discovering opportunities for those on the nerdiest side of life.

Today, we would like to explain staking in six levels of complexity. Choose the initial step of the ladder according to your knowledge and expertise.

Staking became an adult in 2023 when Ethereum transitioned from a Proof of Work to a Proof of Stake consensus mechanism. From that moment, the interest rate paid by the chain to stakers became one of the most transparent, reliable, and trustworthy sources of income for ETH holders, similar to the yield generated by T-bills.

Unsurprisingly, such a solid foundation has become a category of its own. Staking, whether on Ethereum or any other Proof of Stake chain, is now the base layer for many innovations that use yield-bearing assets as the foundation for many different things. Read on!

What is a Consensus Mechanism?

The core contribution of blockchain technology is to allow the safe transfer of data between parties without the need for centralized intermediaries. When you pay for a coffee with your credit card, the traditional conversation between centralized intermediaries is substituted by distributing and communicating transaction info across an open network of voluntary intermediaries called nodes. Blockchains host a conversation between all the nodes, who share information and agree on what is true and valid.

If a traditional bank transfer is like a phone call between two bank clerks, a transfer through the blockchain is like a Zoom call with thousands of participants working simultaneously. How can they agree on anything?

The answer is consensus mechanisms: protocols or algorithms that enable nodes in a distributed network to agree on the same version of the information (“Alice just paid $12 to this coffee shop”).

What is Proof of Stake?

Blockchains work like this:

1. You want to make a transaction, so you sign and broadcast your information: “I want to send 1 ETH to Alice.”
2. Your transaction joins a queue where all the transactions that happened more or less at the same time wait for their turn.
3. Every node participating in network validation makes a list of the transactions they would add next. That list of transactions is a block.
4. Then, the whole network needs to decide whose block is considered valid.
5. Once they all agree, the information in that block is distributed to all other nodes so that everybody saves the exact same copy of the information.

In Proof of Stake, the network decides whose block is valid by organizing a lottery. The network randomly assigns the task of suggesting a block to a node. A node’s chances of getting the assignment are proportional to its staked capital. If it adds a block and everybody agrees it looks good, the node gets rewarded with extra capital. If it does something wrong, its staked assets get slashed. This mechanism guarantees that any individual node’s incentives align with the blockchain’s general purpose.

In the case of Ethereum, any node that wants to run a block validator must stake 32 ETH. That ETH acts as a deposit and a proof of commitment to the network. “I’ll leave my money here, and if I don’t perform properly, you can take it.”

What is Liquid Staking?

Now we know that anyone with 32 ETH ($73k at today’s prices) and the technical knowledge to run a validator can profit from staking.

The next step that the industry came up with was pooled staking. If you don’t have 32 ETH or the capacity to run a network, you can stake any amount you want, pool it with other users’ funds, and give it to a professional validator to do the job and share the revenue.

This form of validation through pooled funds became professionalized. Decentralized protocols emerged that offered to perform validation for anyone with ETH. And the next thing they decided to do was issue a receipt. This gave birth to Liquid Staking Derivatives.

Now, remember this is crypto: everything is tradeable. Those receipts immediately became proxies for the “real” capital, and, as such, people wanted to do business with them.

That’s what LSDs are: Liquid Staking Derivatives. Derivatives that turn a staked asset (= illiquid) into a liquid one..

LSDs allow people to stake their assets, let’s say ETH, and get a receipt in exchange, for example, stETH, that can be used across DeFi. This way, while your ETH produces yield for you passively, you can still try to get some extra revenue on top, for example, lending it for profit.

What is LSDFi?

LSDFi is the name given to crypto protocols that have built DeFi solutions available for LSDs. There are essential services like lending and borrowing through Aave or providing liquidity for trading on Circle. And then there’s a growing list of more complex services that use LSDs as their lifeblood.

Lybra, for example, is a stablecoin project that accepts Liquid Staking Derivatives as collateral for minting its stable eUSD. By holding the eUSD token, users can effortlessly earn yield generated from the underlying LSDs.

Pendle is another example of how crypto leverages the technology’s interoperability and composability to create more layers of added value. Pendle allows interest trading strategies using different LSDs as collateral. It creates derivatives of the LSD (a derivative in itself) to separate the principal from the yield and allow traders to develop strategies using these separately.

What is Restaking?

Are you dizzy yet? Here comes another layer of complexity, abstraction, and yield to the staking ecosystem.

Eigen Layer is a protocol that introduced a new crypto primitive: restaking. Eigen Layer offers a set of smart contracts where users can stake their LSDs to participate in another layer of Proof of Stake validation.

Imagine a developer wanting to launch a protocol secured by Proof of Stake. In addition to the enormous effort of building a decentralized protocol, this developer would have to figure out how to attract validators who would put their effort and capital to work securing the protocol.

Our hypothetical developer could rely on Eigen Layer to provide that locked capital and the subsequent security associated with it through their smart contracts.

Eigen Layer accepts LSDs as stakeable assets. In other words, Liquid Staked assets can be staked again. Re-staked.

What is LRT?

You made it to the top! Here’s as high as staking has taken us in complexity so far. But if you got up here understanding every concept, what’s coming next will be easy peasy.

People can stake ETH on the Ethereum blockchain, but Ethereum does not natively support liquid staking. This created an opportunity for projects like Lido or Rocket Pool to create liquid staking protocols. You give them your ETH, and they mint another token for you that acts as a receipt.

Well, you know who else doesn’t have liquid staking derivative minting capabilities? Eigen Layer. Once you restake your assets, unless… Yeah, you guessed it: other third parties are now adding liquid staking on top of Eigen Layer in this emergent category that we’re seeing now pop up in the form of dozens of protocols getting their LRTs running.

If you are confused or concerned about the complexity of the category, you are not alone. People are already worried about step 3, Liquid Staking. Currently, one single protocol, Lido, handles almost one-third of all the staked ETH. This means that if Lido were compromised, one-third of the whole supply of ETH would be in danger. That could break the supercomputer easily.

Eigen Layer, the other big player in this ladder, also raises concerns about restaking. The additional layers of yield always come with, sometimes compounded, extra layers of risks.

Congratulations! You’ve climbed the ladder! Now, try not to look down.