Restaking Summer: Innovation’s Edge or the Precipice of Risk?

Are we unintentionally adding risk to the network with the introduction of restaking? Everyone is starting to beat the drums that this year will be the year of “restaking”. Instead of DeFi summer, it will be Restaking Summer. EigenLayer’s founder, Sreeram Kannan, originally came up with the idea of using staked assets to secure other networks. Companies quickly capitalized by creating liquid restaking tokens (e.g. Kelp, ether.fi, and Renzo). The most obvious question is when will those liquid restaking tokens be used to secure other networks? And on and on we go. Usually new innovation brings along “known unknowns” but also brings along “unknown unknowns”. This last part is what we should be worried about because we are entering a new world of staking security vertically instead of horizontally — the main virtue of decentralization.

Step 1: Understanding Liquid Staking

Most crypto networks are based on Proof of Stake (PoS) compared to Proof of Work (PoW). PoS is a cryptocurrency consensus mechanism for processing transactions and creating new blocks in a blockchain. Users who are a part of this consensus are usually called validators. They “stake” their crypto as collateral in case their validator makes any mistakes but they are also rewarded when making successful blocks.

Liquid staking came along as a way to allow users to “unlock” their staked tokens while also receiving yield from the underlying staked asset.

Rocket Pool for example, allows users to spin up their own validators through Rocket Pool or to simply stake your ETH in return for rETH. In the backend, Rocket Pool will stake the newly deposited ETH into one of their pools to immediately start earning yield. All yield (i.e. earned ETH) is compounded back into the pools or traded for rETH and burned. This is why the rETH to ETH ratio increases over time because ETH is earned over time.

Step 2: Understanding Restaking

If earning yield on ETH wasn’t enough, restaking was proposed about a year ago through EigenLayer. Basically, EigenLayer is a set of smart contracts on Ethereum that allows consensus layer ETH stakers to opt in to validating new software modules built on top of the Ethereum ecosystem. By software modules, they are talking about consensus protocols, data availability layers, virtual machines, keeper networks, oracles networks, bridges, threshold cryptography schemes, and trusted execution environments — i.e. everything.

Collateral has become one of the main security mechanisms to protect a network and restaking is just adding to it. Liquid restaking is just the tokenization of restaking, similar to liquid staking tokens. Liquid restaking tokens are floating around DeFi and can already be used as liquidity pool providers. It is just a matter of time before these tokens can be used as collateral for other networks.

Step 3: Restaking of Restaking?

So if security is based off collateral, can you just restake the restaking token? Sreeram Kannan from EigenLayer said that you won’t be able to use liquid restaking tokens (LRTs) on the EigenLayer network. You can hear a lot of these answers in the recent Bankless podcast with Sreeram below.

One outcome of the podcast was the obfuscation or unknown for what the future holds. One example was that the slashing mechanism in Eigenlayer has not been released — as heard in the podcast or my emails to the EigenLayer support team. Sreeram mentions at the end of the podcast that the LRTs can be used as collateral to borrow more ETH and restaked into EigenLayer, resulting in an increase in risk to the network. The unknown unknown is whether a new restaking network will come along and allow users to use LRTs as collateral for the network. Now we are stacking security where the underlying structure could be concrete or a house of cards. What happens when one card comes out?

Step 4: Black Swans

If you aren’t familiar with the term “black swan”, it is a metaphor by Nassim Taleb, outlining an event that comes as a surprise and has a major effect. The 2008 financial crisis was considered a black swan event. In relation to ETH staking, major slashing events are the major concern for the network. Slashing occurs when validators make attestations or block proposals that break very specific protocol rules. Put more simply, validators made a mistake and are penalized by the network through the loss of their collateral. In the case of liquid staking tokens (LST), a mass slashing event would result in the decrease in the value of the LST as seen in the graph below. For example, rETH is worth roughly 1.097 ETH. A slashing event would decrease the amount of collateral ETH in Rocket Pool validators, thereby, decreasing the rETH / ETH ratio.

In case you are wondering what happens after 25%? — Good question.

Since we don’t know what the slashing mechanism will be for EigenLayer, we can assume a similar approach to Rocket Pool or Lido staking.

What happens if a mass slashing event happens at the ETH validator level? You think this is impossible but a few weeks ago, 8% of the Ethereum validators went offline because a bug in their software, Nethermind. Another event happened in early January with 5% of Ethereum validators using Besu. Only modest penalties were inflicted but some people started looking at potential black swan events. Especially when 85% of Ethereum validators are running one software, Geth. If there was a bug in Geth, Ethereum could have a mass slashing event thereby collapsing whatever is built on top. This is where stacking security vertically runs into problems. Anything built on top, is immediately impacted from changes below. This is the mass casualty event that everyone should be worried about. This is the unknown unknown because we have no clue what the actual risks are or what could cause them.

Conclusion

As much as I am dismayed with the documentation and unknowns from the EigenLayer team, they are well aware of the potential risks involved. When pushing the frontier of crypto, these are the teams we want experimenting. It is when the froth comes in, the anonymous founders, promising ungodly yield to use their platform. Once we start seeing these come along, be weary as we are entering the final stages of “restaking summer”. DeFi summer ended with massive fraud and stolen funds. This time, it will be a house of cards falling because no one understood how much security was stacked on top of a single asset.

-Just Another Crypto Analyst

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