The (R)Evolution of Ethereum's Proof of Stake System
The synergy of liquid staking derivatives and EigenLayer: Enhancing security and yield on Ethereum. Plus, the role of Distributed Validator Technology (DVT).
by Juan Aranovich and Hans Xiang
Introduction
As cryptocurrency continues to evolve, new concepts are emerging to help investors optimize their returns while minimizing risk exposure. One such concept is liquid staking derivatives (LSDs), which are gaining traction due to their potential to enhance liquidity, flexibility, and accessibility. Additionally, the upcoming Shanghai upgrade and the introduction of EigenLayer could transform Ethereum's economics and value flow, further strengthening the ecosystem.
"Innovation is taking two things that already exist and putting them together in a new way." - Tom Freston
Section 1: Liquid Staking Derivatives
Understanding LSDs
Staking has long been a popular method of earning passive income in the cryptocurrency space. However, staking assets typically require users to lock up their funds, sacrificing liquidity and accessibility. With the emergence of liquid staking primitives and solutions such as Lido and Rocket Pool, investors receive a derivative of the original staked asset, allowing them to maintain flexibility and liquidity while still receiving staking rewards. These derivatives also enable users to use the assets as collateral or lend them without the need to become a node validator on ETH.
The Benefits and Risks of LSDs
LSDs offer several potential benefits to investors, including enhanced liquidity, increased flexibility, and reduced risk exposure. By using these instruments, investors can potentially earn staking rewards without the need to lock up their assets, which could provide greater flexibility in managing their portfolios. However, LSDs also carry risks, including market volatility, regulatory uncertainty, and liquidity issues. The use of these instruments is relatively new, and their long-term performance is still unknown.
The Current State of the LSD Market
As of writing, over 7.8M ETH are locked in ETH2 pools, equivalent to $12.5 billion. However, the inability to withdraw staked ETH from these pools means investors can only trade on protocols. The Shanghai upgrade, tentatively scheduled for March 2023, could amplify the LSD narrative in conjunction with EigenLayer, which is reforming restaking on Ethereum.
Lido is the undisputable leader in the LSD space, as it accounts for almost 75% of the market share. In second place comes cbETH, Coinbase’s LSD, and rETH, Rocket Pool’s alternative.
Section 2: EigenLayer
The blockchain industry is built on the idea of permissionless innovation, yet innovation at the core infrastructure layer has been slower than at the application layer. EigenLayer is an attempt to resolve this contradiction.
Understanding EigenLayer
EigenLayer is a protocol built on Ethereum that aims to address the issue of security fragmentation across decentralized networks such as layer 1 blockchains, layer 2s, and oracle networks.
It introduces restaking, a novel crypto-economic primitive that enables users to reuse their staked ETH to secure multiple networks and earn rewards on their extended capital.
This consolidates the fragmented capital and resolves the scarcity problem in bootstrapping new networks, providing a secondary market for stakers to provide additional security to the existing network.
EigenLayer generates revenue by charging a fee on the rewards that flow from Actively Validated Services (AVS) to restakers, capturing this income through a treasury system.
Notably, EigenLayer offers a compelling value proposition for securing bridges and oracles by increasing the amount of collateral, thus reducing the likelihood of successful attacks. Moreover, EigenLayer facilitates genuinely decentralized Remote Procedure Call (RPC) nodes, a crucial component for avoiding censorship at the client level.
Additional Yield
EigenLayer provides additional yield to stakers, such as oracle fees or data availability fees, in addition to block rewards and transaction fees. It allows for additional sources of revenue for staking ETH and increases the value of the token itself.
As a risk management layer, EigenLayer expands blockspace and bolsters security across all layers of the crypto industry, potentially reducing exploits and creating a garden where more trust can flourish. Any solution or service provider can build on EigenLayer, and stakers can choose the subset of services they wish to provide trust for, creating a two-sided marketplace.
Risks
Slashing risks are present in any proof of stake system, including EigenLayer. Slashing is a penalty that is imposed on a validator's staked tokens if they violate the rules of the network. In EigenLayer, a validator could be slashed if they engage in behavior that jeopardizes the security or stability of the network, such as double-signing or withholding blocks.
The risk of slashing is particularly acute in EigenLayer because of the restaking mechanism. Since users can restake their ETH on multiple networks, a validator could potentially be penalized on one network for a violation that occurs on another network. For example, if a validator is slashed on Ethereum for double-signing, their staked tokens could also be penalized on other networks where they are restaked through EigenLayer.
Section 3: Distributed Validator Technology
Distributed Validator Technology (DVT) is an emerging technology that could significantly impact the future of staking, including liquid staking derivatives (LSDs), restaking, and Eigenlayer.
DVT allows validator duties to be distributed among multiple nodes, reducing the risk of downtime and slashing. By enhancing fault tolerance and reducing slashing risks, DVT could lower the barrier to entry for permissionless nodes, enabling more validators to join the network safely, which would further enhance the decentralization and scalability of staking.
In the context of LSDs, DVT could help to address some of the challenges facing the liquid staking market, such as centralization and scalability. By lowering the bond required for permissionless nodes, LSDs could become more accessible to a broader range of validators, making it easier to stake smaller amounts of cryptocurrency. Additionally, DVT could make restaking more efficient and secure, as validators could distribute their duties across multiple nodes, mitigating the risks of downtime and slashing.