Original Article: Exploring Developments Around Liquid Staking Derivatives

Author: Bridget Harris, Pantera Capital

Translated by: Shenchao TechFlow

Liquid staking derivatives allow users to earn rewards on their staked cryptocurrencies while maintaining liquidity and improving capital efficiency.

As popular liquid staking services like Lido, Rocket Pool, and Frax continue to gain market share, understanding their underlying technologies and their impact on the cryptocurrency space becomes increasingly interesting. In these protocols, the tokens staked by users are delegated to a set of validators, which further helps to secure the overall integrity of the protocol. In exchange, users receive a liquid staking derivative token that represents their stake, which can be traded across decentralized applications (dapps) that support the token. For example, in Lido, when users deposit ETH, they receive stETH, which can be traded or collateralized on supported dapps. Additionally, users can earn rewards for staking ETH.

The liquid staking industry is experiencing rapid adoption: as of early April 2023, the ETH liquid staking balance reached 7.3 million ETH, compared to just 3.3 million ETH in early April 2022. With this rapid growth, an entirely new industry is emerging around liquid staking derivatives, and below are some exciting new primitives that are reshaping this space.

EigenLayer

EigenLayer is one of the recently highlighted categories, utilizing a restaking mechanism to achieve cross-project shared security. EigenLayer significantly enhances efficiency by leveraging existing staked capital on Ethereum to restake into new security networks that require validation.

With this technology, new projects outside of the EVM can gain security assurances without launching their own validator sets. Decentralized applications, rollups, and middleware can all benefit from EigenLayer's restaking security mechanism, achieving better flexibility and scalability.

In the current landscape, there is a challenge: modules not deployed on the Ethereum Virtual Machine (EVM) cannot utilize Ethereum's (robust) validation capabilities. Examples of these modules include sidechains using different consensus mechanisms than Ethereum, data availability (DA) layers, virtual machines, guardians, oracles, cross-chain bridges, threshold cryptography schemes, etc. (EigenLayer whitepaper). Each module is critically important from an innovation perspective, but often difficult to build within these categories due to security complexities.

As the blockchain space continues to evolve from a technical complexity standpoint, this presents a significant limitation for building outside of Ethereum. Developers often have to choose between innovation and not being able to leverage their validator sets, or building on the EVM but having to adhere to the aforementioned constraints. As described in the whitepaper, these projects require actively validated services ("AVS") to achieve proper validation. However, establishing AVS comes with significant limitations.

The four key issues mentioned in the EigenLayer whitepaper are:

• Guiding entirely new trust networks for new AVS,
• Value leakage (from Ethereum), as users must pay two fees (one for securing each network),
• Capital cost burdens (EigenLayer cites opportunity cost/price risk),
• Lower trust models (as validation may not be strong enough).

EigenLayer addresses these issues by applying the security provided by Ethereum's validator set: in their words, achieving pooled security through restaking and free market governance.

Pooled security achieved through restaking essentially allows modules (like those discussed above) to utilize distributed Ethereum security to ensure their proper functioning. Validators can choose to join to secure modules and earn additional fee rewards for securing the module network.

In turn, these modules can slash the ETH staked by validators if they do not comply with certain rules. The entire process is referred to as "restaking"—using existing stakes to secure new networks.

The restaking mechanism fully leverages Ethereum's robust security, which can be distributed to modules that previously could not benefit from the security of a large and relatively stable network.

Additionally, liquid staking tokens such as stETH, rETH, cbETH, and LsETH can all be restaked, enabling better composability and cryptoeconomic security across Web3 platforms.

EigenLayer offers two methods of restaking:

• Pointing staked ETH to EigenLayer smart contracts,
• Restaking by transferring liquid staking derivatives into EigenLayer smart contracts.

EigenLayer has also built a mechanism that allows AVS to choose whether to participate in the modules based on their risk preferences: free market governance. This is beneficial for both new modules and validators: validators profit from securing new modules, while new modules can grow faster, reducing concerns about security issues. Through this mechanism, main node stakers can also stack rewards by securing multiple projects. The risk of securing new modules is that if certain conditions are not met, validators may have their stakes slashed.

In summary, EigenLayer provides a more secure and efficient validation method for modules outside the EVM by offering pooled security mechanisms and free market governance. Its innovative solutions help drive the development of the blockchain and cryptocurrency space.

EigenLayer has developed a market model where AVS can "rent pooled security provided by Ethereum validators." Security no longer solely relies on the native tokens of the network but can utilize restaked ETH. This market model provides better opportunities between developers and validators, promoting the adoption and proliferation of pooled security mechanisms.

The discussions and impacts arising from EigenLayer's solutions will be interesting.

Other protocols are also designing ways to leverage staking incentives to drive innovation in the blockchain industry. To mitigate the risks of validator centralization caused by Ethereum scaling, it is crucial to create effectively decentralized validation designs. Through ongoing collaboration and innovation, it may be possible to create stronger and more resilient validation mechanisms to support the long-term growth and development of the blockchain ecosystem.

Obol

Obol is developing new technologies to build distributed validation for Ethereum. This technology enhances activity and security by delegating computation to clusters of nodes rather than running validators on a single node.

Obol achieves this through distributed validator keys, which are a set of BLS private keys that collectively participate as a threshold key in PoS consensus. This approach can enhance the security and decentralization of validators and further strengthen the resilience and scalability of decentralized systems.

Utilizing this Distributed Validator Technology (DVT), Obol has also built a network that operates as a layer above the consensus layer, providing access to distributed validators (DVs). If successful, Obol's pluggable layer will become a widely used foundational component, helping to ensure the security, resilience, and decentralization of the blockchains that integrate it. This will further advance the development of blockchain technology and lay a solid foundation for future innovations.

Alluvial Finance

Alluvial Finance focuses on bringing institutional participants into the staking ecosystem to better secure PoS blockchains and improve the liquidity of staking tokens. The liquid staking standard that Alluvial is developing, "Liquid Collective," is an on-chain protocol managed by industry participants such as Coinbase Cloud, Kiln, Kraken, and Staked.

This solution provides enterprise-grade infrastructure to prioritize compliance and security at scale. Additionally, "Liquid Collective" operates across protocols and focuses on liquidity (through industry partners), as different protocols may have varying liquidity support for liquid staking tokens. The protocol also offers comprehensive slashing protection for participants, addressing issues such as network interruptions and node operator failures.

Ion Protocol

Ion Protocol is developing a suite of liquidity products and token standards for liquid staking tokens (LSTs). They claim that the two core issues of liquidity fragmentation and complex token models add unnecessary complexity to the staking ecosystem.

Furthermore, governance friction exacerbates the confusion, as discussions about liquidity token standards are scattered across different platforms. Ion also cites the different value accumulation methods of various LSTs, such as Lido's rebalancing mechanism and Frax's dual-token model, which may confuse users and make it difficult to track. By simplifying these processes and introducing a unified token standard, Ion aims to enhance efficiency and liquidity within the LST ecosystem.

As the staking industry evolves, new foundational components will continue to bring innovation to the space. By addressing issues such as staking centralization, lack of institutional infrastructure, and liquidity challenges, these mechanisms will drive the growth of the ecosystem and redefine how individuals interact with staking protocols.