Liquidity Re-mortgaged Tokens or "LRT" Revive Ethereum DeFi, Can the Hype Last?

Written by: Sam Kessler

Translated by: Baihua Blockchain

In just the past month, billions of dollars have flowed into new Ethereum-based liquidity re-staking projects like Ether.Fi and Puffer. These emerging platforms are competing to replace Lido's staked ETH (stETH) token as the preferred asset for decentralized finance (DeFi) traders.

At the core of this trend is the development of a new protocol called EigenLayer, which launched a novel "re-staking" system last June. The platform is building a solution that allows blockchain applications and networks to borrow Ethereum's security system, attracting over $1 billion in new deposits within a 24-hour period this month. Now, the total amount exceeds $7 billion, meaning the platform has accumulated over 1.5% of the circulating Ether (ETH), according to DefiLlama data.

Re-staking provides a way to secure blockchain protocols and networks using the security borrowed from Ethereum's proof-of-stake network. ETH deposits in EigenLayer can be "re-staked" into other protocols, meaning they do not have to establish their own proof-of-stake networks.

Investors are flocking to EigenLayer because it promises higher interest rates than traditional ETH staking. However, the recent growth of the platform is primarily attributed to a group of third parties—"liquidity re-staking protocols" like Ether.Fi, Puffer, and Swell—that claim to simplify the re-staking process on behalf of users.

These liquidity re-staking platforms act as intermediaries between users and EigenLayer: they "re-stake" users' deposits into EigenLayer and deliver corresponding newly generated LRTs in exchange, allowing users to continue trading even when their deposits are being re-staked.

LRTs represent users' deposits in EigenLayer, meaning they can accrue staking interest and can be redeemed for their underlying value. LRTs can also be used in DeFi, allowing people to borrow against and trade LRTs for greater returns.

In addition to the convenience of LRTs, the real appeal of the recent liquidity re-staking platforms lies in "points"—a reward that may qualify users for future token airdrops. While the monetary value of points is unclear, they have spawned a whole new ecosystem of additional platforms, such as Pendle, which allows users to maximize points through trading strategies that typically involve high leverage.

This complex points system, high yields, and high-risk trading strategies evoke memories of 2021—when "yield farming" and the chase for high returns triggered a boom and bust in DeFi, from which the industry has yet to fully recover. While some experts are cautious about the risks of liquidity re-staking, proponents of the technology insist that there is real substance beyond the hype.

1. Staking 101

Liquidity re-staking is built on the foundation of two years of growth in the Ethereum staking industry.

Ethereum is operated by over 900,000 validators, who are individuals around the world locking ETH tokens at addresses on the network to help secure the chain. Staked tokens accrue stable interest, but once they are used to run the network, they cannot be used for other purposes, such as loans or other types of investments.

This limitation has spurred the rise of "liquidity staking." Services like Lido stake on behalf of users and provide them with "liquidity staking tokens" (LSTs) that represent their underlying deposits. Like Lido's staked ETH (stETH) token, LSTs can earn interest like regular staked Ether (currently around 3%), but they can also be used in DeFi—meaning investors can borrow against these tokens for additional yield.

Over the past few years, the liquidity staking industry has flourished. The largest liquidity staking protocol to date, Lido, has over $25 billion in deposits. Its staked ETH (stETH) token frequently sees higher trading volumes than regular ETH on the largest borrowing protocols in the network.

2. From Liquidity Staking to Liquidity Re-Staking

Now, a similar liquidity staking trend is emerging on EigenLayer, a highly anticipated new protocol that introduces re-staking to Ethereum.

"EigenLayer essentially builds a tool that allows other networks to leverage Ethereum's security for bootstrapping," explained Austin King, CEO of Omni Labs, which is building a bridge protocol driven by re-staking.

Investors have turned to EigenLayer to earn additional rewards on their ETH: on one hand, the interest earned for securing Ethereum, and on the other, the re-staking interest earned for securing the so-called AVS (Active Validation Services) that borrow Ethereum's security using EigenLayer.

According to EigenLayer, these AVSs will eventually include Celo, a layer-one blockchain transitioning to an Ethereum-based layer-two network; EigenDA, EigenLayer's own data availability service; and Omni, which is building bridging infrastructure to help different blockchain networks communicate with each other.

However, the system also has drawbacks, one key issue being that tokens re-staked through EigenLayer cannot be used in DeFi after being deposited. This locking mechanism is a major disadvantage for investors looking to maximize returns.

Thus, liquidity re-staking has emerged, essentially designed as liquidity staking for EigenLayer.

Liquidity re-staking protocols accept deposits (such as stETH), re-stake them through EigenLayer, and then issue "liquidity re-staking tokens," such as pufETH, eETH, and rswETH, which can be used in DeFi for additional points and other rewards.

Related parties explain: "It's basically the value proposition of staking ETH, where you can earn staking rewards without the hassle of setting up a validator node. Not only that, but you also get compensated for any rewards brought by these AVS networks."

3. Incentive Gaming

Puffer's pufETH, Ether.Fi's eETH, Swell's rswETH, and other liquidity re-staking tokens (LRTs) are competing with Lido's stETH to become the next significant asset in DeFi. To achieve this, they have turned to the current incentive model in DeFi: points.

Although EigenLayer has already accepted billions in deposits, its AVSs have not yet launched, meaning depositors are not receiving interest on their deposits. Currently, the primary incentive for depositing tokens into EigenLayer is the re-staking points, a vaguely defined count that investors hope will lead to confirmed future EigenLayer airdrops.

Amir Foruzani, CEO of Puffer Finance, pointed out in an interview with CoinDesk last month: "EigenLayer hasn't launched; it has no re-staking." "The only incentive they have right now is points, which is basically a guess at the future value of those points." Major liquidity re-staking protocols, including Puffer, have begun offering their own points as an additional incentive for early investors.

New services have also emerged around points exchange, promoting high-risk trading strategies involving repeatedly re-staking the same tokens—at the cost of higher future returns, increasing exposure to the protocol.

One such protocol is Pendle, which splits liquidity re-staking tokens into two separate tokens—yield tokens and principal tokens—to unlock leveraged trading. One of Pendle's products accepts deposits of Ether.Fi's eETH token and, according to the website's advertising, can yield 45 times Ether.Fi points and 15 times EigenLayer points.

While points remain highly speculative, they seem to have a positive impact on liquidity re-staking deposits. According to DeFiLlama data, the current market leader, Ether.Fi, has $1.2 billion in deposits, five times what it had a month ago. Puffer Finance follows closely with $970 million in deposits, having increased tenfold in just the past three weeks.

4. Penalty Risks

With the surge in liquidity re-staking deposits, the risks of this trend are also increasing.

On one hand, the general risk associated with EigenLayer is the complexity of putting funds into a system composed of layers of protocols: as the complexity of interconnected AVS networks increases, errors will inevitably become more likely.

The greatest risk of these errors will be "penalties," which are economic punishments imposed on stakers due to violations of network rules or connecting to the network using flawed software. Liquidity re-staking protocols often tout "anti-penalty" features in their marketing, but these promises cannot be validated in practice until the AVSs are operational.

In the context of EigenLayer re-staking, penalties occur at the AVS level: each AVS will set its own penalty rules, and liquidity re-staking providers will be able to choose which AVS protocols they want to validate for users. If a liquidity re-staking platform chooses to validate a network with malicious (or flawed) penalty parameters, it could expose users to the risk of their deposits being slashed.

"We will build a similar reputation system in the broader re-staking ecosystem," predicted Riad Wahby, CEO of key management service company Cubist, in an interview with CoinDesk. "If I'm going to put funds into an operator, I'm likely to choose one that gives me the right balance between risk and reward."

5. Speculative Risks

The most apparent risk of liquidity re-staking is that, despite billions in deposits, the practice is currently very speculative.

AVSs may not provide depositors with the interest returns they expect, which could lead investors to leave the system in search of more profitable betting opportunities. Amid all the excitement around points, there is also the possibility that accompanying airdrops may fail or never happen, rendering points and the new markets built upon them nearly worthless.

The risk of this outcome is amplified by the fact that points are often not issued on the blockchain but are tracked directly by the issuer. This makes it difficult to know how many of a specific type of points are in circulation, complicating the determination of their value.

The speculative allure of liquidity re-staking points evokes memories of the yield farming days. In 2021-2022, when the DeFi industry peaked, funds flooded into projects like Olympus and Terra, which promised users market-leading yields in exchange for trust in their complex systems. Critics accused these projects of creating worthless tokens and printing them indiscriminately to artificially support yield figures, and after these platforms collapsed, those criticisms were ultimately proven correct.

Regardless of the superficial similarities, EigenLayer enters the minds of Ethereum developers in a way that the worst actors in yield farming never did, and supporters of liquidity re-staking argue that it has the potential to support the development of applications and infrastructure that transcend the narrow realm of points and gamified speculation.