Liquid staking and restaking protocols are rapidly gaining popularity in the decentralized finance (DeFi) space due to their potential to enhance blockchain security and efficiency. However, alongside rapid innovation, there are inherent risks that come with these protocols.
While these protocols offer users the opportunity to earn unprecedented yields, they also introduce potential systemic vulnerabilities. BeInCrypto sat down with industry experts to delve deeper into the intricacies of staking mechanisms and the challenges they present to users.
The Emergence of Restaking
Staking has evolved significantly over the past year, transitioning from a nascent concept in DeFi to a tool that has revolutionized security measures across blockchain networks. Led by Ethereum and EigenLayer, this protocol has provided dynamic solutions to address the fragmented security found in traditional Layer 2 blockchains.
When Ethereum transitioned to a proof-of-stake (PoS) ecosystem in 2022, it ushered in a new era, replacing mining with staking and opening up new avenues for staking rewards while ensuring mainnet security.
Traditionally, each decentralized network has had to independently develop and maintain its security measures, often relying on PoS mechanisms. This demands substantial investment in security infrastructure, making it a challenge for emerging networks to match the security standards set by established networks like Ethereum.
To counter this challenge, the concept of restaking was born. Restaking involves using already staked Ethereum to provide security to other mainnet components such as bridges, protocols, oracle networks, and scaling solutions.
"Restaking is essentially about bootstrapping economic security for new protocols by utilizing liquid-staked tokens already committed to providing security elsewhere," explained Laura Wallendal, CEO and Founder of Acre.
Restaking presents a promising solution by enabling smaller networks to leverage the security of established PoS chains, thereby bolstering their overall security posture.
EigenLayer at the Vanguard of Restaking Protocols
Launched on Ethereum in June 2023, EigenLayer has emerged as the leading restaking protocol to date. The protocol currently boasts a Total Value Locked (TVL) exceeding $15 billion.
EigenLayer's TVL as of January 16. Source: DeFi Llama.
Sreeram Kannan, the mastermind behind EigenLayer, devised this mechanism to harness the security advantages offered by the Ethereum network and extend them to other protocols and blockchains.
EigenLayer streamlines network startup and management costs, streamlining the process of establishing security for new projects. By leveraging their staked assets to support additional applications on the Ethereum network, restakers can optimize their earnings and repurpose their stake assets.
"Restaking is a legitimate approach that enhances blockchain incentives' efficiency and is poised to become the go-to method for securing multiple decentralized protocols based on a shared set of economic incentives in the long term," shared Sasha Ivanov, Founder of Waves & Units Network.
However, since restaking is a relatively young concept, protocols like EigenLayer are still in the early stages of development, facing their own set of challenges and concerns.
Security Implications
As the adoption of restaking protocols surges, concerns about the potential security risks associated with these protocols are also on the rise. While reusing staked assets across various protocols can offer enhanced yield opportunities, it simultaneously introduces new risk layers within the blockchain ecosystem.
While blockchains rely on smart contracts to ensure security, these contracts may be vulnerable to issues like reentrancy attacks and gas limit concerns.
"Each layer of restaking introduces new smart contracts, expanding the attack surface for potential exploits," pointed out Matt Leisinger, Co-Founder and Chief Product Officer at Alluvial.
The complexity of restaking mechanisms heightens the probability of bugs and exploits in the smart contracts governing these protocols. In the event of a contract compromise, users could incur financial losses.
Moreover, there are slashing risks involved. In case a validator is charged with malicious behavior, a portion of their restaked ETH may face deductions.
"Restaked tokens are often exposed to multiple validator networks. If one network underperforms or violates protocol rules, slashing penalties can propagate across all restaked layers," Leisinger elucidated.
Slashing risks can potentially undermine the very security that the restaking protocol aims to establish initially.
"In a scenario where staked ETH is used to secure multiple AVSs, if one of them is slashed, the ETH is essentially held, penalized, and this could deter providers of economic security from future participation," Leisinger concluded.
Disrupted security could spell trouble for the entire ecosystem.
Illiquidity in Market Downturns
With increased risk exposure comes amplified return volatility. Similar to the broader crypto market, market downturns can result in substantial financial setbacks.
"Reusing staked assets across multiple protocols unlocks additional earning potentials. However, this brings in the risk of volatility and cascading failures triggered by interdependencies. Moderation is critical here. Employing sustainable strategies that target moderate yields can offer rewards in sync with a manageable risk exposure. Moderation, coupled with a comprehensive understanding of risks, is pivotal for both users and the ecosystem's sustainable pursuit of yields," opined Ivanov.
Market volatility also leads to liquidity risks.
"Frequent restaking ties up assets in illiquid forms, making it challenging to exit positions during market turbulence," Leisinger highlighted.
According to Ivanov, diminished economic incentives for users during market downturns can compromise blockchain security.
"If the native blockchain token is restaked, there could be an additional negative feedback loop during market crashes. A token value plunge could trigger forced liquidations, escalating sell pressure, consequently diminishing the economic value securing the blockchain—a primary incentive for validators to sustain their operations," Ivanov articulated.
Considering the financial framework underpinning these protocols, recurring restaking intensifies liquidity challenges inherently.
Risks Associated with High Yield Returns
While protocols like EigenLayer push the boundaries of yield potential, the allure of higher returns raises other considerations.
Since the advent of restaking, numerous protocols have introduced similar services, albeit with varying levels of responsibility.
"Many protocols capitalize on hype cycles to gain traction, offering high short-term rewards as they strive to expand their user base and validate their model. For instance, new protocols might not generate sufficient transactions to sustainably compensate validators, prompting additional incentives to attract early adopters. It's a wager that the protocol will ultimately achieve long-term stability—or it could be a short-term move to accrue rewards before reallocating assets elsewhere," Wallendal highlighted.
Intensely high annual percentage yields (APYs) may seem enticing to novice investors but may entail undisclosed risks.
"With some restaking protocols offering APYs reaching 15-20% on assets like ETH, there's a notable risk of investors chasing yields without fully comprehending the associated risks. Protocols could adopt graduated entry systems, starting with simpler staking options offering 5-7% APY, before graduating to more complex and higher-risk products, to address this concern," suggested Marcin Kazmierczak, Co-founder & COO of Redstone.
Expanding on this, Ivanov added:
"Restaking protocols are akin to traditional compounded financial instruments, where value can sometimes be conjured out of thin air—termed 'weapons of mass financial destruction' by Warren Buffett. However, restaking does have valid use cases where new value isn't created but rather existing incentives are utilized to secure additional protocols. It's a fine balancing act between positive and negative restaking approaches, necessitating an in-depth examination of how the protocols function."
When protocols prioritize yield strategies over sustainability, speculative risks inherent in these investments surge.
"While restaking undoubtedly furnishes economic security for burgeoning networks, it often veers into speculative territory. Without a clear, enduring value proposition, users end up cycling through protocols solely to maximize short-term rewards. It's evolving from ecosystem support to a token exposure chase across multiple networks," Wallendal remarked.
Speculation could inadvertently tarnish the credibility of the foundational layer of any blockchain.
"If staking is reduced to mere speculative yield generation, it casts doubt on its role as a foundation of blockchain security and decentralization," Ivanov added.
Fostering sustainable economic models will be imperative to ensure the success of these protocols as they navigate their refinement.
Centralization Concerns
EigenLayer spearheaded the restaking concept on Ethereum, swiftly ascending to a prominent position as one of the most widely adopted restaking mechanisms. Consequently, it has come under growing pressures associated with centralization.
"EigenLayer centralizes risk by serving as a pivotal nexus for numerous protocols, rendering the ecosystem more vulnerable to systemic shocks. Competition from other players is crucial to avert this scenario," emphasized Ivanov.
Last June, Symbiotic entered the DeFi arena with a noteworthy $5.8 million seed funding round from Paradigm and Cyberfund, challenging EigenLayer's dominant position in the restaking landscape.
Subsequently, other alternatives have emerged.
"While EigenLayer currently dominates with an over 80% market share in the restaking realm, we are witnessing the emergence of alternatives such as Symbiotic, Babylon, or Solayer. Diversity within the ecosystem is essential—having over 90% of restaked assets controlled by a single protocol could expose the system to systemic risks, while diversity fuels further innovation," Kazmierczak noted.
Nonetheless, the concentration of restaking services among a few major players offers an opportunity to scrutinize their disadvantages rigorously.
"There's an alternate view—a major player can expedite the testing process. EigenLayer's prevailing central position allows for real-time observation of the system's behavior, facilitating the identification of vulnerabilities and inefficiencies sooner than a fragmented ecosystem would. The rapid experimentation by a dominant player accelerates the evolution of the broader ecosystem based on key insights gleaned from this testing," Ivanov elucidated.
As these systems mature, the sector displays signs of diversification among competitors.
Accessibility Challenges
Educational barriers and knowledge gaps concerning restaking protocols exacerbate exposure to the pivotal issues linked to this mechanism.
As restaking strategies grow more intricate, this concern escalates.
"Recent surveys suggest that only about 30% of DeFi users have a thorough understanding of restaking mechanisms. Improved educational resources and tools for visualizing risks are imperative. At RedStone, we've noticed that users who grasp the underlying mechanics are more likely to make informed investment decisions," stated Kazmierczak.
The more users engage in restaking, the more they expose themselves to risks.
"Having transparency regarding where participants' stakes are directed will be vital. Shared security versus local security—securing one AVS versus several and potentially sharing security exposure across multiple AVSs—could be risky. A scenario where a node operator not directly related to an individual's stake could impact that stake poses undisclosed risks that investors might overlook. A transparent view of any risk vectors or activities with potential stake impacts is crucial," highlighted Leisinger.
Ultimately, individuals hold the power to educate themselves before venturing into the realm of diverse restaking protocols.
"Delving deeper into a protocol's operations is essential for genuine comprehension. Unfortunately, there's no shortcut to this. It necessitates due diligence involving critical scrutiny of the protocol's documentation, audits to reveal how rehypothecation is managed, and the protective mechanisms in place to mitigate risks associated with leveraging user assets," underscored Ivanov.
Developing tools that facilitate broader investor access to these mechanisms will bolster the long-term sustainability of restaking protocols.
"The roadmap to long-term success entails making these systems more inclusive and establishing infrastructure that supports new participants. While the journey ahead demands time, I harbor optimism that we're progressing towards an era where sustainable staking yields become the norm rather than the exception," Wallendal concluded.