Introduction to Restaking

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A frequently asked question from our paid subscribers is:

“How do I use DeFi to earn higher yield on my crypto investments”

In the past we’ve covered LPing in DEX pools, providing capital to an automated “hedge fund” like Yearn Finance or the Hyperliquid HLP vault, or running funding arbitrage strategies with spot tokens and perpetual swaps on decentralized derivatives exchanges.

While all of these strategies have provided good returns in the past, DeFi participants have a new way to earn yield: restaking.

Basic Introduction: What Is Staking?

Bitcoin and other early blockchains use a Proof of Work consensus system. This required investment in chips and expenditure of processing power (consumption of energy) to solve puzzles. The economic burden required to produce this “work” acts as a powerful disincentive to breaking the rules of the network. Attempting to introduce an invalid block (for example, one which attempts to spend the same coins twice) would result in the work being wasted, so long as the majority of participants remained honest (adhered to the rules of the blockchain defined by the software code).

In a Proof of Stake consensus system, there is no continuing investment in chips and processing power to produce “work”. A PoS chain therefore needs to solve the “nothing at stake” problem. Ethereum was able to move from PoW to PoS by designing a cryptoeconomic security model which aligned validators’ interests with the participants of the network (security and stability).

In simple terms this is a “carrot and stick” model:

1. Validator operators need to lock up some economic value (stake) in a smart contract. On Ethereum they stake the native ETH token.

2. When the validator is online and functioning correctly, the owner is rewarded with newly issued ETH. (carrot)

3. If the validator is offline, the “inactivity leak” penalizes the operator by charging a small fee which is roughly equal to what the validator would have earned if it had remained online.

4. If the validator engages in behavior harmful to the network (either intentionally or due to a software bug), some of its stake is forfeited. This is termed “slashing” (the stick) If the behavior is prolonged or particularly harmful, the validator is also forcibly ejected from the network.

5. Owners can withdraw their capital at any time by giving notice to the network. Their validator exits after a delay and their capital plus any earnings from staking (minus any penalties) is returned.

What Is Restaking?

Restaking refers to using the same pool of capital to provide cryptoeconomic security to multiple services. These services could be L1 blockchains like Ethereum, or they could be other infrastructure services which require cryptoeconomic security: oracles and bridges would be good examples.

Astute readers will immediately notice that staking systems need the ability to impose penalties for malicious behavior (the ‘nothing at stake’ problem). How can multiple services maintain slashing power over the same collateral?

One solution is Liquid Staking Derivatives (also known as Liquid Staking Tokens).

Example:

1. An ETH investor wants to earn a yield and support Ethereum and so becomes a solo staker. Run validator client + deposit 32 ETH in staking

2. Later, the investor learns its possible to obtain around 90% of the reward of solo staking *and* be able to use the staked collateral in other DeFi protocols. Unstake ETH → deposit ETH in Lido → withdraw stETH tokens representing the staked ETH → deposit the staked ETH in Aave to earn additional yield (paid by stETH borrowers)

3. A new crypto app with a high demand for blockspace (e.g. a social media platform or game) decides to launch on its own proof of stake blockchain NewChain to meet its performance requirements. This AppChain offers to pay yield in its native token to any validators who are willing to stake stETH to secure the network. Withdraw stETH from Aave → Download validator client for NewChain → deposit stETH in the staking contract →earn ETH staking yield in ETH through Lido + NewChain yield in NewChainToken

4. Restaking As A Service protocols automate the process and can use their own tokens to subsidize staking rewards (e.g. Eigenlayer, Symbiotic)

Our investor has increased the potential return compared to holding ETH, but at what cost? Staking in multiple services increases the exposure to risk of loss from software bugs and poor cryptoeconomic design. Whether the additional yield compensates for the risk must be evaluated on a case by case basis.

By accepting the rehypothecated third party collateral, NewChain inherits the risks of Lido’s stETH. However NewChain benefits from significant cost savings - as the stETH owner is already receiving a good yield from Ethereum, perhaps they are willing to restake their capital for only an extra 1-2% APY. Whereas NewChain may need to offer up to 4-5% staking yields to attract capital which was not already staked elsewhere.

In summary:

• for investors: restaking allows the same capital to be invested in multiple yield bearing crypto projects simultaneously

• higher yields come with higher risk as there is an increased risk of slashing penalties or loss due to software bugs on platforms which are not as battle tested as Ethereum

• for projects: cryptoeconomic security becomes potentially more cost-effective, while only introducing a small risk (since Ethereum and its major liquid staking issuers are considered to be secure and battle tested)

Note that projects need to pay for cryptoeconomic security, so the addressable market for restaking is: crypto protocols with significant revenue. So far this is oracles, bridges, and potentially app chains which host high value applications like exchanges.

Restaking - Potential Use Cases

Blockchains

Remember that the most liquid restaking token is based on Ethereum staking.

If you’re already trusting the Ethereum validator set, it makes sense to just launch as an Ethereum L2 / validium rather than securing an independent chain with restaking. This is a view endorsed by Ethereum’s co-founder Vitamin Butane.

Exceptions for use cases where high performance is required, more than an Ethereum L2 could deliver (examples: trading exchange, social media platform, gaming).

However, this analysis ignores that small projects don’t yet have the clout (or revenue) to attract capital to provide cryptoeconomic security. Restaking marketplaces provide a (temporary?) solution for bootstrapping cryptoeconomic security.

Successful protocols may disintermediate when they reach scale - for example a perps DEX like dYdX or Hyperliquid can secure their appchain with their native tokens - so restaking providers will need to find creative ways to retain their best customers.

Oracles

The market leading oracles rely on Proof of Stake using their native token, which provides an upper bound to the value of the cryptoeconomic security provided and introduces risks and trust assumptions. There is also an argument that these oracle services are expensive (inefficient) because stakers need to hold a less liquid, higher volatility token and therefore demand higher compensation (safer to hold ETH vs LINK or PYTH).

Extending the security of Ethereum’s Proof of Stake by having Ethereum validators operate as oracle nodes is a credible alternative to existing solutions.

An example of an Etherum-native oracle under development is eOracle; turbo autists refer to their documentation showing improved capital efficiency etc.

Bridges

Restaking can provide cost effective cryptoeconomic security to bridges. This is important as bridges are high value targets for sophisticated hackers, and users have no recourse to other collateral if the worst happens. For this reason we recommend against holding “wrapped” tokens from lock-and-mint style bridges.

Restaking can help. An example would be RenBridge, the now defunct solution for bridging Bitcoin to Ethereum via a RenBridge issued vouched token RenBTC. The Ren network was decentralized, but the validator network needed to post collateral 3x the value of the Bitcoin deposited in the bridge in order to deter theft. This limited the scale of Bitcoin which could be issued; ultimately this model proved to be capital inefficient. Bridged Bitcoin secured by Ethereum validators makes more sense, as people bridging assets to Ethereum already trust the Ethereum validators.

Rollups, Data Availability, and zkCoprocessors

These use cases are technically complex and a detailed exploration is beyond the scope of this article. In simple terms, restaking can provide fast finality and secure data availability services to new rollups, making it easier for teams to bootstrap. Zero Knowledge Coprocessors are smart contracts which can perform complex queries on blockchain data and create a zero-knowledge proof that the data is correct.

Concluding Thoughts

This concludes our introductory post on restaking.

In our next post for paid subs we will cover some of the more prominent restaking solutions and provide our views on whether or not you should be restaking with them.

Remember - there's no such thing as a free lunch. Tens of billions of dollars in crypto assets are held in the contracts of these restaking providers. However, just because a protocol is big, doesn't mean it's safe. We've learned this lesson in crypto many times over the years.

See you in the next paid post where we'll dive deeper on specific restaking protocols!

Disclaimer: None of this is to be deemed legal or financial advice of any kind. These are opinions from an anonymous group of cartoon animals with Wall Street and Software backgrounds.

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