Regime Shift in DeFi Rates for ETH: Risks and Opportunities for Superior Uncorrelated Returns
Liquid restaking, novel credit markets, and the ever-expanding opportunity set for yield in Ethereum.
Key highlights:
- Eigenlayer is introducing the powerful “restaking” primitive; staked ETH can be “re-delegated” to secure other networks or applications.
- Similar to LSTs for liquid staking, Liquid Restaking Token (LRT) protocols act as intermediate protocols that accept ETH or LST funds, deposit them to a curated list of services with Eigenlayer and return a “receipt” of deposited funds that can be used in DeFi.
- Ether.fi has so far been the pioneer and TVL leader among LRT protocols.
- The introduction of restaking and LRTs opens up a whole universe of opportunities for trading and risk-adjusted returns.
- Restaking amplifies slashing and technological risks due to the additional layers of infrastructure and smart contracts introduced. Liquid restaking token protocols add yet another layer of smart contract risk.
- The popular stETH/ETH looping trade is expected to pass the baton to high APR LRT looping strategies on selected venues.
- wETH borrow rates should eventually settle higher, possibly somewhere between the average staking and restaking rewards rates.
- While the likes of Aave and Compound may not be onboarding LRT as collateral any time soon, novel credit markets, like Morpho Blue,Euler v2 and Ajna, are emerging as the venues for leveraged restaking.
- The need for an interest rate swap referencing wETH rates becomes imperative.
- The unfolding landscape in ETH credit markets is one of more liquidity fragmentation, higher rates and rates volatility, and attractive cross-money market arbitrage opportunities. The IPOR vision of the Credit Hub of DeFi is more relevant than ever.
Liquid restaking and the emergence of novel lending protocols have been dominating market narratives and attracting DeFi users’ attention and capital in recent months.
In this article, we briefly introduce restaking as a new DeFi primitive and reflect on the possible implications that this powerful technology may have for the DeFi rates landscape in the years ahead. We discuss the risks and opportunities that restaking enables at a time when liquidity is getting increasingly fragmented across credit markets as new lending protocols emerge.
Eigenlayer and the Restaking Primitive
Restaking, as the term implies, means “re-delegating” staked ETH, which is securing the Ethereum PoS network in order to secure other networks or applications called Actively Validated Services (AVS).
In this context, AVS are leveraging Ethereum validator services for their operations, “borrowing” the security and decentralization that a battle-tested decentralized network with the economic footprint of Ethereum can offer. On the supply side, ETH stakers and validators can decide to take extra slashing risk in return for additional yield by offering their stake and validator services to other decentralized networks, infrastructure, and applications.
The restaking primitive is being introduced by the Eigenlayer protocol. Eigenlayer is essentially a marketplace where AVS and validators connect. EigenDA, is expected to be the first AVS to launch in production, using Eingelayer’s staking to reduce Data Availability costs for L2. At the time of writing, only about a dozen AVSs have been onboarded to Eigenlayer.
From a technical point of view, Eigenlayer is a set of smart contracts interacting with Ethereum staking. Currently in testnet, the protocol will allow users to select the services they are willing to secure from a list of onboarded AVS. Two forms of restaking are supported:
🔸 Native Restaking — Solo stakers can use their stake and validator infrastructure to participate,
🔹 Liquid Restaking — Liquid Staking Tokens (LST) holders (e.g. Lido stETH) can simply deposit their liquid staking token to Eigenlayer.
In the case of native restaking, Eigenlayer ultimately introduces one intermediate step in the withdrawal process; instead of validators sharing their withdrawal credentials with the Ethereum network, they share these details (and deposit their funds) to an Eigenlayer smart contract, called Eigenpod. At the Ethereum level, the Eigenpod contract address becomes the withdrawal address, while Eigenlayer governs slashing conditions. In a nutshell, Eigenlayer acts as a middleware in the Ethereum staking technology stack.
In the event of slashing, Ethereum is “informed” and slashed assets are withdrawn from Eigenlayer. Slashing is a lot simpler in the liquid restaking case, as it only requires LST holdings “changing hands” without the Ethereum staking layer involvement.
Eigenlayer is currently in testnet, with the mainnet launch expected sometime in the summer of 2024. With the introduction of “points” as a precursor of a potential airdrop, Eigenlayer is all the hype in DeFi at the moment. TVL has grown to $8bn, while 10% of the circulating LST supply has already been deposited with Eigenlayer.
The list of AVS to be supported and the resulting range of returns is still anyone’s guess. For now, depositors are simply “point farming” with no staking activity taking place, and market participants are trying to price the value of the Eigenlayer airdrop.
Anecdotal conversations with key actors of the restaking ecosystem suggest that Eigenlayer mainnet launch and the resulting “stratification of risk” could present opportunities for returns with spreads of 5–15% over the stETH rewards rate. An additional caveat here is that restaking rewards might be paid by some AVS in tokens other than ETH, thus introducing more volatility in restaking yield.
Liquid Restaking Tokens — LRT
Similar to ETH staked on the Ethereum network, restaked ETH on Eigenlayer cannot be used in DeFi or transferred before it goes through the withdrawal process. Eigenlayer has a withdrawal queue with a waiting period of 7 days. Several protocols have emerged introducing Liquid Restaking Tokens (LRT), whereby the user deposits ETH or an LST to an intermediate protocol that is acting as a “curator” of AVS for restaking and returns a “receipt” of deposited funds that can be used in DeFi.
Apart from this construct's obvious capital efficiency benefits, LRT may also serve as an additional line of defense in the event of slashing.
With LRT, restaking positions are tokenized in a liquid form, allowing liquidators to simply take over without enforcing a withdrawal (which would reduce the security of AVS). Ahead of mainnet launch, LRT protocols are simply accepting funds in exchange for Eigenlayer and protocol-specific points.
The Opportunity
The restaking primitive is inarguably a great boon for decentralization and ETH. Rollups, other L1s, oracles, or any software service can “borrow” the security of Ethereum. With restaking, Ether is gaining in utility and value accretion.
Once Eigenlayer goes live on mainnet, holders of ETH will be presented with a broad spectrum of risk-adjusted return options. The common analogy to the investment universe of bonds with different credit/default risk is quite astute.
The introduction of LRT opens up a whole universe of opportunities for trading and yield.
The onboarding of these assets as collateral in credit markets brings new life to the popular looping trade, which will now focus on restaking and targeting juicer APRs.
The Risks
Restaking obviously amplifies slashing and technological risks due to the additional layers of infrastructure and smart contracts introduced. Liquid restaking token protocols add yet another layer of smart contract risk.
“Rehypothecation” always cuts both ways, especially if the right risk management principles are not applied. In his 2023 post, Vitalik cautioned against overloading Ethereum’s (social) consensus and highlighted the importance of prudent decisions when restaking. A valid concern is that the restaking primitive could have “second-order effects” as it may incentivize excessive risk-taking. In an excellent thread, Eignelayer’s founder has dismissed these concerns as misplaced, introducing the notion of pooled security and attributable security.
In the specific case of DeFi and LRT, it is reasonable to expect more frequent LRT depegs and an increased risk of cascading liquidation events. LRT (and possibly also LST) can act as release valves in such cases.
Depegs and liquidations undoubtedly create attractive opportunities but can also lead to prolonged periods of volatility for ETH and impede institutional adoption. For the time being it seems that partial slashing has not been implemented, suggesting a complete loss of the 32 ETH pledge of restakers.
The impact to the ETH price is not straightforward in this context; while slashed ETH of native restakers shall be burnt (deflationary), slashing restaked LSTs essentially leads to transfer of ownership and possibly sell pressure.
The potential dominance of a single LRT protocol, playing the role of the “curator” of a list of eligible AVS similar to Lido for staking, could in fact result in less decentralization overtime.
Drivers of the wETH Borrow Rate in Credit Markets
Before restaking, the opportunity set for deploying ETH in DeFi has been rather limited. With the onboarding of several LST (predominantly stETH) as eligible collateral in the blue-chip credit markets and the introduction of high loan-to-value (LTV) for correlated assets (like stETH/ETH), leveraged staking became the dominant use case.
Going into the Shapella upgrade, borrowed wETH could be used to play the “repeg” of different LSTs. Borrowing wETH against wBTC collateral may also have been used as a (rather inefficient) expression of the long BTC/ETH trade.
After the Shapella upgrade, the de-risking of withdrawals and subsequent elimination of the illiquidity premium, the “rinse and repeat” strategy of leveraged staking with LST protocols (deposit LST in the credit markets, borrow more wETH and keep looping) became the only game in town.
The spread between the Lido rewards rate and the wETH borrow rate has been one of the most watched quantities in DeFi.
The stETH rewards rate has served as a ceiling to the wETH borrow rate, with the spread intermittently inverting in 2023.
As more people piled into the trade, more ETH was staked (staking ratio reached 25%) and activity on the network remained overall subdued, the spread has been in constant decline over the last year.
It is reasonable to assume that the popular stETH/ETH looping trade has most probably run its course.
The historical evolution of ETH APYs on one of the most popular platforms for one-click leveraged staking illustrates the above. Professional leveraged stakers have been increasingly looping using the improved rates of the Morpho Optimizer, trying to “squeeze” some extra basis points per loop.
LRT Rewards Rate — The New Gravitational Force?
Restaking essentially pushes the upper bound of accessible returns for ETH holders higher. The question naturally posed here is whether the borrowing rate of ETH can still be “capped” by the stETH rewards rate or whether, going forward, the rates offered by restaking and LRTs become the new gravitational force.
Purely intuitively, the expanding opportunity set creates increased demand for leverage. It shall eventually allow wETH borrow rates to settle at higher rates, possibly somewhere between the average staking and restaking rewards rates. The increased demand for wETH on Aave in recent weeks seems consistent with this view.
Notwithstanding, an in-depth analysis of the credit market landscape presents a more nuanced picture.
The subtle point here is that the promised additional returns are a lot less appealing when adjusted for risk and, therefore, will most probably not dominate flows from the get-go.
Similar comments apply to the percentage of DeFi participants who will be actively involved in the LRT looping trade.
For context, out of the total ETH supply, 25% is currently staked, of which approximately 45% is in LST protocols. About 10% of LST supply is currently deposited in Eigenlayer, only exposed to smart contract risk for the time being, farming points. The retention rate of capital post-mainnet launch is questionable at this point.
What seems to be more likely is that the likes of Aave and Compound will not be onboarding LRT as collateral any time soon.
The supply side of credit market pools for wETH is expected to attract more attention and capital and serve as a backstop against higher rates.
Aave and Compound have historically been very conservative at onboarding assets. Risk aversion has become part of the DNA of traditional credit markets. Still, it is ultimately an implication of the fact that the lending pool primitive is a foundational block of these markets. The emergence of novel isolated market designs (see Morpho Blue, Euler v2, Ajna) allows for the permissionless onboarding of the long tail of assets.
With the first LRT pools already launched on Morpho Blue, it is becoming clear that the new credit markets will be the venues for leveraged restaking.
All in all, the unfolding landscape in ETH credit markets is one of:
- more liquidity fragmentation,
- at least moderately higher rates across the board and higher rates volatility (higher demand for leverage and migration of the less conservative credit market LP capital to greener pastures),
- cross-venue “arbitrage” opportunities (see Morpho vs Aave v3 markets snapshot below).
The need for an interest rate swap referencing wETH rates becomes imperative.
Fragmented Liquidity, “Smart” Looping, and the Credit Hub of DeFi
The looping trade is not necessarily going away, it is simply evolving.
Leveraged staking has already become more competitive, requiring the optimized sourcing of rates from different venues or intermittent locking-in of spreads.
The popular stETH/ETH looping trade will soon pass the baton to “leveraged restaking.”
Looping LRT/LST or LRT/ETH pairs is set to become the next niche high APR strategy on selected venues.
Increased demand for borrowing stETH is a distinct possibility going forward, assuming the rate differential to wETH borrow inverts decisively and the spread vs. LRT remains attractive.
The IPOR vision of the Credit Hub of DeFi is more relevant than ever. Welcome to Defiance city!
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