๐Ÿ“šUnderstanding the Staking and Restaking Ecosystem

A comprehensive overview of the staking ecosystem on Ethereum.

The Shift from PoW to PoS

Consensus mechanisms serve as the bedrock of any crypto network. They are designed to ensure network safety, provide transaction validity, and facilitate coordination among network participants for state transitions. Ethereum's consensus protocol aims to make the blockchain more expensive to destroy or disrupt than to use or maintain.

Ethereum's transition from PoW to PoS solved three significant problems:

  1. PoS offers more security for the same cost than PoW.

  2. Malicious actors on the network are easier to disincentivize.

  3. Itโ€™s easier to encourage decentralization.

We believe in the inherent value of security and are building for the future, making re-staked value composable with on-chain markets. By participating in Ion, holders of any validator-backed asset can participate in DeFi without sacrificing composability.


Deposits and Withdrawals in Ethereum Proof of Stake

As mentioned above, Ethereum has transitioned from PoW to PoS, which provides an effective security mechanism for the blockchain. In PoS, stakers are required to deposit 32 ETH to become a validator, and these validators are randomly assigned as proposers (responsible for producing blocks) or attestors (responsible for submitting attestations).

Validator balances increase due to deposits and rewards and decrease due to withdrawals and penalties. Ethereum has also transitioned from a monolithic blockchain to a modular one, comprising the consensus layer (CL) and the execution layer (EL). These two layers communicate through the Engine API.

Deposits and withdrawals play a crucial role in Ethereum's consensus layer. They ensure that the blockchain operates smoothly and securely. Here's how these mechanisms work:

Deposits

In Ethereum's PoS, there are two types of deposits:

  1. Initial deposits, used to create a validator

  2. Top-up deposits, required when a validator balance falls below the maximum effective balance.

A user deposits to the Ethereum Deposit Contract (EDC), and this transaction is verified by the consensus layer. This deposit mechanism is quite straightforward.

Withdrawals

Unlike deposits, withdrawals are a more recent development that require a closer look. There are two types of withdrawals:

  1. Partial withdrawals: If a validator's balance exceeds 32 ETH, the excess is transferred to the execution layer (EL). This happens automatically and allows the validator to continue their responsibilities.

  2. Full withdrawals: If you exit from the validator set, all your ETH is transferred to the EL. This action has to be done manually and it involves unlocking the entire validator balance, effectively causing the validator to stop participating in the beacon chain.

The withdrawal mechanism enhances the resiliency of the Ethereum network while allowing stakers to claim their rewards and exit the network at their own will. The introduction of withdrawals was initially met with skepticism. However, Ethereum has proven its robustness in securing the network and significantly de-risking ETH staking. As a result, the network has seen a significant increase in the number of validators.

By facilitating validator diversity, capital flow, and composability, the withdrawal mechanism enhances Ethereum's security and versatility. These attributes align with Ion's features, particularly the diversity in supported collateral types, integration of reward distribution, and validator risk underwriting.

In essence, this mechanism enables Ion Protocol to unlock the value of validator staked capital.


Liquid Staking x DeFi

Liquid Staking DeFi, also referred to as LSTfi, is a rapidly evolving sector within the broader decentralized finance ecosystem.

LSTFi protocols build innovative financial instruments on Liquid Staking Tokens (LSTs). This strategy is designed to boost capital efficiency, diversify provider incentives, and expand access to yield strategies.

LSTs have sparked a revolution in the staking landscape by democratizing access to staking, preserving on-chain liquidity, and enabling more interoperability between validator-backed assets. This growth has been amplified by the entrance of new liquid staking providers like Frax Finance, Swell Protocol, and more.

However, the introduction of LSTs and the strategic flexibility they provide for validator collateral are not without risks. These include slashing risks, LST pricing risks, smart contract risks, and validator infrastructure risks.

We are adopting a risk-first approach to support these LSTs and the diverse strategies associated with them as collateral. We have devised a unique method for quantifying risk within our collateral vaults and isolating risk exposure for users on a provider-by-provider basis.

Our approach enables us to build innovative primitives for a new asset class entering the ecosystem: re-staking positions. Protocols like EigenLayer are developing platforms for re-staking validator capital, and within Ion, users can utilize these re-staking positions as collateral.


Staking Mechanisms: Rewards, Penalties, and Slashings

To understand slashing, we first have to comprehend the reasons behind the existence of rewards and penalties for validators. Validators stake their claim in Ethereum's security, pledging to follow certain rules. This commitment invites rewards if rules are followed and penalties if violated, serving as the basis for providing security via proof of stake.

The two pillars that underpin the PoS consensus on Ethereum are safety and liveness. Safety ensures no conflicting blocks in the canonical chain, while liveness guarantees the chain grows plausibly and probabilistically without interruption.

These principles led to the creation of Gasper, a fusion of Casper FFG, a finality tool, and LMD GHOST, a fork-choice rule.

Validators are expected to perform certain predetermined actions that allow them to contribute to the networkโ€™s consensus:

  • Attesting for a source, target checkpoint, and head block

  • Signing off on blocks in the sync committees

  • Proposing blocks

The most common and rewarding duty is attestation, while sync committee and proposer duties are assigned randomly. Each duty has respective weights reflecting their importance within the protocol.

To measure time in Ethereum's consensus protocol, epochs made of 32 slots are used. Active validators must attest once per epoch. Their rewards are distributed in a weighted manner according to their performance concerning specific duties in the form of newly minted ETH.

Epochs are made of 32 slots

1 slot = 12 secs

1 epoch = 6 mins 24 secs

Bad behavior doesn't go unpunished. The beacon chain disincentivizes inappropriate behavior through penalties and slashing. Validators can be penalized for missed votes, equal to their potential reward. Slashing, however, is an irreversible punishment for validators who make attestations or proposals that contradict Gasper's consensus rules. It deducts a percentage of the offender's stake, leading to a steady loss of ETH over time.

Certain conditions can lead to slashing, including:

  • Proposing and signing two different blocks for the same slot

  • Attesting to a block that "surrounds" another one

  • "Double voting" by attesting to two candidates for the same block

A slashing penalty is comprised of:

An initial slashing penalty upon confirming a slashable condition and a collusion-based penalty experienced halfway through the withdrawal period.

At Ion, we view the validator's effective balance as the standard of health for a validator. If a validator's balance decreases due to slashing, their health declines too. A slashed validator impacts the health of the entire validator set since they're forcibly exited from the beacon chain.

Although the risk of slashing is generally low, we anticipate the complexity of validator risk profiles to increase as more liquid staking and re-staking providers join the market. At Ion, we're gearing up for this future, striving to create an ecosystem with a variety of providers and re-staking platforms to increase options and decentralization for stakers across the ecosystem.


Extending Ethereumโ€™s POS Security

Ethereumโ€™s PoS consensus mechanism offers a unique advantage: it's programmable and scalable security via cryptoeconomic value. This security, intrinsic to Ethereum, extends seamlessly to all of the protocols that are secured by the underlying continuity of the beacon chain as a byproduct. This is a diverse array of smart contract protocols, ranging from decentralized exchanges (DEXs) to NFT marketplaces. However, until recently, this robust security framework didn't wasnโ€™t able to innately extend itself to other applications or distributed systems such as bridges, sequencers, data availability layers, or other blockchains that required some other form of consensus. Systems like these have traditionally been tasked with bootstrapping their own consensus mechanisms to safeguard their operations, a challenge exemplified by platforms like Axelar and its native PoS network.

Restaking: Bridging the Security Gap

Addressing this gap in extendability of security provisioning led to the inception of restakingโ€”a pioneering concept that allows staked assets on Ethereum to bolster the security of arbitrary distributed systems. EigenLayer, the first restaking protocol, coined the term "Programmable Trust" to describe this mechanism. More intriguingly, the distributed systems benefiting from this trust mechanism are termed Actively Validated Services (AVSs).

EigenLayer: Amplifying Commitments and Security

At its core, EigenLayer operates as an amalgamation of smart contracts and off-chain software, amplifying the commitments a validator or other external node operator can undertake. This enhancement enables validators to engage with AVSs, requiring them to run supplementary software.

Concurrently, the EigenLayer smart contracts introduce new slashing conditions on the restaked Ethereum, predicated on the specifications of the chosen AVS. In exchange, these restakers are able to earn rewards for providing security to these systems. These conditions are agnostic to whether Ethereum is staked directly or via LSTs from an affiliated liquid staking provider. This makes it easier for distributed systems to build a security model without having to worry about bootstrapping security providersโ€“stakers. Restakers can opt-in to multiple AVSs, exposing their stake to multiple slashing conditions and earning rewards from multiple AVSs. Ultimately, EigenLayer pools security through restaking instead of fragmenting it. Pooling security is what enables multiple parties to combine their resources to provide greater security for the entire restaking ecosystem.

Unveiling EigenLayerโ€™s Potential: AVSs and New Yield Opportunities

The emergence of AVSs that can harness programmable trust heralds a transformative phase for distributed systems. Not only do they offer unprecedented access to inherited security, but they also unlock a myriad of additional yield opportunities for stakers. By providing security to these services, stakers can tap into innovative avenues for rewards while maintaining alignment with Ethereumโ€™s long term goals and supporting the services they desire.


Potential Limitations of Restaking

Introduction to Potential Limitations

While restaking brings an enticing opportunity for stakers to amplify their returns, it's not devoid of challenges. The added slashing conditions introduced by platforms like EigenLayer lead to augmented rewards for stakers, compensating for the heightened risk. Yet, the architectural constraints of EigenLayer hint at potential composability issues with restaking positions, notably due to the intricate risk profiles that arise. This complexity mirrors the challenges that PoS grappled with during its early stages.

Future Scenarios for Restaking in DeFi

Broadly, there are two potential trajectories for the integration of restaking positions into the DeFi landscape:

Scenario 1: Governance-Gated Risk Management

Liquid staking providers might decide to mitigate some of the inherent risks of restaking strategies by implementing governance-based selections. Here, the strategies deemed appropriate for their users' risk tolerance are permitted. Consequently, this could lead providers to segment their offerings, targeting specific risk demographics. For instance, a platform like Lido, aspiring to be perceived as a 'safety-first' provider, may renounce users with a higher risk appetite, as they'll be more inclined to seek providers promising greater yields through aggressive restaking strategies.

Scenario 2: Non-Fungibility and the Push to LST Users

Should situations arise where dominant platforms like EigenLayer experience significant slashing events or there's a widespread erosion of trust in providers, it may become infeasible for liquid staking providers to endorse restaking at the node operator level. Instead, the decision-making may shift to LST users. Here, EigenLayer restaking positions could become the predominant staked asset representation. However, due to their distinctive risk profiles, these assets are inherently non-fungible. This poses challenges in assimilating them into the broader DeFi ecosystem since most protocols are parameterized based on price-based dependencies. Restaking positions would find trouble here due to their intrinsic scarcity of liquidity and limited price discovery.

The Conundrum of Staked Asset Financialization

While EigenLayer and similar platforms seek to fortify PoS networks through innovative staking models, the escalating complexities in validator risk profiles inadvertently spawn secondary challenges. Both aforementioned scenarios hint at a landscape where staked and restaked assets become fragmented and illiquid. This dynamic severely hampers the feasibility of leveraging restaking positions within the DeFi ecosystem.


Liquid Restaking Tokens (LRTs) Explored

Definition and Overview

Liquid Restaking Tokens, or LRTs, are the derivative representations of restaking positions. Analogous to LSTs, LRTs have emerged to grant broader and more intuitive access to restaking positions. Numerous protocols are championing this initiative, though the frontrunner is yet to emerge. Before delving into these protocols and distinguishing their attributes, it's essential to appraise the pros and cons of LRTs.

The Differences Between a Liquid Staking Provider and LRT Provider

Liquid staking providers and LRT providers have similar end goals, which is to provide stakers or restakers respectively with a liquid representation of their underlying position. However, they reach this end by different means. The liquid staking provider is solely focused on providing depositors with a means of connecting with a reliable node operator so that they can spin up validators and provide receipt tokens for staking positions. They help match capital to hardware operators. On the other hand, LRT providers must also account for the risk profile of AVSs which they opt-in to and further expose their LRT holders to. Liquid restaking helps manage capital delegation between yield opportunities as a form of portfolio management. Their goal is to return the user upside while minimizing risk exposure. Identifying an appropriate risk to reward framework which characterizes the LRT is one of the primary objectives of an LRTโ€™s governance mechanism, whereas the governance mechanism for liquid staking providers is less objective.

Advantages of LRTs

LRTs facilitate more seamless integrations between restaking and DeFi. This aligns closely with the first potential future for restaked assets we previously discussed. That is, LST providers create liquid representations of restaking positions and manage them through governance-gating. This could enable LST providers to create well-defined risk profiles, enabling users to properly manage their portfolio of restaked assets and relish enhanced versatility. This approach enables restakers to participate in DeFi while still gaining the benefits of restaking.

Considerations for Users

While the benefits of LRTs are apparent, potential users should remain cognizant of their constraints. As described in the first scenario, many upcoming LRTs incorporate some form of governance oversight. This can restrict the flexibility of LRT holders to express their risk appetite and support their desired AVSs. This governance model raises pertinent questions about the motivations underpinning LRT providers' endorsements of specific AVSs and their ability to create a well justified risk to reward model. A transparent exploration of these motives in governance forums will be crucial for maintaining trust and transparency.

Challenges in Underwriting LRTs

The task of underwriting LRTs presents its own set of complexities. It might be equally, if not more, challenging than underwriting LSTs, given the nuanced risk profiles and unique pricing dynamics of LRTs. Addressing these challenges mandates protocols to adopt a more asset-specific approach towards creating markets for which LRTs can be sustainably supported. A deep understanding of the underlying mechanics of Ethereum core infrastructure, PoS, AVS design, and LRT design will be crucial.

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