Original author: LongHash Ventures

Translation by: Blockchain Simplified

Key points:

• Composable capital efficiency and staking as the native benchmark interest rate in crypto

• Staking, Restaking, and LRTfi

• Solving centralization and externality issues in Staking and Restaking

In our research, the main aspects of Ethereum, Solana, and Polygon are maturing, and the staking mechanisms of Bitcoin and Cosmos are also evolving. In Ethereum, there are two possible outcomes: if the value of Ethereum stays intact, it may lead to an oligopolistic monopoly, where the share of top participants is close to 33%, but not exceeding this proportion; or if the value of Ethereum is not maintained, it may result in the establishment of Layer 2 networks. In Cosmos, the Inter-Chain Standard (ICS) is in its early stages, and the staking rate of Solana has already reached 90%.

The secondary layer of restaking has led to a race for high returns, with capital flowing into projects with the highest yields, especially towards the Layer 2 staking token (LRT) pools. As the first Layer 2 network to adopt a staking mechanism, Blast and Manta have caused a sensation globally, instantly attracting over 1 billion dollars in total locked value. However, in a scenario with sufficient supply and high demand, the expected returns from Automated Vault Strategies (AVS) and restaking in Layer 2 networks are not yet clear. In addition, the restaking mechanisms in Bitcoin, Cosmos, and Solana are still in their early stages.

On the third level, synthetic stablecoins, yield optimization, and yield tokenization are pursued to increase innovation diversity. At this level, capital efficiency and risk surpass composability. The key success factor here is achieving the widest composability with the lowest risk.

1. Composable Capital Efficiency and Staking as the Native Cryptocurrency Benchmark Interest Rate

Composability is a hallmark of Web3, characterized by frictionlessness, low minimum requirements, and self-custody. In contrast, in traditional finance, yield stacking faces high friction. For example, using government bonds as collateral for borrowing entails multiple friction points, such as third-party custodians, case-by-case assessment of LTV ratios, and high minimum requirements to prove labor costs involved, to name a few.

The emergence of LST (Layer 2 Stablecoin) unlocked the composability of consensus layer yields and execution layer DeFi activities. This composability made the DeFi summer of 2020 possible. Time flies, three years have passed, and composability now feels so natural that it is almost taken for granted. We have become accustomed to frictionless yield stacking to increase capital efficiency. For example, we expect to stack yields by minting LPTokens for superliquid staking or minting LST to deposit LP positions.

Self-custody, low minimum requirements, and frictionless - these features are unique to Web3 and highlight the potential for efficiency improvements in the broader financial market. Imagine being able to tokenize your stock holdings and use them to participate in an LP on a stock trading platform. Imagine being able to tokenize your real estate equity and easily use it for re-staking. With LSTfi, we can catch a glimpse of what composability means for traditional finance.

Through LSTfi, we get a glimpse of what composability means for traditional finance.

Fundamentally, there are five types of income sources in the crypto space, and they are stackable, or in other words, composable. The IOUToken of one income source can be used as an input token for another income source.

Of course, risk and reward go hand in hand. Of these five basic income sources, Staking yield is the safest. Since Ethereum started staking, only 226 out of 959,000 node operators have been penalized. On the other hand, while sovereign bonds are often touted as the lowest-risk investment, there have been bond defaults in recent times from Italy, Spain, Portugal, Ireland, and Greece (not to mention the continuous defaults of Venezuela and Ecuador). Even the gold standard U.S. bonds "defaulted" when they detached from the gold standard in the 1930s and resorted to unlimited money printing to repay debt. Sovereign bond default is related to a country's ability to repay debt. Its risk level is more akin to the risk of "borrowing to generate income" rather than the risk of "staking yield." Sovereign bond yield is based on expectations of future debt repayment, while staking yield is related to the current level of network usage.

For this reason, we consider Staking as the benchmark interest rate in the crypto space.

On top of Staking is the capital efficiency engine that drives yield stacking. We have started to see some innovations, such as L2 networks with Staking guarantees similar to Blast and Manta, cross-domain Restaking similar to Picasso and Babylon, and LST cycles similar to Gravita.

The composability of LST will drive further innovation in yield stacking design.

2. Staking, Restaking, and LSTfi/LRTfi

Staking is the security foundation of POS chains and the risk-free benchmark interest rate in Web3.

Justin Drake attributes two purposes to ETH, economic security and economic bandwidth. Through the combination of various DeFi and Restaking activities, LST and LRT enable the same ETH to participate in both purposes simultaneously.

In places involving economic security, to mitigate potential collusion, a PoS chain must protect decentralization and neutrality. Designing protocols in game theory to maintain decentralization and neutrality is a balancing act. We will soon return to this tension.

First, let us use Ethereum as an example of the stacking process in a PoS chain. The primary layer allows users to stake their ETH and receive LSTs such as stETH, cbETH, wbETH, and rETH. In the secondary layer, LST or ETH can be restaked for security with other Staking services and receive LRTs such as eETH, uniETH, and pufETH. Then, the third layer combines LSTs and LRTs with various DeFi activities for yield stacking.

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Therefore, composability and capital efficiency are the main driving factors for adoption, while risk is the boundary condition that limits the range of choices.

3. Main Layer - Staking

In the main layer, validators deposit native tokens such as ETH, ATOM, and SOL to secure the PoS network and earn transaction fees as rewards.

As Staking is the lowest-risk form of income generation in the crypto field, we expect Ethereum (with a staking rate of 23%) to catch up with Solana (with a staking rate of 90%) and Atom (with a staking rate of 70%) over time, representing market expansions worth hundreds of billions or even trillions.

Staking can be categorized into three types: centralized, semi-decentralized, and decentralized. Centralized and semi-decentralized staking facilitate custody of transactions at the expense of convenience and composability. Decentralized staking, or independent staking, is the safest for protocols, but it is difficult to maintain and lacks composability. In theory, self-custody nodes can also issue LST, but without composability, there are no rational thinkers who would buy it.

1) Collateral Deposit

In regular independent staking, the validator creates two pairs of keys, one as the validator key and one as the withdrawal key, and then sends 32 ETH to the Ethereum 1.0 deposit smart contract. The base fee is destroyed, and the transaction fee is sent to the validator. Only 8 validators per epoch or 1800 validators per day can be activated.

Rocket Pool, Diva, and SwellThe staking pool allows independent node operators to support a pool composed of deposits from stakers. From the operator's perspective, lower collateral results in higher capital efficiency as they can earn a portion of commission from the deposited ETH. Essentially, lowering the collateral requirement can provide greater leverage.

• Rocket Pool: 8 ETH deposit

• Stader: 4 ETH deposit

• Puffer:  1 ETH deposit

It is estimated that node operators can earn up to 6-7% ETH rewards and up to 7.39% staking pool token rewards.

On Polygon, validators need to obtain permission. Validators must apply to join the validator set and can only join when already approved validators are unbound. On Solana, validators can join without permission and the Solana Foundation provides validators with a choice of clusters. Solana also formally tracks the number of minority validators holding over 33% of staked SOL.

In the staking on centralized exchanges (CEX), the mechanism for depositing collateral is opaque. Retail stakers can provide the full deposit, while centralized node operators can shift all potential penalties onto retail stakers. However, stakers also benefit automatically from the smoothing effect, often generating higher returns than independent staking.

2) Earning Rewards

Every 2 to 3 days, the Ethereum Beacon Chain performs liquidation of validators and distributes rewards. In addition to the consensus layer, validators can also earn rewards from the execution layer through priority fees and MEV. Protocols like Jito in Solana utilize MEV to enhance the yield of their LST.

MEV increases reallocate MEV from block producers to validators, who can then distribute rewards to stakers. Eventually, MEV burning may be implemented to return value to ETH holders. Fundamentally, the reallocation of MEV revolves around the philosophy of fairness. But currently, MEV can be used to increase staking rewards.

Validator rewards typically have high volatility. Due to the inherent randomness in validator selection, rewards may not be evenly distributed. In Ethereum, a deterministic randomness involving the hash and seed of the previous block is used to select the next validator.

For this reason, Rocket Pool offers a smooth pool based on the way validators choose to join. The smooth pool accumulates rewards from validators choosing to join. As a rule of thumb, if a validator's small pool has fewer nodes than the number in the smooth pool, it is more likely to receive greater returns from the smooth pool. For projects like Lid.o This type of project, the smoothing function has been embedded in the smart contract.

In centralized exchange platforms (CEX), smoothing is automated, and stakers can expect stable returns over time.

3) Penalties

Penalties are very rare events. Since Ethereum staking began, out of 959,000 node operators, only 226 have been penalized.

Validators may be penalized when they 1) fail to produce blocks or 2) fail to attest within the expected timeframe. The penalties are relatively minor. Usually, validators can regain their rewards within a few hours equivalent to their offline time. On the other hand, penalty sanctions are more severe.

Penalties occur when one of the following three conditions are met: 1) Double-signing: Signing two different beacon blocks for the same slot. 2) Signature wrapping: Signing an attestation around another attestation. 3) Double-voting: Signing two different attestations for the same target. Validators will present evidence of misconduct in a block, socialize with the set of validators, and the penalty will commence once all validators have signed the evidence.

The following consequences may arise in a penalty event:

• Initial Penalty: 1/32 of the remaining balance is deducted

• Relevant Penalty: If there are multiple violations within a short period of time, the amount deducted may be as high as the remaining balance. Quadratic penalties can prevent collusion.

• Exit: Validators will enter the withdrawal state within 8192 epochs (36 days)

DVT (Decentralized Validation Technology) aims to enhance the security of the staking pool by protecting validators from risks of block generation or authentication failure and reducing penalty risks. DVT is implemented on a redundant set of validators through Distributed Key Generation (DKG), Multi-Party Computation (MPC), and Threshold Signature Scheme (TSS).

SSV (Socially Shared Validators), as a part of the DVT network, is a fully open, decentralized, and open-source public product currently being tested for protocols like Lido. Obol utilizes Charon as an unmanaged middleware responsible for communication between validator clients and consensus clients. Diva uses its own DVT implementation to support its LST in a permissionless manner, allowing anyone to run a node. Puffer's Secure-Signer is a remote signing tool funded by the Ethereum Foundation, designed to prevent punishable misconduct using Intel SGX. Puffer's Secure-Signer represents the consensus client managing validator keys.

From a capital efficiency perspective, running multiple clients with DVT consumes computational resources. In practical implementation, the same hardware can participate in multiple DVT groups. Importantly, DVT enhances protocol security so that even if a group of node operators goes offline or behaves abnormally, the staking pool can still operate correctly.

Cosmos Interchain Security has an interesting approach to penalties (proposal #187). Since ICS is still in its early stages, governance voting needs to address all potential punishable events. Although this is intended to prevent any security contagion from consumer chains to the central hub, governance currently hands decision-making authority to human arbitration rather than code.

4) Withdrawal

In Ethereum, four exits are allowed per epoch. Due to mismatched entry and exit restrictions, there may be long queues for withdrawals, with 8 validators entering and 4 validators exiting per epoch. Once a withdrawal is initiated, validators must wait for 256 epochs before completing it.

In Solana, delegation is established. Standard delegation to the staking pool requires a cooldown period before withdrawals. However, liquidity staking through the staking pool does not require a withdrawal cooldown period.

4. Future Outlook

With the development of EthereumIncreasing the pledge rate, while keeping network usage unchanged, the basic yield rate should gradually approach 1.8%. This is the minimum yield rate set by the Ethereum Foundation, but the increasing gas fees and MEV may offset this trend to some extent.

Typically, opportunity costs would prompt validators to stop staking when the yield is lower than other available income sources. However, Liquid Staking Tokens (LST) can mitigate opportunity costs as holders can simultaneously participate in economic security and economic bandwidth. Therefore, despite the low return rate, validators are likely to continue depositing and use their LST to participate in DeFi for additional income.

Due to the decrease in Ethereum staking rewards, another phenomenon is centralization. Independent validators will find their earnings continuously decreasing, eventually surpassing hardware costs.