Original author: FRANCESCO

Original compilation: Deep Chao TechFlow

Rehypothecation is a new financial operation involving cryptocurrencies, but it is not without risks. In this article, author FRANCESCO will explore the concept of rehypothecation, how it works, and the potential risks it brings. Shenchao compiled the full text.

This is the third article in my series on re-staking, initially focusing on EigenLayer and then delving deeper into the world of re-staking finance.

Since then, we have seen some new players emerge in the restaking space, such as Kelp DAO, Renzo, and $RSTK, which are attracting more and more attention.

Rehypothecation appears to be positioned as one of the major narratives driving 2024. However, while many people talk about how remortgaging works and its benefits, it’s not all good.

This article aims to take a step back and analyze restaking from a higher level, highlighting its risks and answering the question: is it really worth it?

Lets start with a quick introduction to the topic.

What is re-pledge?

Ethereum’s Proof of Stake (PoS) is a decentralized trust mechanism in which participants ensure the security of the Ethereum network by committing their rights and interests.

The concept of restaking is that the same stake used to secure Ethereum PoS can now be used to secure many other networks.

Re-staking can be interpreted as programmable staking, where the user chooses to include any positive or negative incentives to secure additional infrastructure.

In practice, EigenLayers re-stakeholders provide economic trust (in the form of staked eth) so anything objectively verifiable can be slashed.

EigenLayer is “modularizing” Ethereum’s decentralized trust so that Active Verification (AVS) services can leverage Ethereum’s decentralized trust without bootstrapping a validator set, effectively lowering the barrier to entry into the market.

Typically, such modules require Active Verification Services (AVS), which have their own distributed verification semantics for verification. Typically, these actively verified services are either secured by their own native tokens or are permissioned in nature.

Why would someone choose to pledge again?

Simply put, it’s because of financial incentives and benefits.

If Ethereum staking returns hover around 5% per year, restaking may offer an attractive additional benefit.

These rewards cannot be estimated at this time as they will depend on demand and supply dynamics on the Eigen Marketplace.

However, this creates additional risks for stakeholders.

In addition to the inherent risk of leveraging their staked ETH, when users choose to re-stake their tokens, they are essentially entrusting the EigenLayer contract with the power to slash their holdings in the event of errors, duplicate signatures, etc. in any AVS they secure. .

Therefore, re-staking adds a layer of risk, as the re-stakeholder may get slashed on the ETH, the re-staking layer, or both.

Is the extra income worth staking again?

Risk of re-pledge

For stakers, re-staking means you can decide to opt-in to as many networks as possible and increase your returns, which is why EigenLayer calls itself the “AirBnb of decentralized trust.”

But it’s not all good, as re-staking adds some significant risks:

• ETH must be staked (or LST must be staked, so the token is not liquid)

• EigenLayer’s smart contract risks

• Agreement-specific reduction conditions

• Liquidity risk

• concentration risk

In fact, by re-staking, users are taking a token that is already at risk (this risk is created by staking) and adding additional risk on top of it, ultimately leading to layers of risk, as shown in the figure below.

Furthermore, any additional narrative development on these foundations adds further complexity and additional risks.

In addition to the personal risk of re-staking, the Ethereum developer community has also raised questions about re-staking, taking Vitalik’s article on not overloading the Ethereum consensus as an example. The problem with re-staking is that it adds a new avenue of risk for Eth staking Ethereum to protect the mainnet, using some of it to protect other chains.

Therefore, if other protocol rules (which may be buggy or insecure) are misbehaved, their deposits will be slashed.

The developers and EigenLayer are trying to find a way to coordinate and ensure that Ethereum is not weakened by these technological advancements. Reusing the most important Layer to ensure the security of Ethereum is indeed not an easy task.

Furthermore, a key issue in this regard is the extent to which rehypothecaters are allowed to engage in risk management.

Many re-staking projects leave the whitelisting process of AVS in the hands of their DAO. However, as a restaker, I would want to personally review and decide which AVS to stake into to avoid being attacked by malicious networks and reduce the possibility of new attacks.

All in all, Rehypothecation is an interesting narrative worth examining.

However, the concerns of Vitalik and others cannot be ignored. When talking about restaking, it is important to remember how this will impact the security model of the Ethereum mainnet.

However, it’s fair to position restaking as adding an extra layer of risk on top of the most important mechanism for securing Ethereum.

Ultimately, whether re-staking is worth it is a personal choice.

Risks of re-pledge:

• Collusion risk: multiple operators may attack a group of AVS at the same time and compromise security

• Slashing risk: Users who re-stake face slashing penalties from ETH and AVS

• Single point of failure: receiving withdrawal certificates from eth certificates (system risk to the mainnet)

• Validator Centralization Risks

• Adding additional risks to secure Ethereum

Attractiveness of re-pledge institutions

Surprisingly, many institutions have expressed their interest in re-staking as an added bonus on top of staking Eth.

However, they will likely re-hypothecate through their custodian rather than joining any other services that would expose them to additional risk of haircuts.

Given the risks highlighted previously, it will be interesting to see whether retail or institutions have the greatest interest in rehypothecation.

For those already involved, the additional benefits on top of native Eth staking are attractive, but given the risk, these benefits are not high for those seeking extreme returns.

Re-staking opens up new use cases for Ethereum as a financial instrument. Interestingly, some compare rehypothecation to corporate bonds.

The new network hopes to achieve L1 security, similar to how a company or country uses its financial system to create bonds and protect its assets.

In the crypto space, Ethereum is the broadest and most liquid network, probably the only one capable of sustaining such a market, and the most secure from a state perspective similar to that in a traditional financial economy.

Currently, most interest in restaking appears to be driven by speculation about the EigenLayer airdrop, which may be the largest airdrop in crypto history.

How will things change after the airdrop?

Perhaps a realistic risk and reward analysis might nudge some people toward other avenues that might be more fruitful.

I would venture to say that most of the capital in the re-hypothecation is hired capital and will probably leave after the airdrop.

To assess users’ true interest in this new narrative, it is necessary to separate out the speculative component.

Personally, the rehyping narrative is a bit overhyped and the current risks must be carefully assessed.

The key to re-pledge

• Due to restaking, AVS has a lower cost barrier as they leverage Ethereum’s highly robust security layer

• Users can choose to re-stake ETH, thereby improving capital efficiency and thus receiving more staking rewards

• Rehypothecation adds additional risk on top of other risks

Re-staking is an exciting narrative that could inspire a range of new use cases.

While full development of the Eigen Market will be completed in about a year, there are already some interesting restaking experiments being explored.

Some of the concerns raised by Vitalik relate to the centralization of staking power at the expense of independent staking.

It will be interesting to see how EigenLayer will work with the Ethereum Foundation to solve these problems. But beyond these, there are other problems.

How do we mitigate these risks?

Some solutions to mitigate rehypothecation risk include optimizing rehypothecation parameters (TVL cap, haircut amount, fee allocation, minimum TVL, etc.) and ensuring diversification of funds across AVS.

One immediate step that rehypothecation protocols could consider is allowing users to choose different risk profiles when rehyping their deposits.

Ideally, every user should be able to evaluate and choose which AVS to stake to, without having to delegate this process to a DAO.

This requires AVS and EigenLayer to work together to ensure there is a plan in place to minimize these risks.

The EigenLayer team has worked with the Ethereum Foundation to further coordinate and ensure that rehypothecation does not increase systemic risk to Ethereum, LST, or the AVS that utilizes it.