The New Frontier of DeFi: the Rise of Repeated Collateralization, Liquidity Mining, and LSD Tokens

DeFi's New Frontier: The Emergence of Collateral Reuse, Liquidity Mining, and LSD Tokens

Author: Conor Translation: Plain-spoken Blockchain

Since Ethereum transitioned to PoS, anyone willing to stake ETH can get a return of about 4%. However, for experienced DeFi users, earning a stable return by holding tokens is not enough, and there are many protocols emerging that allow stakers to earn returns from their staked assets and re-stake their tokens. This could be a huge growth area for DeFi, and there are already many methods available, depending on the type of staking being done.

Staking activity on Ethereum can be divided into two camps: running validators or using liquidity pools to stake derivative tokens.

If you run a validator on the Ethereum network, you will lock up 32 ETH and run both a consensus layer and an execution layer client yourself. You will receive staked Ether rewards deposited directly into your Ethereum wallet.

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1. LSD token

Liquidity staking derivatives (LSD) tokens are tokens issued by services that allow you to delegate your ETH to them for staking. In return, you receive a token that tracks the value of your staked ETH and can be redeemed at a 1:1 ratio at any time.

The advantage of LSD tokens is that they provide liquidity for staked ETH, which means additional earning opportunities for most DeFi users.

Imagine if you could deposit money into a bank savings account and the bank issued you with equivalent funds to use at your discretion. That’s essentially what LSD tokens are giving you.

The two most popular LSD tokens are Lido’s stETH and RocketPool’s RETH. Both have similar yields but are implemented differently.

For stETH, rewards are paid directly to the wallet holding stETH, so income tax may need to be paid. For RETH, staking rewards accumulate through the increase in token value, so accumulated rewards are only calculated when the tokens are sold.

Users can obtain stETH or RETH by depositing ETH through Lido or Rocketpool websites, or simply exchanging ETH for these tokens through DEX like Uniswap.

Alternatively, you can directly stake 16 ETH with Rocketpool to not only receive additional ETH staking rewards, but also Rocketpool’s governance token RPL.

Lido currently limits the number of participants who can stake on their network. While they plan to open up to the public in the future, this centralized staking service model is a major criticism.

2. LSD Yield

Providing yield opportunities is a recent hot spot in DeFi, and LSD tokens are a relatively new asset class that services are accelerating to meet their needs. These services offer LSD token yield in addition to the basic staking yield they already benefit from.

Curve Finance is a popular venue for LSD token yield, providing liquidity pools for these tokens such as stETH/ETH and RETH/ETH to earn yield. Then, Convex Finance can boost liquidity pool rewards on the curve.

Frax Finance is providing a DeFi ecosystem (stablecoins, DEXs, and loans) that also caters to LSD tokens. These Frax stablecoins are fully encrypted collateralized and none of them use fiat currencies like USDC.

In addition, you also have Origin Protocol’s OETH, which provides a convenient way to earn yield from many of these DeFi services by simply depositing ETH or LSD tokens into their application.

These yield opportunities provided by DeFi platforms and other LSD tokens are no different from other stablecoins as their investors provide liquidity for DeFi services such as automated market making.

However, a mechanism for re-staking funds is about to emerge, and Eigenlayer is at the forefront of this new DeFi infrastructure.

3. Related Staking

Eigenlayer offers staking opportunities to stakeholders in the form of re-staking. Re-staking with Eigenlayer involves acquiring existing staked assets to ensure other services such as rollups, bridging, and data availability networks.

With Eigenlayer, teams building core services will no longer need to bootstrap trust to protect their systems. Historically, when a blockchain network starts, a token is needed to protect it, while ensuring that the token has sufficient value to prevent malicious attackers from owning a majority stake.

Eigenlayer solves this problem by allowing stakers to re-stake their staked ETH. These restakers can then choose to allocate a portion of their staked assets to new services launched using Eigenlayer’s features to protect themselves.

As far as I know, Eigenlayer is unique in the Ethereum ecosystem and is sure to incentivize many new services to launch using their infrastructure as a backbone.

They haven’t launched on the mainnet yet, but plan to support not only LSD tokens RETH and stETH, but also allow ETH stakers to send their staking rewards directly to the protocol’s smart contract for stakers to allocate.

4. Related Risks

Ethereum only just completed its transition to proof-of-stake in April, when staked ETH became withdrawable. While Lido, Rocketpool, and other LSD projects have been around for some time, they are still in their early stages compared to other parts of the DeFi ecosystem like lending, DEXs, and fiat-backed stablecoins.

When you consider acquiring an asset that generates a 4% yield, then reinvesting it to earn another 4% yield, maybe even another yield, the returns can be quite attractive. However, each reinvestment compounds your overall risk profile.

While this hasn’t happened to LSD tokens yet, we all know that smart contracts can sometimes be hacked, or token values can go to zero. I’m certainly more comfortable staking ETH at 4% than I am depositing it into a protocol where the overhead may be more than double that yield, but it hasn’t been proven yet compared to the Ethereum network itself.

There are also some social factors to consider, as Vitalik recently discussed.

He believes that If eventually a large portion of the Ethereum validator set re-stakes, and these validators are easily influenced by the social consensus of the applications they help protect, they may ultimately impact the decisions made on the Ethereum mainnet due to the stake they represent. This could lead to changes in Ethereum as decisions made by fully independent applications running on a network protected by Ethereum re-injecting funds.

It’s also important to remember that if there is a real liquidity crunch with Curve Pool or LSD protocol, can you ensure that you will be able to queue up first to withdraw funds safely?

Restake and LSD protocol are really taking off and are important areas of growth for DeFi. The sustainability of the current series of projects remains to be seen, but it’s an exciting time as it is just getting started.

What do you think about repeat staking and LSD schemes? Are they the next big thing in DeFi?

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