IOSG: Starting from the underlying logic, in-depth discussion of the future development of LRT

Author: Jiawei Zhu, IOSG Ventures

There has been a lot of discussion recently around EigenLayer's re-pledge and LRT (Liquid Restaking Token). Users are betting on the potential airdrop expectations of each protocol, and re-pledge has become the hottest narrative in the Ethereum ecosystem. This article will briefly discuss some of the author's thoughts and opinions on LRT.

The underlying logic of LRT

LRT is a new asset class derived from the multi-sided market surrounding EigenLayer. The purpose of LRT and LST is similar to "liberating liquidity", but due to the different composition of LRT's underlying assets, LRT is more complex than LST, has diversity, and has a dynamically changing nature.

Considering the ETH standard, if the Ethereum pledge under LST is regarded as a currency fund, then LRT as an asset manager can be regarded as the Fund of Fund for AVS. Comparing LST and LRT is a way to quickly understand the underlying logic of LRT.

Source: IOSG Ventures

1. Portfolio

LST's investment portfolio only has one type of Ethereum pledge, but LRT's investment portfolio is diverse, and funds can be invested in different AVS to provide them with economic security, and naturally have different risk levels. The fund management methods and risk preferences of different LRT protocols are also different. At the level of fund management, LST is passive management and LRT is active management. LRT may provide different management strategies corresponding to different levels of AVS (such as EigenDA vs. newly launched AVS) to adapt to the user's return/risk preference.

2. Yield, sources and composition

The yields of LST and LRT are different, as well as the source and composition of the yields:

• The rate of return of LST is currently stable at around 4.9%, which comes from the joint income of the Ethereum consensus layer and the execution layer, and is composed of ETH.
• The rate of return of LRT is temporarily uncertain, but it is basically derived from the fees paid by each AVS, and may be composed of AVS tokens, ETH, USDC, or a mixture of the three. According to the information we received from communicating with some AVS, most AVS will reserve a few percentage points of the total token supply as incentive and security budgets. If AVS is already online before issuing coins, it may also pay ETH or USDC, depending on the specific situation. (In this way, Restaking can actually be understood as the process of re-staking ETH to mine third-party project tokens)

Since it is AVS token-based, the risk of token fluctuation will be greater than that of ETH, and the APR will also fluctuate accordingly. AVS may also have entry and exit rotations. All these will bring uncertainties to LRT's yield.

3. Penalty Risk

There are two penalties for Ethereum staking: Inactivity Leaking and Slashing, such as missed block proposals and double voting. The rules are very certain. If operated by a professional node service provider, the Correctness can reach about 98.5%.

The LRT protocol needs to believe that the AVS software coding is correct and have no objection to the penalty rules to avoid triggering unexpected penalties. Since AVSs are diverse and most are early-stage projects, there is inherent uncertainty. Moreover, AVS may have rule changes as its business develops, such as iterating more functions and so on. In addition, at the risk management level, it is also necessary to consider the upgradeability of the AVS Slasher contract, whether the slashing conditions are objective and verifiable, etc. Since LRT acts as an agent for managing user assets, LRT needs to comprehensively consider these aspects and choose partners carefully.

Of course, EigenLayer encourages AVS to conduct a complete audit, including AVS's code, slashing conditions, and logic that interacts with EigenLayer. EigenLayer also has a multi-signature veto committee to conduct final review and control of forfeiture events.

Rapid growth of LRT in the short term

Source: EigenLayer

EigenLayer adopts a phased open model for LST re-pledge and has no restrictions on Native Restaking. Restricting LST may be a means of hungry marketing, but in fact it is more important to promote the growth of Native Restaking. Because after restricting LST, if users want to re-stake, they can only turn to the third-party LRT protocol to provide Native Restaking, which also greatly promotes the development of the LRT protocol. The current ETH flowing into EigenLayer through LRT accounts for about 55% of EigenLayer's total TVL.

In addition, the implicit point is that Native Restaking can provide Ethereum Inclusion Trust, which is also the third trust model provided and advocated by EigenLayer in addition to Economic Trust and Decentralization Trust. That is, in addition to making commitments to Ethereum through staking, Ethereum validators can also run AVS and make commitments to AVS. Most of these commitments are related to MEV. One of the use cases is "future block space auction". For example, the oracle may need to provide price feeding services within a specific time period; or L2 needs to publish data to Ethereum every few minutes, etc. They can pay the proposer to reserve future block space.

Competitive Landscape of LRT

First of all, in order to make the liberated liquidity useful, the integration of DeFi is the main point of competition between LRT protocols.

As mentioned above, although AVS theoretically need to calculate the economic security they require to reach a certain security threshold, the current approach of most AVS is to use a portion of the total token supply for incentives. Since different AVS rotate in and out, incentives depend on the price of AVS Token, so the uncertainty of LRT assets is much greater than that of LST (LST has a stable "Risk-free rate" and good expectations for ETH price), in mainstream DeFi In terms of protocol integration and compatibility, it is difficult to become a "hard currency" like stETH.

After all, as a pledge agreement, LRT's liquidity and TVL will be the first criteria that DeFi protocols pay attention to, followed by brand, community, etc. Liquidity is mainly reflected in the time period of exit. Generally speaking, it takes seven days to withdraw from EigenPod, followed by a certain amount of time to withdraw from Ethereum staking. Protocols with larger TVL can build better liquidity, such as the Liquidity Pool Reserve operated by Etherfi, which can provide fast withdrawals (i.e. eETH -> ETH).

However, it is still too early to discuss the integration of mainstream DeFi before the EigenLayer mainnet is launched, because many things are still unknown.

In other aspects, Ether.fi recently launched the $ETHFIWIFHAT meme token tweet on the official website to build momentum for the token’s launch and make people think. Swell uses Polygon CDK, EigenDA and AltLayer to build zkEVM L2, using its LRT rswETH as the Gas token. Renzo focuses on multi-chain integration on Arbitrum, Linea and Blast. I believe that each LRT protocol will launch its own differentiated approach in the future.

However, whether it is LST or LRT, the degree of homogeneity is relatively high. Although LRT has more room for development than LST, even if an LRT introduces a new idea to the market, competitors are still able to follow suit. The author believes that the moat still lies in consolidating and improving TVL and liquidity. Etherfi currently has the highest TVL and the best liquidity. Assuming that all LRT protocol airdrop expectations are fulfilled, Etherfi will have a greater advantage in attracting new funds. (The adoption of institutional users cannot be ignored. 30% of Etherfi’s TVL comes from institutional users)

After the airdrop event ends, it is entirely possible that the LRT landscape will be reshuffled, and the competition for users and funds among LRT protocols will become more intense (for example, after the Etherfi airdrop is released, some funds may immediately flow to other platforms). Until EigenLayer is fully launched on the mainnet and AVS starts to provide revenue, LRT will not be very sticky to users.

Sustainability of LRT

The sustainability of LRT can actually be seen as the sustainability of the EigenLayer system, because the income from Ethereum staking will always exist, but AVS may not. A question often asked is: With the current TVL of 11b, how can EigenLayer provide a matching rate of return (for example, 5% per year)? The author believes that there are the following points:

• Although EigenLayer’s TVL reached 11b before the mainnet was fully launched, even exceeding AAVE, after the airdrop of a series of related protocols ends, EigenLayer’s TVL will definitely have a correction period of mean reversion. Overall, it doesn't take that much to consider yield in the short term.
• Secondly, each AVS token provides different returns, durability, and volatility, and each pledger’s risk preference and pursuit of returns are also different. In this process, there will also be spontaneous dynamic regulation by the market (more Staking ETH to a certain AVS will reduce the yield, prompting pledgers to switch to other AVS or other protocols), so it is not possible to simply use the percentage of the entire TVL to directly calculate the income that needs to be provided.
• From a mid- to long-term perspective, the driving force for the sustainable development of the EigenLayer ecosystem still lies on the demand side, that is, there needs to be enough AVS to pay for economic security, and it must be sustainable. This is also related to the performance of AVS's own business. At present, in addition to the 12 early AVS partners such as AltLayer, a series of AVS have announced cooperation. The author learned that there are dozens of AVSs waiting in line for integration. Of course, this is also related to the project quality of AVS, the performance of Token and the design of the incentive mechanism. There is currently no way to give definite comments.

Summary

Finally, regarding the future pattern of LRT, the author has the following views:

1. Despite fierce competition, LRT is still the preferred direction for investment in the primary market EigenLayer ecosystem. When investing in AVS in EigenLayer, the investment logic of this middleware should be considered. This is not different because EigenLayer is used to start the network, but the way to implement the product is different. In the future, there may be dozens or hundreds of AVS built on EigenLayer, so the concept of AVS is not unusual. The direction of node service providers is already firmly occupied by some mature companies. LRT is obviously closer to users. As an abstraction layer between users and EigenLayer, it has the attributes of Staking and DeFi. As an asset allocator, it has a greater say in the ecosystem. Throughout EigenLayer's ecological layout, we also focus on areas such as developer tools, Anti-slashing key management, risk management, and public goods.

2. Currently, the proportion of EigenLayer re-staking through LRT and LST is approximately 55% and 45%, respectively. We expect that with the gradual development of EigenLayer, the advantages of LRT in unlocking liquidity will become apparent, and this ratio may reach about 73% (assuming that some giant whales and institutions that conservatively hold stETH still choose to passively hold stETH). Of course, the risks of LRT cannot be ignored. Due to the nested asset structure, we also need to pay attention to systemic risks such as depeg under extreme market conditions. In the long run, we hope to see AVS in the EigenLayer ecosystem thrive and provide LRT with a relatively stable underlying structure and revenue.