Decentralized Finance (DeFi) is witnessing a resurgence, propelled by the emergence of a novel asset class known as “Liquid Restaking Tokens” or LRTs. The concept of “restaking” has captivated the attention of crypto enthusiasts worldwide, resulting in substantial capital inflows in this domain.

This article explores the intricacies of crypto restaking, elucidating its mechanics, advantages, and associated risks. Let’s delve deeper into the discussion.

What is Crypto Restaking?

In simple terms, crypto restaking entails continuously reinvesting staking rewards into the crypto staking pool, thereby compounding them over time. Instead of withdrawing rewards, holders of crypto tokens opt to restake them, fostering exponential growth in their staked assets. This strategy optimizes the potential returns derived from staking activities.

Understanding Restaking

‘Restaking’ refers to the process of staking an asset again following its initial staking. This practice renders a staked asset available for staking on another program or platform, enhancing the asset’s utility and offering the holder an additional set of rewards, albeit accompanied by increased slashing risks.

Let’s consider Ethereum as an example. The Ethereum network stands out as one of the most secure Proof-of-Stake (PoS) networks, thanks to its multiple validators and the distribution of staked assets among these validators. However, sometimes staked ETH remains inactive on Ethereum, leading to the emergence of liquid staking derivatives. These derivatives transform staked ETH into liquid staked derivative tokens usable in DeFi platforms. Furthermore, liquid staking derivatives do not impose minimum staking requirements, unlike native staking, which demands 32ETH, allowing smaller holders to partake in staking rewards.

Restaking extends this concept further. Restaking protocols enable other decentralized protocols to leverage staked assets on Ethereum to bolster their security. Validators and assets engaged for this purpose receive rewards based on the incentivization terms of the renting protocol or platform. Both validators and nominator stakers earn multiple rewards from the parent Ethereum network and the network or protocol to which they are restaked.

Types of Crypto Restaking

There are two types available to users for crypto restaking:

• Native restaking

Native restaking involves using smart contracts to manage assets within a validator’s node, thereby enhancing their crypto-economic security. Validators participating in native restaking programs are required to implement additional node software specific to the restaking module. This enables them to securely offer their staked assets for further utilization within the restaking ecosystem. Through this process, assets are kept secure, while validators gain access to additional reward opportunities.

• Liquid restaking

The second option is liquid restaking, which involves using Liquid Staking Tokens (LSTs). In this form of restaking, users stake their assets within an application in exchange for an LP (Liquidity Provider) token. Subsequently, users can stake their LP tokens in a staking protocol.

How Does Crypto Restaking Work?

To understand the mechanics of restaking, let’s examine an example using EigenLayer. EigenLayer is a protocol that facilitates restaking on Ethereum by establishing an EigenLayer application that operates atop the Ethereum virtual machine (EVM). This app is pivotal in serving as a conduit between Ethereum stakers and other networks or protocols necessitating enhanced security.

The use of EigenLayer entails possession of liquid staking tokens (LSTs) such as stETH or rETH, which are acquired by staking ETH on platforms like Lido or Rocket Pool, respectively. Subsequently, users can deposit their LSTs into EigenLayer pools accommodating various applications or services, encompassing layer-2 solutions, DeFi protocols, oracles, and more.

Upon depositing LSTs into an EigenLayer pool, users essentially lock them up for a predetermined duration, during which they accrue restaking rewards in the form of EL tokens, EigenLayer’s native currency. EL tokens represent one’s share of the pool’s rewards and governance entitlements.

Restaking rewards stem from applications or services utilizing the EigenLayer app for security, remunerating the app in fees to leverage its stake as collateral. These fees are then disbursed among EigenLayer pools based on their stake contribution and associated risk profile.

The risk profile of each pool hinges on the slashing conditions of the supported application or service. Slashing, a mechanism penalizing validators or stakers for misconduct or dereliction of duty, extends to EigenLayer pools supporting the affected application or service, resulting in a loss of LSTs for pool participants.

Hence, restaking necessitates a delicate balance between higher rewards and increased risks. Participants can join pools offering elevated rewards alongside heightened slashing risks or pools with lower rewards but commensurately lower slashing risks. Diversifying LSTs across different pools enables participants to manage their risk-reward ratio effectively.

Advantages of Crypto Restaking

The key advantages of crypto restaking are:

• Enhanced Flexibility

Restaking affords traders heightened flexibility by allowing them to utilize staked assets across diverse financial activities without necessitating unstaking. This provision facilitates access to liquidity while retaining the potential for rewards. Such flexibility fosters more efficient capital allocation and optimizes the utility of staked assets.

• Mitigation of Traditional Staking Limitations

Restaking effectively mitigates the opportunity cost inherent in traditional staking, where assets remain locked and inaccessible. It empowers token holders to extract liquidity from their assets without sacrificing potential rewards, rendering staking more appealing to those prioritizing liquidity and flexibility.

• Scalable Security Measures

Restaking endows protocols with a degree of adaptability concerning security tailored to the network’s requirements. Through restaking, protocols can ramp up their security by engaging validators within a restaking protocol as necessitated. Protocols can subsequently scale down their security measures upon fulfilling security requisites and reverting to normal network operations. This approach enables protocols to adopt a cost-effective strategy for scaling network security.

• Enhanced Security for Emerging Protocols

Emerging protocols and networks often struggle to establish robust security systems, particularly during the nascent stages of development. Restaking offers these protocols access to many validators early in their lifecycle, significantly bolstering their security infrastructure.

Potential Risks of Crypto Restaking

While crypto restaking presents numerous advantages, as previously discussed, it also entails certain risks affecting the parent network, the renting network, and the stakers themselves. Some of these potential risks include:

• Slashing

Restaking agreements often incorporate additional slash conditions in exchange for augmented rewards. Depending on the terms stipulated by the protocol, slashing may entail the loss of a significant portion of assets staked by a validator. Stakers opting into such agreements are bound to adhere to the contract rules and risk facing slash penalties for malicious behavior.

• Yield Volatility

Although EigenLayer aims to facilitate protocol utilization of Ethereum for security purposes, restakers are primarily incentivized by the reward structures of the protocols in which they stake their assets. Consequently, restakers may gravitate towards protocols offering the highest yields to maximize returns. There’s also concern that investors may perceive restaking as a swiftly leveraged financial product, potentially impacting the stability of the Layer 1 network.

• Impact on the Layer 1 Blockchain

Vitalik Buterin, Ethereum’s co-founder, has underscored a risk associated with restaking, wherein protocols depend on Ethereum’s social consensus in case of a fork or reorganization following significant losses. This situation could lead to conflict regarding the canonical version of the Layer 1 network. As a potential resolution, Sreeram Kannan, EigenLayer’s founder, advocates for applications reusing Ethereum’s validator set not to be bailed out by Layer 1’s social consensus.

Future of Crypto Restaking

The potential influence of restaking on the broader crypto ecosystem could be profound, impacting blockchain technology and crypto investment practices significantly. By fostering long-term investment engagement, restaking has the potential to bolster the stability and expansion of the broader crypto landscape.

The outlook for restaking appears promising, with ongoing advancements and a growing array of platforms endorsing the practice. It is poised to emerge as a fundamental strategy for astute investors seeking to optimize their digital asset portfolios further.

Conclusion

Restaking initiatives present a compelling opportunity for crypto investors to enhance their returns through the automated compounding of staking rewards. By leveraging the power of compounding interest, investors can potentially unlock greater wealth accumulation within the dynamic crypto market. However, prudent research, effective risk management, and a comprehensive grasp of the underlying mechanisms are imperative for successfully navigating the intricacies of restaking initiatives. As the crypto ecosystem continues to evolve, restaking projects underscores innovation and the quest for financial empowerment in the digital era.

Disclaimer: Cryptocurrency is not a legal tender and is currently unregulated. Kindly ensure that you undertake sufficient risk assessment when trading cryptocurrencies as they are often subject to high price volatility. The information provided in this section doesn't represent any investment advice or WazirX's official position. WazirX reserves the right in its sole discretion to amend or change this blog post at any time and for any reasons without prior notice.