DeFi Grows Up: Restaking and the New Utility-Based Yield Curve

As DeFi comes of age, it's worth looking back at the events of the past two years. Only eighteen months ago, DeFi was a burgeoning ecosystem of startups, all offering new and innovative ways to use blockchain technology to shake up traditional finance. Investors, traders, and bored degens–trapped in pandemic lockdowns–poured money into these projects, convinced they were on the cusp of something big. But the fervor dissipated, and the DeFi landscape has become more subdued.

What happened? It was a tale of hype meeting reality. The initial excitement surrounding these groundbreaking projects gave way to an endless proliferation of forks and derivatives, diluting the potency of each subsequent iteration. Hacks, rugs, and competition pushed easy returns down, raising questions about the long term viability of DeFi.

But all is not lost. The DeFi ecosystem is still in its infancy and the road ahead is long, winding and bumpy. And, as we've seen before, true innovation often emerges from humble beginnings.The lull we've seen in the past year is not a sign of failure, but rather a necessary stage in the development of any new technology. And if we look closely, we can see signs that DeFi is growing up.

What will kick off the next wave of DeFi? Our prediction is that it will be with the launch of EigenLayer (who the LAO and its members have supported since its inception). EigenLayer will enable Ethereum validators to provide security and earn fees on multiple blockchains. By offering a utility-based service—shared security—and generating a stream of fees, EigenLayer will create opportunities for new, sustainable DeFi applications and services.

It's important to remember that progress is never a straight line. The future of DeFi is not predetermined, but rather something that we will shape together. The launch of EigenLayer is a promising step forward and it will be exciting to see how the ecosystem evolves in the coming months.

DeFi is Dead; Long Live DeFi

DeFi has undergone a metamorphosis, evolving from a frenzy of yield farming, to a more mature and sustainable ecosystem. The initial phase, dubbed "DeFi Summer," was marked by a deluge of governance tokens being doled out as rewards for trying out new projects. This led to a rush of early crypto enthusiasts, as well as funds and institutional capital, all chasing the perceived easy profits.

But, as is often the case with hype, the reality was less rosy. Many of these projects were underdeveloped, overhyped, and short-lived, resulting in a market correction and significant losses. Users—lured in by the promise of quick returns—collected tokens, harvested profits, and then abandoned these projects, leaving them barren and devoid of activity.

In the aftermath of the first wave of DeFi projects, a new breed emerged. These were the Ohms, the Terras and the Lunas, the algorithmic stablecoins and other bold experiments in financial engineering. They came with new mechanism and token designs, and they grew with extraordinary speed. But their ascent was also, in many cases, their undoing.

Despite these setbacks, the underlying technology and principles of DeFi remain sound. Amidst the recent market volatility and risks caused by the collapse of centralized platforms, smart contract-based financial projects such as Uniswap, Aave, and Maker have remained strong, without the drama and cascading risks presented by less decentralized crypto companies.

DeFi projects continue to evolve and improve, with new projects still emerging, albeit at a lower frequency. The growing demand for alternative financial solutions and the increasing adoption of blockchain technology continue to fuel the development of DeFi. Though the market may have hit a rough patch, DeFi is here to stay and will serve as the backbone for global, permissionless marketplaces, and other financial products and services.

To a certain degree, DeFi can be analogized to the development of e-commerce. Like e-commerce, DeFi is a revolutionary force that has swept through its industry with a tide of excitement. Like the early days of the internet, when e-commerce companies were hyped and overvalued, DeFi has seen a similar surge of speculation and inflated valuations. And as we saw with e-commerce, when the market corrects, many investors are left holding the bag, a la the dot com bubble.

But, as with e-commerce, the story of DeFi is just getting written. The initial wave of excitement may be in the process of dissipating, but what will remain are the projects with strong business models, a dedicated user base, and a clear value proposition for their users. Just as e-commerce evolved from a wild west of speculative investments to a more regulated and mature industry, DeFi too will follow a similar path. The future of DeFi is not in hype, but in utility and opportunity for its users.

Restaking and the Next Wave of DeFi

As the world of DeFi continues to mature, it's becoming increasingly clear that the staking will be the driving force behind the next key wave of growth in DeFi. Decentralized networks are expanding at an unprecedented rate, and with this growth comes a surging demand for reliable validation services and network security.

From the early days of Bitcoin to the most recent upgrades of Ethereum and other layer 1 networks, establishing robust crypto economic security has been a complex issue, fraught with trade-offs. One of the most pressing challenges in blockchain design is fragmented security, particularly on the Ethereum network. Middleware and non-EVM applications built on top of the Ethereum network are responsible for generating their own trust network, which is inefficient, expensive, and time-consuming.

Enter EigenLayer, a new platform that has pioneered a mechanism called "restaking" to overcome these challenges and aggregate security across the Ethereum network. Restaking functions as a set of smart contracts in which users that stake ETH can repurpose their locked ETH to extend crypto economic security to other applications built on the network. The protocol creates an opt-in middle layer where users can grant EigenLayer additional enforcement rights on their staked ETH, allowing it to be restaked on other applications.

Eigen extends early staking primitives like Lido and Rocketpool by creating an opt-in feature that creates additional slashing conditions on staked ETH that persist above the consensus layer. This helps to facilitate extensible security as new slashing conditions can be introduced to meet the demands of other projects such as bridges and data availability layers being built on top of Ethereum. EigenLayer can freely deploy restaked ETH to additional applications while leveraging slashing conditions to enforce honest behavior and disincentivize malicious behavior.

This represents a significant evolution of the concept of merge mining, which has been discussed in the cryptocurrency space since the early days of Bitcoin. Merge mining, in simple terms, is the process of using the computational power of one blockchain to secure another, unrelated blockchain. This allows for the sharing of resources and increases the overall security of the network. EigenLayer takes this concept and applies it to decentralized networks that rely on Ethereum – such as zkrollups, dapp chains, and L3s – allowing validators to provide their services to multiple networks simultaneously.

What’s more, EigenLayer is Ethereum's answer to the Cosmos SDK, the popular framework for building inter-blockchain communication networks, but with some additional benefits. EigenLayer works seamlessly with Ethereum, enabling Ethereum's existing protocols, applications, security, and large user base to plug into new innovative and new decentralized networks. As a result, EigenLayer has the potential to become the "app store" of Ethereum, making it easy for developers to launch new networks and democratizing the creation of new projects.

New opportunities for innovation open up with EigenLayer. EigenLayer should help take care of the security for the networks that run on top of it, enabling teams to focus on the core product (instead of building their own decentralized network) which in turn should lead to better products and better user experiences. It is a win for validators, a win for emerging decentralized networks, and a win for Ethereum's growing network effect.

A Utility-Based Yield Curve and the Crypto Risk Free Rate

Once launched, EigenLayer has the potential to bring about a seismic shift in the world of DeFi, thanks to its introduction of new staking primitives for Ethereum. Unlike the previous waves of DeFi, which focused on yield farming and aggressive mechanism design, Eigen's new mechanism of restaking offers a steady, reliable stream of fees for validators who play a crucial role in securing decentralized networks.

This shift towards providing a needed service rather than speculation represents a major change in the DeFi landscape. It opens the door for new projects and opportunities to emerge around these streams of fees, whether for individual validators or for groups of validators.

Ethereum validation, and other trusted services relying on EigenLayer, we believe will create a crypto "risk-free" rate that is likely to be higher than returns generated by traditional financial instruments like low-risk treasuries, bonds, or other financial products issued by governments or local municipalities. Because capital seeks returns, this will provide a degree of comfort for existing and new sources of capital to purchase Ether, validate, and increase the security of the network.

When paired with emerging liquid staking derivatives (LSDs), DeFi will increasingly wrap around these new restaking primitives. Post the Shanghai hard fork, LSDs will likely act like treasury bonds, providing investors with a steady, reliable stream of yield, but with a key difference: unlike traditional bonds, these derivatives will be built on Ethereum and composable with other DeFI projects and primitives, offering a 2-3 month forward-looking options, baked-in yield, along with permissionless 24/7 liquidity, lending, borrowing, and leverage options.

Similar mechanics will also likely apply to restaked ether, creating a new ecosystem of opportunities–all grounded on the principle of providing a needed service (network security) rather than just speculation. This shift towards utility-based opportunities is crucial for the long-term sustainability of Ethereum, zk-rollups, dapp chains, and the entire DeFi ecosystem.

With these developments, Ethereum is edging towards what many in the ecosystem aspire it to be—a deflationary asset, widely supported, and composable with a growing ecosystem of trusted, transparent, and highly automated marketplaces and associated products. What’s more, Ether will offer holders the unique combination of earning a stream of fees paid in a deflationary asset, defying the conventional wisdom that yield and inflation are mutually exclusive.

In our view, the Ethereum ecosystem is coming of age, and the forthcoming emergence of a utility-based yield curve is a sign of its maturity. This is not the wild west of yield farming we saw in the early days, but something far more substantial, rooted in the principles of providing a needed service and creating sustainable opportunities for growth. This is not the end of the journey, but the beginning of a new chapter, one where Ethereum becomes a trusted, reliable and widely supported platform for decentralized finance, along with other decentralized networks. The hype is dying, but teams like EigenLayer are focused on the hard work of building a better future–—one in which Ethereum is the most secure, and trusted blockchain network, with a growing ecosystem of transparent, and highly automated marketplaces, decentralized networks, along with associated products, services, and secure assets.