Liquid Staking Derivatives (LSDs) and Liquid Restaking Tokens (LRTs): A Race to Capital Efficiency
Introduction
In the quickly evolving world of decentralized finance, capital efficiency has become the new measurement of success. Everyone involved with crypto, from validators to yield farmers to protocol builders are trying to squeeze every bit of yield out of their assets while preserving security. Liquid Staking Derivatives (LSDs) and Liquid restaking Tokens (LRTs) are two of the larger innovations that have come from this search - both appear to be smart ways to earn more from your ETH. The main differences being that LSDs find yield in Ethereum, while LRTs can find yield across protocols.
This article will discuss how these models compete with each other in, what can only be called, a capital efficiency arms race. It will discuss how they are each structured, the risks in each area and what that means for DeFi users who are searching for the best possible return on their funds.
The Smell of LSDs
The first significant enhancement of the liquidity of staked ETH came in the form of Liquid Staking Derivatives. In exchange for staking their ETH on the Ethereum consensus layer, users receive an LSD like stETH or rETH. Users can engage in the trade of stETH or rETH through services like Lido or Rocket Pool.
LSDs have two purposes: they accrue staking rewards just as if the ETH were untouched, while also providing an asset that is liquid and can easily be used in DeFi protocols. Because those with LSDs can lend, borrow, and farm with them while receiving staking rewards, they can effectively double their earning potential when prices are stable.
One of the overarching advantages of LSDs is the ability to combine them with other assets. As of now, LSDs are being treated as safe collateral for DeFi protocols like Save, Curve, or Balancer. LSDs allow users to deposit LSDs as collateral, borrow against the LSD in stablecoins, re-stake, and seek higher yields.
LSDs are still tied to only one protocol: Ethereum’s consensus layer. This gives them a stable and well-regarded reputation, they cannot appreciate as much. From more aggressive DeFi options payouts, the staking payout is rather low; it is currently at 3-4%.
A Look at LRTs
LRTs are built on the LSD paradigm but introduce a powerful new feature called restaking, which has made them possible thanks to projects like EigenLayer. Essentially LRTs allow you to rehypothecate staked ETH to improve the security of several protocols at the same time.
In practice, users supply their LSD, which is usually stETH, to a restaking platform, where the user receives a LRT as a receipt. The LRT is a tokenized claim on the original staking rewards, and additional incentivization for being restaked on other chains.
Now you have two streams of income: one income stream for validating Ethereum, and a second stream for ensuring the safety of other services or protocols. They see this as a major advancement in capital efficiency, whereby you can take one asset, use it as a yield engine, enabling it to effectively do two things.
The alternate side of the trade-off is complication and risk. As a first, LRT holders are actually undergoing slashing events with multiple different networks. Furthermore, if any one of the networks that this restaked ETH backs up has a failure or is attacked, the user could be losing some value.
However, for risk-taking DeFi developers, LRTs are the next wave of future wealth. LRTs could be integral to the future of cross-chain security markets.
Using Capital Wisely
Capital efficiency, in its most rudimentary form, informs you the efficiency with which an asset might be utilized. LSDs have forged ahead in making staked ETH liquid. This liquidity allows DeFi participants to stack up yield and use their avenue as collateral. LRTs take it a step further by allowing idle staking capital to become a multi-yield solution.
For instance, LSDs enable the user to take their stETH and deposit it into Aave so they can earn interest on their borrowings and continue to earn staking rewards.
LRTs allow clients to take that same stETH, restake it via EigenLayer, to earn further rewards by being a security mechanism for other protocols while still maintaining liquidity because of the delivery of an LRT.
One of the many reasons why LRTs are considered the next evolutionary step of capital efficiency, is the increased reward potentials. The composability and leverage aspects of LRTs may even make the system more fragile especially because many protocols around the DeFi space are based on the same collateral.
LSDs and LRTs
LSDs vs. LRTs put side by side demonstrate two different ways of thinking about yield optimization. LSDs take a much simpler, safer, and more composable approach in a single known environment. Whereas LRTs are much more aggressive in capital efficiency and more diversifying the risk across multiple networks.
Here's how they differ at their core:
LSDs
- Only consider Ethereum's staking layer
- Offer yields that are lower and easier to predict
- Carry less danger of cutting and systemic failure
- Very well connected across the main DeFi platforms
LRTs
- More than one protocol should be used to get a higher yield
- Offer bigger possible rewards, but with risks that are linked to them
- Rely on new infrastructure such as EigenLayer
- Are still in the early stages of getting used to and growing in liquidity
For more cautious DeFi clients, LSDs will provide consistent returns, as well as a lot of liquidity in the marketplace. LRTs are the best route for the more sophisticated user wanting to stack yields and utilize multiple protocols, but carry significantly more risk.
Risks and Choices
There are almost always terms that come with the promise of a higher yield. The most notable risks associated with LSDs are fairly simple: Ethereum slashing, smart contract risk, and liquidity shocks during stressful market conditions.
But the emergence of LRTs presents a new layer of systemic risk. Users staked across multiple protocols are exposed to risks of cross-protocol slashing, correlation risk, and dependency chains. The failure of any single restaked protocol could spell disaster for the entire ecosystem and lead to cascading liquidations across interconnected DeFi protocols.
For example, let's say an LRT provider undergoes a slashing event that causes the value of their tokens to be reduced by 20%. If that token is being used as collateral for a lending process, then that slashing could result in a linkage of liquidations: draining liquidity and confidence, the contagion effect, if you will, similar to how traditional finance operates.
The DeFi community needs new ways to help manage risk to keep the multi-layered economy stable as these new tools mature, including insurance pools, altering collateral requirements, circuit breakers etc.
Outlook for the Future
In the future, Liquid Restaking Tokens (LRTs) may act as the security backbone of Web3: one particular pool of capital providing security to a multitude of decentralized services. This promise brings an unprecedented level of efficiency: ETH holders could earn from staking, validating, and verifying simultaneously across chains. But there is much composability with a great level of fragility. The more protocols are connected, the greater the potential systemic failure.
It will all come down to how future DeFi designs construct these re-staking systems with transparency, modularity, and isolation techniques. We can also be expected to see the emergence of new ideas around tokenizing risk, where markets could individually price and trade slashing risk similar to how credit default swaps work in banking. If LRTs can get it right out there, then we can imagine fundamentally changing where value moves around in DeFi through turning unused capital into a decentralized security being relied upon for the decentralized web.
Conclusion
This is much more than a technical battle of LSDs and LRTs; it gets at the clash between safe composability and aggressive efficacy. LSDs opened up liquidity in staking and became a mainstay among Ethereum DeFi projects. LRTs take that idea to the next level, whereby one ETH could protect several different systems and produce different streams of income concurrently.
To the individuals using DeFi, it is most important they understand what risk they can handle and what timeframe their mechanism will have some degree of reliability. Individuals that want something steadfast and that works with a lot of other things will prefer LSDs. LRTs will be appealing to those who like a new idea and new levels of complexity and even the chance to make more money when they are working on a certain level of complexity.
What is clear in the quest for capital efficiency is that sustainable yield is about mastering risks not stacking on risks.
This article is contributed by an external writer: Razel Jade Hijastro.
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