Liquidity Recollateralized Tokens or “LRTs” Revive Ethereum DeFi: Can the Hype Last?

In the past month alone, billions of dollars have poured into new Ethereum-based liquidity rehypothecation projects like Ether.Fi and Puffer. These emerging platforms are racing to replace Lido’s collateralized ETH (stETH) token as the asset of choice for decentralized finance (DeFi) traders.

At the heart of the whole trend is the development of a new protocol called EigenLayer, which debuted a new “re-hypothecation” system last June. The platform is building a solution that lets blockchain applications and networks borrow Ethereum’s security system, and it attracted more than $1 billion in new deposits in a 24-hour period this month. Now, the total is over $7 billion, which means the platform alone has accumulated more than 1.5% of all circulating ether (ETH), according to DefiLllama.

Re-collateralization provides a way to secure blockchain protocols and networks using security borrowed from Ethereum's proof-of-stake network. ETH deposits in EigenLayer can be "re-collateralized" into other protocols, meaning they don't have to build their own proof-of-stake network.

Investors have flocked to EigenLayer because it promises higher interest than traditional ETH staking. However, the platform’s recent growth is largely due to a group of third parties — “liquidity re-hypothecation protocols” such as Ether.Fi, Puffer, and Swell — that claim to simplify the re-hypothecation process on behalf of users.

These liquidity re-hypothecation platforms act as middlemen between users and EigenLayer: these platforms “re-hypothecate” users’ deposits to EigenLayer and deliver the corresponding newly generated LRT in exchange so that users can continue to trade even when their deposits are being re-hypothecated.

LRT represents a user's deposit in EigenLayer, which means they can accumulate collateral interest and can be redeemed back to their underlying value. LRT can also be used in DeFi , which means people can borrow and exchange LRT for greater returns.

In addition to the convenience of LRT, the real attraction of recent liquidity re-hypothecation platforms is "points" - rewards that may make users eligible for future token airdrops. While the monetary value of points is unclear, they have spawned a whole new ecosystem of add-on platforms, such as Pendle, which allows users to maximize points through trading strategies that often involve high leverage.

This complex points system, high-yield and high-risk trading strategies are reminiscent of the 2021 scene - "yield farms" and the pursuit of high returns triggered the boom and bust of DeFi , and the industry has not yet fully recovered. Although some experts are cautious about the risks of liquidity re-hypothecation, supporters of the technology insist that there is real substance beyond the hype.

1. Staking 101

Liquidity rehypothecation builds on two years of growth in the Ethereum staking industry.

Ethereum is operated by more than 900,000 validators, which are addresses where people around the world lock ETH tokens on the network to help secure the chain. The staked tokens accumulate stable interest, but once they are used to run the network, they cannot be used for other purposes, such as loans or other types of investments.

This limitation has led to the rise of “liquidity staking.” Services like Lido do staking on their behalf for users and give them “liquidity staking tokens” (LST) that represent their underlying deposits. Like Lido’s staking ETH (stETH) tokens, LSTs earn interest like regular staking ether (currently around 3%), but they can also be used in DeFi — meaning investors can borrow against these tokens to earn additional yield.

The liquidity staking industry has boomed over the past few years. Lido, the largest liquidity staking protocol to date, has over $25 billion in deposits. Its staking ETH (stETH) token often sees higher trading volumes than regular ETH in the largest lending protocols on the network.

2. From Liquidity Pledge to Liquidity Re-Pledge

Now, a similar trend towards liquid staking is taking off on EigenLayer, a high-profile new protocol that’s introducing re-staking to Ethereum.

“EigenLayer is basically building a tool that allows other networks to bootstrap using the security of Ethereum,” explained Austin King, CEO of Omni Labs, which is building a bridge protocol powered by recollateralization.

Investors have turned to EigenLayer to earn additional rewards on their ETH: interest earned for securing Ethereum, and re-staking interest earned for securing so-called AVS (Active Validation Service) that borrow Ethereum security using EigenLayer.

According to EigenLayer, those AVS will eventually include Celo, a layer-one blockchain that’s in the process of transforming into a layer-two network based on Ethereum; EigenDA, EigenLayer’s own data availability service; and Omni, which is building bridging infrastructure to help different blockchain networks communicate with each other.

But the system also has disadvantages, one of the key issues is that the tokens re-collateralized through EigenLayer cannot be used in DeFi after deposit . This locking mechanism is a major disadvantage for investors who want to maximize returns.

Therefore, liquidity re-hypothesis came into being, which is essentially liquidity staking designed for EigenLayer.

The Liquidity Re-Pledge Protocol accepts deposits (e.g. stETH), re-pledges through EigenLayer, and then issues “Liquidity Re-Pledge Tokens” such as pufETH, eETH, and rswETH, which can be used in DeFi to earn extra points and other rewards.

“Basically the value proposition of staking ETH is that you get the yield of staking ETH without having to go through the hassle of setting up a validator node. Not only that, but you get compensated for any rewards that come from these AVS networks,” the person explained.

3. Incentive games

Puffer’s pufETH, Ether.Fi’s eETH, Swell’s rswETH, and other Liquid Re-collateralized Tokens (LRTs) are competing with Lido’s stETH to become the next big asset in DeFi. To do this, they have turned to the current incentive model in DeFi: points.

Although EigenLayer has accepted billions in deposits, its AVSs have not yet been activated, which means that depositors have not received interest on their deposits. Currently, the main incentive for depositing tokens into EigenLayer is re-collateralization points, a vaguely defined count that investors hope will earn them future confirmed EigenLayer airdrops.

“EigenLayer hasn’t launched yet, it doesn’t have any re-hypothecation,” Amir Foruzani, CEO of Puffer Finance, noted in an interview with CoinDesk last month. “The only incentive they have right now is points and basically speculation on the future value of those points.” Major liquidity re-hypothecation protocols (including Puffer) have begun offering their own points as an additional incentive for early investors.

New services have also emerged around point swaps, promoting risky trading strategies that involve repeatedly staking the same token — increasing exposure to the protocol at the expense of higher future returns.

One of those protocols is Pendle, which splits the liquidity recollateralization token into two separate tokens — a yield token and a principal token — to unlock leveraged trading. One of Pendle’s products accepts deposits of Ether.Fi’s eETHToken and, according to the site’s ads, can earn 45x Ether.Fi points and 15x EigenLayer points.

While the points remain highly speculative, they appear to have had a positive impact on liquidity re-collateralization deposits. According to DeFiLlama data, market leader Ether.Fi now has $1.2 billion in deposits, five times what it was a month ago. Puffer Finance follows closely with $970 million in deposits, a 10-fold increase in the past three weeks alone.

4. Risk of punishment

The risks of this trend are growing as liquidity re-hypothecation deposits surge.

On the one hand, there are the general risks associated with EigenLayer that come with investing money in a complex system of layered protocols: as the complexity of the interconnected AVS network increases, errors will inevitably become more likely.

The biggest risk of these errors will be "punishment," where a staker is financially penalized for violating network rules or connecting to the network with faulty software. Liquidity re-pledge protocols often mention "anti-punishment" features in their marketing, but until AVS starts running, these promises will not be verified in practice.

In the context of EigenLayer re-collateralization, penalties occur at the AVS level: each AVS will set its own penalty rules, and liquidity re-collateralization providers will be able to choose the AVS protocol they want to validate for their users. If a liquidity re-collateralization platform chooses to validate a network with malicious (or flawed) penalty parameters, it will put users at risk of having their deposits slashed.

“We’re going to build similar reputation systems across the broader rehypothesis ecosystem,” Riad Wahby, CEO of key management services firm Cubist, predicted in an interview with CoinDesk. “If I’m going to put money into an operator, I’m likely going to choose one that gives me the right balance between risk and reward.”

5. Speculation Risk

The most obvious risk of liquidity rehypothecation is that, despite billions of dollars in deposits, the practice is currently highly speculative.

AVS may fail to provide depositors with the interest returns they expect, which could cause investors to leave the system in search of more profitable staking opportunities. Amid all the excitement about the Points, there is also some possibility that the accompanying airdrop may fail or never occur, rendering the Points and the new markets built on them virtually worthless.

The risk of this outcome is amplified because points are typically not issued on a blockchain but tracked directly by the issuer. This means it is difficult to know how many points of a particular type are in circulation, making it difficult to determine their value.

The speculative appeal of liquidity re-hypothecation points is reminiscent of the days of yield farms. In 2021-2022, when the DeFi industry reached its heyday, money poured into projects like Olympus and Terra, which promised to provide users with market-leading returns in exchange for trust in their complex systems. Critics accused these projects of creating worthless tokens and printing them recklessly to artificially prop up yield numbers, and these criticisms were ultimately proven correct after these platforms collapsed.

Whatever the superficial similarities, EigenLayer has entered the minds of ethereum developers in a way that yield farming’s worst actors never have, and proponents of liquidity rehypothecation say it has the potential to support the development of applications and infrastructure beyond the narrow realm of points and gamified speculation.