Alchemists of Decentralised Finance - Unpacking Risk in Liquid Staking and Re-staking
Financial Stability Risk within Decentralized Financial System BGIN Block #12
Key Takeaways:
Liquid staking and restaking create new forms of leverage and rehypothecation in DeFi
EigenLayer enables staked assets to secure multiple protocols simultaneously
Cascading failures across protocols could trigger system-wide instability
Slashing events in one protocol may affect multiple dependent services
Links between DeFi and traditional finance create potential contagion pathways
Building a House of Cards?
BGIN Block #12 in Tokyo examined the emerging complexity of liquid staking, restaking, and liquid restaking—sophisticated financial structures in DeFi that parallel traditional finance's leveraged products. As one participant noted:
"We're witnessing the birth of a new financial layer with both innovative capital efficiency and potential systemic risks that we don't fully understand yet."
The session brought together DeFi developers, traditional finance experts, and regulatory observers to explore how these mechanisms could impact financial stability both within cryptocurrency markets and beyond.
Deconstructing the New Financial Building Blocks
Liquid Staking: The Foundation
Liquid staking democratized Ethereum staking by removing the 32 ETH requirement, allowing:
Users to stake any amount of ETH through protocols like Lido
Receipt of liquid staking tokens (LSTs) like stETH that can be traded or used in DeFi
Participation in consensus while maintaining liquidity for the underlying asset
While this innovation increased capital efficiency, it also created the first layer of potential leverage. As one speaker explained:
"Liquid staking tokens represent a claim on staked ETH plus rewards, but they trade independently and can be used as collateral in lending markets—creating a form of rehypothecation unique to DeFi."
Restaking: Multiplying Security
EigenLayer took this concept further by introducing restaking, which:
Allows already-staked ETH to provide security for additional protocols
Lets validators (operators) secure multiple services simultaneously
Creates a network of interdependent security relationships
A participant explained the mechanism: "Operators in EigenLayer delegate their withdrawal credentials, essentially giving the protocol permission to enforce slashing across multiple services. This means their staked ETH can be penalized if they misbehave on any service they choose to secure."
This introduces a complex bipartite graph where operators connect to multiple Actively Validated Services (AVSs):
Sparse connections reduce overall security for individual AVSs
Dense connections increase the risk of cascading failures
Liquid Restaking: Compounding Complexity
The final layer, liquid restaking tokens (LRTs), compounds these risks:
Restaked positions themselves become tokenized and tradable
LRTs can be used as collateral in DeFi protocols, creating further leverage
Price fluctuations in LRTs could trigger liquidation cascades
Financial Engineering or Financial Risk?
The session presented a compelling simulation demonstrating how failures could propagate through the restaking network.
"If an operator misbehaves on one AVS and gets slashed, they lose ETH staked on Ethereum. This impacts their ability to secure other AVSs, potentially triggering a domino effect across the ecosystem," explained the presenter.
Key risk factors identified include:
Cascading Failures
A slashing event affecting one operator can spread to multiple AVSs, creating a chain reaction throughout the network. The simulation showed how even a small number of operator failures could significantly degrade security across the system.
Leverage Amplification
A study presented during the session estimated that leveraged staking strategies have an average multiplier of 3.5x—meaning many positions are significantly leveraged. This creates fragility similar to over-leveraged positions in traditional finance.
Correlation Risks
Participants debated whether slashing events would remain idiosyncratic or could become correlated under stress scenarios:
"While slashing is tied to specific misbehavior, we shouldn't discount the possibility of infrastructure failures affecting multiple operators simultaneously," noted one participant. "Remember how mortgage defaults were considered uncorrelated until they weren't in 2008."
Bridging to Traditional Finance
Perhaps most concerning was the discussion about how these risks might propagate beyond DeFi into traditional finance:
ETH ETFs and institutional staking services could expose traditional investors to underlying DeFi risks
Banks and investment funds with DeFi exposure could face unexpected losses
Market turbulence in LST prices could trigger broader cryptocurrency market volatility
"The challenge is that many traditional financial institutions considering crypto exposure don't fully understand these stacked risks," observed a financial stability expert. "We need to map these connections clearly before they become systemically significant."
TradFi Parallels and Lessons
The session drew several parallels to traditional finance:
Rehypothecation Risks
The reuse of LSTs as collateral mirrors rehypothecation in traditional securities lending, where the same asset is pledged multiple times, creating opaque chains of ownership and risk.
Clearing House Function
EigenLayer functions similar to a clearing house by mediating slashing and enforcing penalties, but without the same regulatory oversight or capital requirements.
Risk Measurement Challenges
As with complex derivatives before 2008, quantifying risks in these new structures is challenging due to:
Limited historical data on slashing events
Unclear correlation patterns between different protocols
Off-chain governance decisions that can change parameters unpredictably
Governance and Risk Mitigation
The session revealed limited existing guardrails against these risks:
"The Ethereum Foundation reportedly considered protocol changes to restrict smart contracts as withdrawal addresses, which would have limited EigenLayer's capabilities, but ultimately took no action," noted one participant.
This hands-off approach raises questions about who, if anyone, is responsible for systemic risk management in DeFi. Some potential risk mitigation approaches discussed included:
Protocol-level caps on collateralization ratios
Circuit breakers in lending markets using LSTs as collateral
Transparency requirements for operators in restaking systems
Stress testing of interdependent protocol networks
The Research Frontier
The session concluded with calls for deeper research in several key areas:
Network Modeling: Better understanding how security and risk propagate through operator-AVS networks
Stress Testing: Developing scenarios to test the resilience of the restaking ecosystem
Early Warning Indicators: Identifying metrics that could signal building risks
Cross-Domain Risk Transfer: Mapping connections between DeFi and traditional finance
"We need cross-disciplinary collaboration between DeFi developers, financial economists, and risk managers to fully understand these new mechanisms," concluded the moderator. "This is precisely the kind of multi-stakeholder effort that BGIN was created to facilitate."
Get Involved
The financial stability working group within BGIN welcomes researchers and practitioners interested in exploring these issues further. The next phase of research will focus on quantifying risks in leveraged staking and mapping potential contagion channels.
This blog post is based on discussions from BGIN Block #12, Tokyo, Japan, March 3, 2025.
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