Recovery Emerges as Ethereum's Second Largest DeFi Sector: Report

A recent report from Coinbase Research found that the rally has become the second largest sector of decentralized finance (DeFi) on ethereum.

He study highlights the EigenLayer recovery protocol as an important component for new services and middleware on the ethereum network, potentially offering significant eth rewards for validators in the future.

EigenLayer recovery protocol

ethereum's proof-of-stake (PoS) consensus mechanism is the largest economic security fund in the crypto space, with nearly $112 billion. While validators securing the network traditionally earned base rewards in locked eth, the introduction of Liquid Stake Tokens (LST) paved the way for participants to interact with DeFi by trading or leveraging their staked assets.

The EigenLayer recovery protocol, launched on the ethereum mainnet in June 2023, has grown rapidly to become the second-largest DeFi protocol in the ecosystem by total value locked (TVL), currently $12.4 billion.

This protocol allows validators to earn additional rewards by securing Actively Validated Services (AVS) by re-staking their staked eth and introducing a new revenue stream known as “security as a service.”

As EigenLayer prepares to launch its first AVS, EigenDA, early in Q2 '24, the ethereum community anticipates its potential benefits to the network. EigenDA's role as a data availability layer could impact layer 2 (L2) transactions, offering a modular solution to reduce fees and improve efficiency.

The report predicts EigenDA's initial earnings by comparing them to ethereum's blob storage expenses. Top Layer 2 solutions currently spend around 10 eth daily on blob transactions. If EigenDA experiences similar usage levels, the projected annual rewards of around 3.5k eth will amount to approximately 0.1% in additional profits.

Risks and complexities

While the introduction of AVS can strengthen the ethereum ecosystem, it also comes with challenges. Each AVS sets its own reduction conditions and claims, creating potential conflicts if multiple AVS are involved. EigenLayer's “shared security” model complicates matters further, allowing AVSs to customize their security with “attributable security”, creating a complex technical landscape for operators.

The introduction of Liquid Restoration Tokens (LRT) removes most of this complexity for token holders, which could lead to hidden risks. LRT providers may prioritize maximizing returns to gain market share, which could increase the risk profile. LRTs could also create downward selling pressure on non-eth AVS rewards if payments are made in eth, limiting the accumulation of value for buyback.

LRTs also carry valuation risks, with potential dislocations in their underlying value during periods of high bet withdrawals. Proper assessment of the collateral value of LRTs becomes crucial as changes in portfolio holdings or earnings of AVS could affect its risk profile. In extreme scenarios, failures in the recovery mechanism could threaten the ethereum consensus protocol.

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