It doesn't matter how many people can leverage a pool of capital through derivative extensions, only one person/protocol truly holds control of the value of the underlying asset, everyone else is just holding a debt they can't make claims on in a scenario where the system collapses.
The fun fact about this is that anyone in the chain of said derivative extension can hold the most influence over the value of the underlying asset, it just depends on how each of the systems are designed. Also, depending on each individual use of said derivative, there's also a scenario where none of these individuals hold the most influence, this is where the most influence goes to public market participants.
Now I know that this may be confusing so let me quickly give some examples.
If a protocol allows an address to stake ETH and get xETH — an example liquid staking derivative(LSD) — but imposes a slow unlocking mechanism for reclaiming the ETH, this makes the initial address the most disadvantaged in a case of a system collapse, especially if similar unlock limits are not enforced throughout the ecosystem in the various protocols that accept LSDs.
That said, a scenario where none of said LSD holders benefits is one where all systems have features such as one mentioned above. This causes the holders of these debt positions to be most disadvantaged because public market participants can more easily exploit any system collapse faster than they can get out of their risky investments.
Knowing this, it's crucial to understand that even though most of these processes of locking tokens for LSDs are handled by smart contracts when interacted with by qualifying addresses, this in no way eliminates the threat associated with a careless extension of liquidity, essentially debt because LSDs are fungible tokens with free-market trading pairs.
A flaw in the system at any point will result in another case of LUNA-UST.
This is because liquid staking derivatives — LSD tokens — are not inherently unique to individual blockchain addresses and depending on the direction of a crash, interacting with an on-chain contract may not be a necessary step to exploit a flaw in the system.
The solution to LSDs threat to DeFi’s liquidity is value haircuts
One of the crypto ecosystem’s most recent offerings is what's called liquid staking and restaking.
Liquid staking has to do with the ability to stake a token and still be able to use said token across the DeFi ecosystem. How this works is that the protocol to which you stake the original token creates and issues to you a derivative representation of your staked tokens which you can then use in whatever external DeFi protocol that accepts it for whatever purposes.
Truth is, the feature has always existed, but was never framed and adopted as of today because each staking tx always leads to a certificate of deposit token being created and issued to the staking address.
But let's move on. What then is Restaking?
Well, unlike liquid staking and its application across multiple DeFi protocols, Restaking appears to still be unique to Eigen Layer, the originators of the idea.
Restaking has to do with using an already staked token to secure secondary other chains.
The reason this is being discussed here is because both have to do with a derivative of a token that has already been committed to a protocol or chain.
To restake, you need to have already staked a specific asset, e.g ETH and received an LSD — the liquid token representing that staked ETH. The said LSD is what can then be restaked to secure secondary chains via Eigen Layer.
The problem?
Yes, these solutions definitely all sound super cool but the problem with all of them is that it enables the creation and extraction of more value than is attracted, externally.
A user can buy 1,000 ETH, stake to Lido, receive 1000 stETH, then restake that on Eigen Layer, securing multiple secondary chains.
What happens is that said user now earns yield from multiple sources without fresh capital injection, using just the initial 1,000 ETH.
This is bad because it can be repeated multiple times and multiple projects will only keep being born and creating more LSDs, some even atop of already existing LSDs, essentially further extending the debt owed back to the primary chain, which in this case is Ethereum.
It is debt because these values don't really exist beyond the stage it's being staked on Ethereum, and the only way the system works is if more people do the same.
Essentially, we are following the traditional finance playbook, which is absolutely a bad idea because look what shit we've got ourselves in now, no?
The solution is value haircuts and this can be based on underlying token market value(USD valuation) or direct on-chain token value — that is the very count of the token an address holds.
To explain, I'll use the latter because it would be the most effective for retaking.
If a user stakes 1,000 ETH and receives the LSD, the protocols that accept this LSD should have a value haircut on said token, maybe a 60-70% haircut, which means that the system only values the position for 600-700 ETH, even though the real convertable worth is 1,000 ETH.
If another protocol builds atop the above protocol, the haircut for the next protocol can be further lowered to 25-40%, because it is based on an LSD of another LSD.
By doing this, the cost of the debt uniquely declines as more protocols try to capitalize on the flexibility of capital through liquid staking.
This is a far more safe system to the zero haircut rule being used currently which creates a system that allows max value extraction with no limits or features set in place to combat risks of looping with LSDs in the mix.
This rule can be designed as a hard code(token contract) to ensure that it is enforced across mainnets, L2s and even App-chains.
At some point, we have to think about the risk of capital being reused multiple times to farm yields. It's a net negative for any ecosystem because not only does it enable max value extraction, it discourages further liquidity injection because users can achieve extensive levels of yields using little one-time investments.
We need active liquidity that isn't burdened by too much debt.
If we circle back to restaking, we can see how this is greatly beneficial to chains that use tokens like ETH and its LSDs for governance.
Haircuts create a situation where Ethereum validators cannot simply control(monopolize) every of these secondary chains(because this is what Eigen Layer is essentially doing) because ETH staked to these chains and the LSDs will not hold the same value.
1,000 ETH staked on Ethereum and its LSD being used to secure said chain would be valued at 600-700, whilst a fresh validator can directly stake said 1,000 ETH on the secondary chain and hold more governance influence.
At this point, the importance is greatly evident.