An Exciting June – ETF Applications and Eigenlayer Innovation
June 2023 Commentary
What a dramatic turnaround in the sentiment towards bitcoin we’ve witnessed in June! In early June, the SEC charged Binance with a series of securities law violations, including the commingling of customers’ assets and the unregistered trading of certain digital assets and lending products. The next day, the SEC also charged Coinbase for “operating its crypto asset trading platform as an unregistered national securities exchange, broker, and clearing agency”.
This was enough to put a damper on the market. After notching gains to top the $30,000 level back in mid-April, bitcoin eased to just below $25,000 by mid-June. Interestingly, in both lawsuits, the SEC provided a list of a dozen or so indicative “crypto asset securities” that, astute readers were quick to note, did not include bitcoin or ether. While bitcoin pulled back around 7% by the middle of the month, assets that were listed didn’t fare as well. Cardano, for example, dropped by 28% over the same time period.
Spot Bitcoin ETF Applications
It's often said that a year in the digital assets market is like a dog year, given the speed of changes. June was no exception. Emboldened perhaps by bitcoin not being listed by the SEC as a cryptoasset security, various institutional asset managers in mid-June submitted their respective applications for their physical bitcoin ETFs/ETPs. Leading the pack was Blackrock, the world’s foremost asset manager with over $9 trillion of assets under management. This news was enough to cause bitcoin investors to pull their BTC off centralized exchanges after June 15, a potentially bullish indication as it reduces the supply of BTC available for trading.
Source: Glassnode, as of June 23
Altogether, the excitement pushed the price of bitcoin up by over 12% for June, far better than ETH which rose a mere 3%, and significantly better than some of the Alt-L1s such as cardano (ADA) which actually dropped over 22% for the month as it remains under the cloud of being labeled as security by the SEC.
Protocol Innovation – the Eigenlayer
ETF applications from TradFi asset managers based on spot BTC (and presumably ETH in the near future) are a significant step for institutional adoption of digital assets into investment portfolios. These new ETFs will generally be better products than ETFs based on BTC or ETH futures. They avoid the roll costs associated with futures products, clarify the role of the custodian, and help to establish benchmark pricing across what has been fractured liquidity.
What has been equally exciting in Web 3 has been protocol innovation, and the conversations that have been heating up over this past month around Eigenlayer for the Ethereum chain. Its founder Sreeram Kannan, an Associate Professor at the University of Washington, led a series of discussions across various venues including Bankless and a16z, a venture capital firm, to describe and discuss the benefits of Eigenlayer.
In summary, Eigenlayer is a smart contract that enables a validator to re-stake their staked ETH, thereby incurring additional slashing risk, for the purpose providing trust to any new middleware service, and for which the validator receives an additional reward for that validation service.
So what’s the big deal?
If you recall, from our discussion about Layers and Bridges, blockchain/Alt-L1 developers have been trying to tackle the blockchain trilemma of simultaneously improving the chain’s scalability, security, and decentralization. Over the last few years, several chains have launched but hardly any one of these have been able to unseat the dominance of Bitcoin and Ethereum. If you also recall, from the same discussion, the core components of a chain consist of the data model, the execution engine, and the consensus mechanism. Each Alt-L1 tweaks the characteristics of scalability, security, and decentralization to make its chain “better” fit for purpose and issues its own token.
According to Dr. Kannan, token issuance is an inefficient use of capital. In addition to solving the technological challenges, the innovators need to create crypto-economic incentives to bootstrap the adoption and trust in the new chain. Eigenlayer, he proposes, obviates the need to create new crypto-economics with a new token, and by doing so, it will usher a new era for permissionless innovation at the core layer of the blockchain. This is no small claim!
Eigenlayer achieves this by allowing Ethereum validators to re-commit their staked assets in a Proof-of-Stake consensus (PoS) to further validate the transactions or outputs for middleware services such as a bridge (e.g., verify wrapped assets on a bridge are properly collateralized by an appropriate amount of underlying assets) or an oracle (e.g., verify exogenously sourced spot prices brought to a derivatives exchange are indeed correct prices). There is no new token to own; validators commit the ETH that they have already staked. If they act in bad faith, their ETH, or a portion thereof, will be slashed. The cost of attacking a small service is no longer limited by the token value of the service itself but has massively expanded to the cost of attacking the main Ethereum chain. If validators act in good faith, they receive additional rewards on top of the amount that they are already receiving for validating the Ethereum chain itself.
Too good to be true?
Discussions about using the same asset to provide trust for another protocol eerily sounds like rehypothecating the same collateral to secure trust for derivative contracts in the TradFi markets. Noted that while we are not talking about financial obligations here, the general idea of leveraging the same foundation to build increasingly larger structures offers a promise for growth in the beginning but risks strains when unforeseen circumstances later arise. For example, this equally applies to an urban transportation network built on top of an infrastructure that hasn’t been commensurately upgraded.
Indeed, the Ethereum Foundation has been vocal about their concerns. Vitalik Buterin penned an article, “Don’t Overload Ethereum’s Consensus”. In it, he warns, ”[a] blockchain's "purity", in the sense of it being a purely mathematical construct that attempts to come to consensus only on purely mathematical things, is a huge advantage. As soon as a blockchain tries to "hook in" to the outside world, the outside world's conflicts start to impact on the blockchain too.” More generally, he added, “Any expansion of the "duties" of Ethereum's consensus increases the costs, complexities and risks of running a validator. Validators become required to take on the human effort of paying attention and running and updating additional software to make sure that they are acting correctly according to whatever other protocols are being introduced.”
These concerns were large enough such that members of the Ethereum Foundation, Dr. Kannan, and a young but brilliant and insightful intern gathered on Bankless to discuss Restaking Alignment at the end of June. One of the key takeaways was that restaking is neither categorically good nor bad. It has the potential of providing capital efficiency and offering extra yield for validators while providing trust for new services to enable permissionless innovation at the core level of the blockchain. However, it remains too early to understand its complexities and ramifications on key issues such as the impact from aligning the crypto-economic incentives between the middleware and the chain, on the chain’s decentralization and neutrality characteristics. “Social norms” of acceptable behaviors will need to be adopted and evolved as the use cases reveal themselves and expand.
Used wisely, leveraging existing assets does promote valuable growth. Borrowing against one’s home to pay for a child’s education is typically an investment that pays future dividends. Pooling security resources across nations into alliances offers smaller nations more defense than what they can afford by themselves and larger nations the reach that they may not otherwise have. Restaking, as introduced by Eigenlayer, does indeed offer the potential to promote innovation without the need for the services to spend on the capital costs of issuing new tokens for consensus. However, as with any leverage, one needs to be sure that one is building or acquiring an asset and not just a boondoggle.