Introduction
In the context of liquid restaking protocols like ether.fi, AVS allocation decisions are pivotal in shaping a stable source of revenue in the future and to minimize liquidity and slashing risks. However, the current lack of information regarding future slashing rules and reward distribution means that no quantifiable risk measures are available at this time. Nevertheless, there are several other risks associated with AVSs that have pass under the radar of the community.
Despite these uncertainties, it is imperative for ether.fi to minimize dependencies on specific NOs or AVSs. By ensuring a broad distribution of eETH across a diverse set of NOs and AVSs, ether.fi can significantly reduce the reputational risks associated with the failure of any single third-party provider. Such strategic diversification not only mitigates potential slashing risks but also contributes to a more stable and predictable income as soon as they are available.
Additionally, it is crucial to address liquidity constraints carefully. ether.fi must be cautious not to overcommit eETH for long periods, especially given the uncertainty around future returns, slashing conditions, and external incentives. These factors can lead to sudden shifts in the eETH market cap, which can heighten liquidity needs.
Chaos Labs has spent the last 4 weeks studying the AVS risk landscape as it exists today, to help guide ether.fi AVS allocation decisions.
The Risks and Potential Pitfalls Posed by AVS Allocation Decisions
Due to all the uncertainty around slashing, we will focus mostly on risks and potential pitfalls that can be studied and mitigated from the start. Nevertheless, we understand that will be the biggest quantifiable concern in the future, so we will start by addressing it.
Slashing
Slashing is a critical mechanism within staking protocols to ensure NOs act in the best interests of the network. The slashing design space is already very big by itself, and on top of that each AVS will be able to define its own rules. If there wasn’t enough unknowns already, pooled security will add a completely new layer of complexity.
- Complexities Introduced by Pooled Security: Since the collateral staked can provide security to several AVSs at the same time, it’s crucial for each restaking protocol to design a slashing mechanism that will never slash more than 100% of the total NO stake and that each AVS will stay secure at all time.
- Economic Security and AVS Longevity: While lenient slashing conditions may initially seem advantageous for AVSs as they could potentially attract more capital, the absence of effective slashing conditions undermines the economic security of the network, potentially jeopardizing the longevity of the AVS. Thus, while designing slashing rules, AVSs must carefully balance the need to secure the network with the desire to attract and retain capital.
- Impact of Inactive NOs due to slashing on AVS Commitments: The consequences of slashing extend beyond immediate financial penalties. For instance, a node operator might be forced to exit the platform, resulting in their capital being locked up for extended periods. This not only affects the liquidity of eETH liquidity but can also jeopardize financial commitments of the AVS, and possible rebalance strategies.
- Correlations and Systemic Risks: It is also crucial to consider that slashing events might not be isolated incidents. There may be correlations between the operations of different AVSs, the geographical locations of node operators, and the software they use. These factors can create systemic risks that might propagate through the network if multiple slashing events occur simultaneously or in close succession.
To mitigate the risks associated with slashing, a diversified approach to resource allocation is advisable. Spreading commitments across various NOs and AVSs can help cushion the impact of any single slashing event. Additionally, it is essential for all commitments and strategic decisions to be re-evaluated in the context of active slashing and reward mechanisms. This continuous review process ensures that the protocol can adapt to evolving risks and maintain a robust security posture.
Other Potential Pitfalls
When evaluating long-term commitments with AVSs there are several other key risks to consider:
- Opportunity cost: Locking assets into certain AVSs for extended periods may result in missed opportunities for better returns or the ability to onboard new, promising AVSs in different fields. Although it is possible to use the same capital to onboard new AVSs, it might increase ether.fi dependency on specific node operators, making it unfeasible from a risk perspective.
- Rebalancing Restrictions: Although intrinsically related to opportunity cost, rebalancing deserves its own emphasis. In portfolio theory, rebalancing is used to mitigate ruin risk and return volatility. While there is no current information about AVS performance/slashing correlations, stable returns are essential for a project of the size of ether.fi, even if it means marginally smaller returns.
- Liquidity constraints: Liquidity constraints are also a critical concern since stake committed for a long period can be needed for LRT redemptions. Exit liquidity on ether.fi is distributed in four different types: weETH liquidity in DEXs for initial shocks, the eETH liquidity pool for quick conversions, normal restaked ETH with a one-week unstaking period, and eETH in long-term contracts. So proper management is essential for smooth operations and risk mitigation.
- AVS reward token risk: Receiving rewards in different tokens can introduce price risk to the yield offered by an AVS. Token price risk can be difficult to quantify a priori, but certain desirable business model attributes can help manage reward token price risk.
- Attracting new node operators (NOs): Very specific AVSs may require very specific NOs, possibly putting ether.fi in a position where the protocol overly relies on them. This could result in higher costs and added higher dependency on a smaller set of NO.
- Centralization Risks: It’s important that the AVS is able to secure different types of collateral besides eETH. No collateral or NO should control more than the AVS-specific corruption threshold in order to not create trust issues. This should be taken into consideration when making long and bigger commitments. While this might be challenging initially, spreading the collateral over NOs from different companies can mitigate this problem.
In summary, while AVS allocation decisions are essential for the stability and growth of liquid restaking protocols, they must be made with a clear understanding of the associated risks and potential pitfalls. The long-term commitment required by the AVS should offer a premium that adequately compensates for the associated risks.
Mitigation Measures
Aside from liquidity risks and opportunity costs, the other potential pitfalls can be mitigated with a strategic distribution of stakes across AVSs and NOs.
To maintain a robust and resilient system, it is crucial to avoid reliance on any single AVS. Dependence on one AVS can lead to vulnerabilities, especially if long-term commitments end simultaneously or if slashing occurs due to malfunctions on the AVS, which can severely impact the peg of weETH and other commitments.
Minimizing reliance on a particular NO is equally important. While major slashes due to NO should be less common, their inactivity can significantly affect daily rewards. To maintain consistent rewards, ether.fi should ensure that the inactivity of any single NO does not significantly impact overall revenue.
What Makes a Good AVS in a Liquid Restaking Protocol
A robust AVS (Actively Validated Service) in a liquid restaking protocol must possess several key attributes to ensure stability, security, and profitability for LRTs. These attributes include:
- Sound Business Model: A reliable AVS should have a sustainable business model. This ensures a steady and trustworthy source of income for participants, and is a good predictor that native token rewards will retain their value.
- Support from Multiple NOs: An effective AVS should be backed by a broad array of node operators. This support enhances the protocol’s reliability, reduces the risk associated with dependency on a single operator, and decreases the risk of coalition attacks.
- Balanced Collateral or ETH Only: Maintaining balanced collateral is essential to mitigate risks and ensure the security of the staked assets. This balance diversifies the risk associated with collateral backing eETH. ETH is considered the only collateral that does not require diversification from a risk standpoint.
- Positive risk-reward: The delegation reward should adequately compensate restakers for the risks taken on. The primary risk comes from potential slashing, but there are other nuanced risks introduced by onboarding an AVS. Because neither rewards, or slashing is live we list this attribute last, but are keeping a close eye on how this develops in the future.
Benefits of A Well Considered AVS Onboarding Methodology
Onboarding multiple AVSs provides several immediate benefits and if done correctly will put ether.fi in a good position when rewards and slashing are active. Being an early adopter of multiple AVSs confers a first-mover advantage, and can help create strategic partners. On the technical side, will also help to collect valuable information about the performance of each AVS and NO, which can be crucial to mitigate unintended slashing in the future and will enable well-informed decisions when navigating higher-risk scenarios.
Next Steps
Chaos Labs has been working on applying the risks identified in this analysis to an actionable methodology for ether.fi. This methodology will empower the community to take a proactive stance towards the management of AVS risks in ether.fi, setting the protocol up for long-term success. We aim to publish this methodology by 4 August.
Future work will then focus on managing the risks of the LRT token, and everything contributing towards its ability to hold peg as tightly as possible.