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Hello and welcome to the FT Cryptofinance newsletter. This week we look at a new, fast-growing trend in decentralized finance.

The excitement generated by the arrival this year of stock exchange funds investing directly in cryptocurrencies has obscured the rapid changes taking place in the world of decentralized finance, or DeFi.

The hottest event in the market right now is the emergence of EigenLayer, a new network that allows Ether cryptocurrency holders to simultaneously lend the same coin multiple times.

Underscoring its appeal, its Seattle-based parent company, Eigen Labs, in February raised $100 million from Andreessen Horowitz’s a16z, one of the most influential crypto venture capitalists.

The concept behind EigenLayer is “takeover”, a new concept for the crypto market. Currently, Ether holders can earn interest, in the form of more tokens, if they deposit or “stake” their Ether on Ethereum, allowing the system to secure and validate transactions on the blockchain.

They gain a reward for it, but it keeps their pieces locked and immobile. EigenLayer takes the staked ether and allows it to be reused in other applications also built on Ethereum, allowing them to earn additional yield in the process.

This may sound familiar. This is because, fundamentally, it is remortgaging, or the practice of lending the same asset over and over again. It’s a situation that global financial regulators have cracked down on since the collapse of Lehman Brothers in 2008, when it emerged that the U.S. bank had used collateral posted by its clients to help finance its own deals. It took years for clients to regain their assets.

In the world of cryptography, this vice turns into a virtue. Other services such as Lido Finance also remortgage assets but distribute tokens which represent the value of the ether staked.

The problem with EigenLayer is that it attempts to extend the security that underpins the Ethereum network to other applications also built on Ethereum. EigenLayer sits in the middle, connecting people who want to use their staked tokens to lend with the new apps being built. EigenLayer uses automated algorithms and smart contracts to manage the process.

The good thing about EigenLayer is that, at least in theory, it solves a major problem for the Ethereum network. Each application built on Ethereum must manage its own security with its own validation, making it a very inefficient, fragmented and expensive system that is difficult to scale. EigenLayer can help the network grow by leveraging the complex and efficient system that validates it.

Since a start in December, there are now just under 5 million ether coins, valued at $18.6 billion, locked up in EigenLayer, according to data provider DefiLlama. This makes it the second largest application in the DeFi market, between long-time players Lido with $36 billion and AAVE with $13 billion.

But in a research paper This week, Carol Alexander, a professor of finance at the University of Sussex in the United Kingdom, argued that the re-easing created a major new risk in the market.

She said the $18.6 billion figure was “vastly overestimated” because some figures had been counted multiple times. The real number supporting this activity is closer to two-thirds, she thinks.

This is important because, she said, each new application must rely on highly leveraged tokens with very little support in a small market.

The EigenLayer system is designed to punish bad actors such as hackers by confiscating a portion of staked tokens or deposits as a penalty. It relies on algorithms that unilaterally decide when malicious activity occurs.

This leaves the leveraged staking market exposed in the event of deliberate attacks aimed at stealing funds, if prices are manipulated, or if lenders simply have poorly coded algorithms, lenient borrowing standards, or risk controls. mediocre. And it’s all based on an ether IOU, she says.

“Because the vast majority of betting is done on Ethereum, any stress event. . . have the potential to spread credit contagion throughout the DeFi ecosystem, which could precipitate another DeFi winter,” she concluded.

Already the multiplication of layers makes you dizzy. Apps like Renzo have re-staked ether tokens onto EigenLayer – and created another token to represent that transaction. Apps like Renzo “take very significant credit risk,” Alexander warned.

This could lead to a cascade of liquidations in the market and the tokens could decouple from other tokens whose value they are supposed to track, she said.

It’s already arrived. The terra stablecoin collapse, which sparked the 2022 crypto market crash, began with ether tokens staked on the DeFi market and spread because the largest traders and lenders were linked to other markets.

However, some have argued that introducing application layers on top of staked ether constitutes a “financialization” of the Ethereum network.

Either it can be an open innovation protocol, more like a commodity, or it can be an investable asset that will generate a return for investors, said the head of research at a staking service that declined to be identified.

“It’s not really possible for them to do both. If you optimize ether as a financial asset. . . you encourage the creation of these types of layers and go further into the risk curve to maximize return.

Yet market demand is potentially pushing ether and ethereum to become an investable asset, just as U.S. lawmakers and financial regulators are leaning toward ether being a commodity.

If the Commodity Futures Trading Commission becomes the primary U.S. regulator for crypto, as expected, then the agency could find itself in a very deep hole when it pieces together the aftermath of the next stock market crash.

What do you think ? Send me an email to philip.stafford@ft.com

Highlights of the week

• Ryan Salame, former FTX executive has been condemned to more than seven years in prison after pleading guilty last year to charges of election fraud and conspiracy to operate an unlicensed money transfer business while at the crypto exchange bankrupt currency of Sam Bankman-Fried.

• BlackRock IBIT became the world’s largest Bitcoin exchange-traded fund even though it only launched in January. Its holdings of just under 300,000 bitcoins have surpassed those of Grayscale, even though its rival held more than 619,000 at the start of the year.

• Gemini Earn Loan Program Users get almost $2 billion of their crypto blocked at Genesis, following the bankruptcy of the digital asset trader in January 2023.

Soundbite of the week:

Elon Musk has dismissed reports he spoke to Donald Trump about digital assets. He wrote on his social media site X:

“I’m pretty sure I’ve never discussed crypto with Trump, even though I’m generally in favor of things that shift power from the government to the people, which crypto can do.”

Data mining: the rise of Ethena

Among the signs of growing optimism towards DeFi is the emergence of a stablecoin called Ethena. It is pegged to the ether cryptocurrency rather than the US dollar and offers buyers a 36% yield. Starting from zero in January, it is now the fourth largest stablecoin in the world, with almost $3 billion in circulation. Its supporters argue that it is entirely decentralized – tied to the price of ether, so there are no assets deposited in a bank. Instead, it uses derivatives to keep the value in balance. This week it surpassed First Digital USD, which has $5.29 in circulation and is now behind Dai, which has $5.3 billion in circulation.

Cryptofinance is edited by Laurence Fletcher. To view previous editions of the newsletter, click here.

Your comments are welcome.

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