“Seeing Yourself Through My Eyes” – Demot Kennedy, “Lost”
We have spent a significant amount of time studying the field of rehypothecation protocols at Reverie, as it is an attractive investment opportunity for us. This market is filled with uncertainty, which often presents opportunities in ambiguous markets, and it is highly active with dozens of projects set to launch in the rehypothecation space in the next 12 months.
During our exploration of the rehypothecation market, we have made some observations about its future development. Many aspects of the market are still emerging, so what holds true today may not be applicable tomorrow. Nevertheless, we wanted to share some preliminary insights into the business dynamics of the rehypothecation market.
LRTs as Leverage Support
Currently, LRTs (Liquidity Rehypothecation Tokens) like Etherfi/Renzo hold a strong position in the rehypothecation supply chain. They are well-positioned between the supply side (pledgers) and the demand side (AVS, or Active Validation Services), giving them an advantageous position in transactions. As a result, LRTs have the ability to (i) determine their fee structure and (ii) influence the fee structure of underlying markets like EigenLayer and Symbiotic. Given their strong position, we can expect the rehypothecation market to introduce first-party LRTs to control the power of third-party LRTs.
AVS/Pledgers as Leverage Support
The best markets have two characteristics: a decentralized supply side and a decentralized demand side. To understand this intuitively, it helps to consider the opposite scenario where either the supply side or the demand side (or both) is concentrated (AVS refers to Active Validation Nodes).
Imagine a simple market for trading apples, where the largest apple seller controls over 50% of the apple supply. In this case, if the market operator decides to increase the market fee from 5% to 10%, the large apple seller may threaten to take their business elsewhere.
Similarly, on the demand side, if the largest apple buyer controls over 50% of the apple demand, she can also threaten to use another market (or buy directly from apple suppliers) if the market operator increases the market fee.
Applying this to the rehypothecation market, if the market structure is concentrated on the AVS side (where the top 10% of AVS accounts for over 50% of the revenue) or the pledger side (where the top 10% of pledgers account for over 50% of the deposits), the natural outcome is a weakening of the market’s ability to charge fees (thus reducing the market’s valuation). While there is currently not enough data to rigorously validate this point, our intuition suggests that power laws will also apply here: large AVSs will account for the majority of total payment volume, giving them bargaining power over market fees.
Competition for Exclusive AVSs
From the perspective of each rehypothecation market, anything that can be done that competitors cannot do is worth trying. The simplest way to differentiate is by offering exclusive access to AVSs for pledgers, be it through first-party AVSs like EigenDA or through exclusive partnerships with third-party AVSs. This concept is similar to Sony developing exclusive games for PS5 to drive hardware sales.
Given these dynamics, we expect rehypothecation markets to take action, such as introducing more first-party AVSs or striking exclusive agreements with third-party AVSs. In short, we will see a battle for AVSs in the coming months.
AVS Subsidies
AVSs need to pay service fees to operators/pledgers, which effectively means AVSs need to have their local tokens, ETH/USDC, or potentially tokens/airdrops for consumption at operators/pledgers. However, since most AVSs currently are early-stage startups without tokens, large balance sheets, or well-designed points/airdrop programs, signing contracts with operators/pledgers is a cumbersome process (most EigenLayer partnerships are customized contracts negotiated privately).
In short, this creates a situation where there is demand for services from customers who may have good financial conditions but currently lack sufficient funds.
To facilitate business development, rehypothecation markets are likely to make upfront payments to operators/pledgers, which can be made in their local tokens, balance sheet assets, or by issuing “cloud points” for AVSs to spend at operators/pledgers. As a return for the prepayment, it is expected that AVSs will commit to a token airdrop or distribution to the rehypothecation market. Alternatively, the rehypothecation market can prepay the money to AVSs to convince them to choose their market over competitors.
In short, we expect intense competition among rehypothecation markets through subsidies to AVSs in the next 12 to 24 months. Similar to the market dynamics of Uber and Lyft, the market with the most funds/tokens is likely to emerge as the winner.
Personalized Guidance
From “I want to launch an AVS” to actually going into production is not as straightforward as it may seem, especially for small teams with limited R&D resources. Teams need to address questions like how much security to purchase, how long of a security commitment to make, how much to pay operators/pledgers, what to penalize, and how much to penalize.
Best practices will eventually emerge, but before that happens, rehypothecation markets will need to guide AVS teams hand in hand through these questions (note that EigenLayer currently does not have payment or penalty mechanisms).
For this reason, we expect winning rehypothecation markets to resemble enterprise sales businesses, providing integrated/service assistance for personalized guidance to customers in order to smoothly onboard their products.
Development of AVSs
The most successful AVSs may gradually move away from rehypothecation markets and start using their own tokens or income to purchase security. Today, the incentives provided by rehypothecation markets are most important for smaller-scale projects that do not have enough time, funds, brand, or network to recruit a set of validators. However, as projects grow in scale, they may shift towards recruiting their own validators and using their more valuable tokens to ensure network security. This transition is similar to the stages of market development, where the most successful customers gradually become independent, and market operators need to be prepared for this.
One-Stop Cryptographic SaaS
To illustrate this observation, let’s first look at some software history: cloud service providers like AWS have enabled developers to have easy access to everything they need to launch applications or network services (e.g., hosting, storage, and computing). This has led to a class of more specialized web services by significantly reducing the costs and time required to develop software. Cloud service providers combine first-party cloud services with a plethora of “microservices” offered within their platforms to become a one-stop shop for everything you need beyond core business logic.
Rehypothecation markets like EigenLayer aim to create a similar set of microservices for Web3. For example, before EigenLayer, cryptographic microservices could centralize their off-chain components entirely (and pass this risk onto their customers) or bear the cost of curating a set of operators and economic shares to purchase security.
Rehypothecation markets may disrupt this trade-off for microservices—if they work as expected, you will be able to prioritize security without sacrificing cost and market speed.
Let’s say you are developing a low-cost, high-performance zk-rollup. If you go to a rehypothecation market like EigenLayer, you will have multiple core service options, such as DA and bridging, for easy access. Through this process, you will see dozens of other AVS microservices that you can integrate with.
The more microservices rehypothecation markets offer, the better the customer experience—no longer needing to evaluate the service features and security of dozens of independent suppliers, applications will be able to purchase all the services they need from a single rehypothecation market. As a result, users may come for Service X but stay for Services Y and Z.
Some AVSs will have network effects (e.g., preconfs/pre-configured)
So far, rehypothecation use cases have mainly focused on exporting validators and economic shares from Ethereum. But there is another category of “inward” rehypothecation use cases that can enhance Ethereum’s consensus without requiring protocol changes.
The idea is simple—allow validators to opt into additional commitments on proposed blocks in exchange for payment and hold them accountable through penalties if they fail to fulfill these commitments. We suspect only a few commitment types will have enough demand to attract high levels of participation, but the value flowing through these commitment flows could be immense.
Unlike “external” rehypothecation use cases, the effectiveness of these use cases is directly tied to the participation of validators. In other words, even if you are willing to pay to be included in a block, it won’t be of much use if only 1 out of every 10 validators chooses to abide by that commitment.
But if every validator chooses a given commitment, then the guarantee behind it will be equivalent to the guarantee provided by the Ethereum protocol itself (i.e., valid blocks). Based on this logic, we can expect this category to have strong network effects as users of AVSs will benefit from marginal validators joining the commitment market.
While this category of AVSs is still in its early stages, the logical distribution channel for promoting these use cases may be through Ethereum client tooling and plugins (e.g., Reth). Similar to how proposers may outsource this work to specialized participants in exchange for revenue shares, it seems likely that proposers will outsource this work to specialized participants in exchange for revenue shares.
It is unclear what form these AVSs will take. While it is possible for a single entity to create a generic market for any type of commitment, we suspect it is more likely to see a few participants focused on specific sources of demand (e.g., interoperability-driven L2-to-L1 DeFi demand).
