Former Lido employee talks about stETH decoupling

I apologize in advance for the plethora of mistakes. Before starting, I would like to make a proper note.

First of all, none of this is financial investment advice, as I am not qualified to give financial investment advice and I am not actually qualified to do anything. They’re just my thoughts, not my employer’s because I don’t have an employer – probably because of my lack of qualifications.

Second, I previously helped build Lido, which is a subject in this article. I don’t work for Lido now, and certainly not writing this article on Lido’s behalf. Did write for Liao before. I have not worked at Liao for over a year. I’m too lazy to even show this thread to those who work at Liao – mostly because I’m too lazy to edit it if they find something wrong.

Finally – I have some LDO, and some ETH, and some stETH. So it’s quite possible that I’m very biased and have bad views on this topic, and you can ignore those views. But I do try to be as impartial as possible because this article succeeds when you find the right answer, not repeating the wrong answer to a lot of people on the internet. Still, I’m a hopeless person, so I’ll have many flaws.

Slow down, Cobie, what is Lido?

Here’s my October 2020 blog post on what Lido should be: Introduction to Lido.

In short, it is a coordination protocol for ETH staking. It’s a staking pool, you stake ETH and it gives you tokenized ETH.

You pledge 1 ETH, and Lido will give you 1 stETH back. Your ETH is staked via Lido with a validator selected from a set of node operators. ETH is rewarded for staking, and your stETH balance is automatically changed to match that beacon chain balance.

After the ETH developers finally roll out the merger and the ensuing fork, stETH will be able to “unstake” and the underlying ETH can be redeemed.

Since Ethereum designed their staking a bit oddly, and with the launch of the Beacon Chain in late 2020 (but there is still no concrete merger date), Lido has become very popular. For users, this is the most common way to stake ETH.

Do you understand? Well, go ahead.

stETH “pegged”?

For most of stETH’s lifespan, it traded close enough to ETH to a ratio of 1:1.

The first few months of stETH’s life cycle were very volatile, with prices ranging from 0.92 to 1.02 ETH per stETH. As liquidity increases, the stETH/ETH pair becomes less interesting over time.

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Then UST “decoupled”, Luna crashed, and stETH took some contagious hits. Since then, the price of ethereum has fallen by around 50% — in fact, ethereum has been falling for the last ten weeks.

Perhaps because it is the closest price trading pair in history (and perhaps because “pegging” is the latest PTSD hot topic after UST), people mistakenly believe that stETH is “pegged” to ETH. Of course, this is not true.

stETH is not pegged to ETH and does not need to be traded 1:1 with ETH for Lido (or stETH) to work. stETH trades at market prices based on demand/liquidity of staked ETH, not a simple peg.

Lido is not the only liquid staking protocol. A look at other less used and less liquid collateralized derivatives makes it clear that a 1:1 liquid collateral market is not what one would expect.

BETH on Binance:

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A ETHC by Ankr:

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These two collateralized derivatives work similarly to Lido. Ankr launched a little earlier than Lido, and Binance’s BETH launched a few months later. So they’ve been around for about the same amount of time.

As you can see, there are basically no “pegged” transactions during their lifetime. BETH price once dropped to 0.85 ETH. AEHC price once dropped to 0.80 ETH.

Collateralized derivatives are not stablecoins, or even “algorithmic stablecoins.” Some describe them as more akin to Greyscale’s GBTC, or a futures market with an unknown future delivery date. I also don’t know much about these comparisons. Fundamentally, it is tokenized ownership of locked collateral. The transaction price should be lower than the price at which it is locked in the underlying asset.

Redemption, arbitrage, and pricing staked ETH

By staking on Lido, you can instantly create 1 stETH with 1 ETH.

Therefore, stETH should never trade above 1 ETH. If stETH trades at 1.10 ETH at any point, a trader can simply mint 1 stETH for 1 ETH and sell it for 1.10 ETH – they can repeat this for easy profit until parity recovers.

This instant arbitrage opportunity is currently one-way.

ETH liquid collateral tokens (stETH, BETH, RETH, AETHC, etc.) cannot be redeemed until they are merged and tradable on eth2.

When the merger will happen is anyone’s guess. If I had to guess, I think it might be October of this year, but it’s also likely to be delayed until the end of the year or early next year. After merging, the fork of the state transition also needs to wait for a while. No one knows how long this will take, maybe 6 months after the merger.

Of course, there is a limit to the amount of ETH you can unstake at one time. If every ETH staked by any method was simultaneously unstaken, it could take more than a year to unstake the queue. .

After all of this, there will be arbitrage opportunities in both directions for liquid staking tokens. A trader can buy 1 stETH for 0.9 ETH, and exchange 1 stETH for 1 ETH, and repeat.

Still, even if this arbitrage route opens outside of an active bull market, the price of liquid staking tokens may still fall below 1:1. The fair price may depend on how much the buyer wants to earn in % vs. the risk of holding during the redemption/release period – during which the seller will weigh the impact of waiting for the release period against itself vs. the discount of an immediate sale .

Now, the lack of the current redemption path results in a liquidity discount.

In a bull market, the demand for ETH is high. Buying stETH at a small discount is attractive because traders can buy stETH for less than 1 ETH as a way to earn extra ETH. Also, the need for liquidity in a bull market is low. There is less selling pressure on stETH as investors are happy to hold their yield-generating assets.

However, in a bear market, the demand for ETH disappears and the hunger for liquidity quickly manifests. Especially for assets that are typically highly reflexive, long-term demand has fallen sharply. More and more people want to exit their staked ETH positions, and long-term locked assets are less attractive than short-term ETH positions.

The stETH-to-ETH discount depends on how much liquidity existing stETH holders need, and how much demand there is to buy this collateralized ETH derivative at a discounted price.

Some of the larger whales have recently expressed their need for liquidity by exiting stETH.

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Of course, there are other factors as well. Discounted pricing already includes smart contract risk, governance risk, beacon chain risk, “will a merger happen?” risk, etc. While these risks are more “constant” than variables of buyer/seller demand, the way people assess their importance may change as market fears change.

Macro liquidity preference still appears to be the biggest variable, while sentiment about the merger has so far not been the dominant factor.

forced seller

While many focus on stETH price, most likely due to UST ptsd, I think stETH has the potential to be another story.

Now, perhaps the most noteworthy factor in the StETH discussion is: Who are the coerced sellers?

There appear to be several groups of sellers:

1.  Leveraged stakers

2.  Entities that need to process redemption deposits

The first group is identifiable on-chain.

leveraged stakers

Traders use Aave to “leverage-stake” ETH. The transaction looks like this:

1. Buy ETH

2. Stake ETH as stETH (or buy stETH on the market)

3. Deposit new stETH into Aave

4. Borrow ETH with this deposit

5. Stake the borrowed ETH as stETH

6. Repeat

Products like Instadapp (and others) turn this kind of trading into a “vault,” attracting massive deposits into leveraged stETH positions.

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Unless traders can provide more collateral for these positions, they are at risk of on-chain liquidation. At the same time, deleveraging these positions requires exchanging stETH for ETH, which helps with the pricing of stETH.

If their liquidation price is triggered, these forced sellers could cause the stETH price to drop significantly, which in turn triggers a lower liquidation price.

CeFi deposits withdrawals

The second set is a bit opaque.

There are rumors and on-chain research that entities like Celsius have so-called liquidity issues. Of course, since Celsius is a “CeFi” company, we can’t really understand their financial health or financial management strategy.

So it’s entirely speculative and it’s impossible to really know what’s going on inside Celsius.

But researchers speculate that the rate at which users are currently withdrawing money quickly outstrips the liquidity that Celsius has.

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There is also speculation about Celsius’ losses on DeFi. Celsius allegedly lost funds at StakeHound, Badger, and possibly Luna/UST.

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The research statement seems to be:

Celsius is said to use customer deposits for DeFi liquidity mining to provide yield. They may have lost some funds in the leak, in addition, they also staked a lot of ETH (both using Lido and staking ETH directly with illiquid staking node operators). This pledged ETH is illiquid and can last for 6 months, or just a little over a year.

And for Celsius, even liquid staking is illiquid because their position size is larger than the liquidity available to stETH.

To restore liquidity to user withdrawals, if Celsius is forced to sell stETH, this could be the event that triggers the liquidation waterfall. In fact, even fear of such an event can be a trigger.

Again, this is speculative. We don’t really know what Celsius’ actual financial position looks like, what tools they have access to, what customer liabilities they have, etc.

While it seems unlikely that Celsius will completely lose customer funds, it seems theoretically possible that Celsius will eventually have users requesting withdrawals, but Celsius has locked these assets on the beacon chain, and the unlock date appears to be extendable at a later date.

How Celsius handles this hypothetical situation may matter. If they raise debt against those pledged assets to pay off their customers, that might just delay them from becoming coerced sellers and ultimately make things worse.

So, who will be the victims ?

I’m not going to pretend to know what’s going to happen to the stETH price (or BETH, AETHC, RETH, etc.) in the future.

Instead, I’ll try to understand who the victim is in the worst-case scenario: imagine that Celsius fud (fud: fear, uncertainty, doubt) is accurate, while on-chain leveraged stakers are unable to post collateral, etc.

Who will be unlucky?

Celsius and Celsius depositors were clearly victims – either Celsius was unable to process withdrawals for everyone prior to the merger, or ended up selling at a low price and processing withdrawals prior to the merger inflicted considerable losses.

(Side note: If I were in this situation at Celsius, I would probably sell my stETH position on a private OTC (over the counter) at a considerable discount to save face and maintain some public confidence.)

Stakeholders on leveraged yield farms will obviously be out of luck as well, as if their positions are liquidated.

And anyone who wants to exit a stETH position before the beacon chain state transition will also be inconvenienced: if a trader or investor stakes ETH today (or buys “discounted” stETH today), and needs to wait 3 weeks or 3 months exit, it obviously does not guarantee that the price of stETH/ETH will be the same as their entry price.

Non-leveraged stETH holders who plan to exit by unstaking on the beacon chain are guaranteed the same price after all mergers etc., as each stETH has a 1:1 counterpart on the beacon chain ETH.

Is 1:1 redemption guaranteed ?

When Ethereum can be released after the merger, 1 stETH, 1 BETH, 1 ETHC, etc. can all be exchanged for 1 ETH. So, if you have 10 stETH today, you can get 10 ETH back when the Ethereum developers finally merge Ethereum.

But – what can stop this from becoming a reality? There are two main things:

1. Penalty – If you have 10 stETH today and the Lido validator has some penalty, this loss is averaged among stETH holders. stETH rebases upward through rewards and downward through punishment. Through some kind of penalty event, 10 stETH could become 9.5 stETH. I think it’s the same for Ankr. RocketPool requires validators to post additional collateral, so here is the difference.

2. Serious protocol bugs – If Lido, RocketPool, Ankr, or any of their providers have serious protocol bugs, then this may also have an impact on the redemption of their liquid collateral tokens.

Both of these things are possible because they happen all the time. But on beacon chains, penalties are rare, and I think most liquid staking protocols have carefully curated sets of validators.

Of course, the protocol has also been extensively audited – but I’m sure the defi vulnerability is as strong as it is to you, to me, to the ptsd of the audited protocol.

While these are all very real risks (one mild, one serious), both are unlikely in my opinion – and their risks have not increased or decreased over time.

There are also smaller risks such as Eth2 delivery risk (will the merger happen, will it happen soon?) and governance risk. But again, they didn’t increase or decrease substantially.

(Side note – if ETH2 never delivers, one can speculate on what will happen to the staked ETH. It may need to be recovered somehow through community consensus, as liquid staking derivatives only account for about 1/3 of all staked ETH, Every crypto company and exchange will be exposed to ETH staking in some way. This will be a bigger problem than just staking tokens.)

In any case, in addition to these risks, 1 liquid staking “ETH” from any liquid staking protocol can be exchanged for 1 liquid staking “ETH” when unstaking on Ethereum is possible, regardless of the market rate of stETH/ETH at the time ETH.

Towards a state transition

For those willing to accept the risk of smart contracts and validators, this situation presents an interesting opportunity: how long are traders willing to hold stETH for arbitrage redemption, and at what price will they enter?

Arbitrage may become more attractive as mergers and state transitions on the beacon chain get closer. Perceived price risk may be less due to shorter redemption times – but it will still largely depend on traders’ market sentiment towards USD prices.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/former-lido-employee-talks-about-steth-decoupling/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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