From the stETH discount: stETH pricing, liquidity and risk

Recently, rumors of the insolvency of the well-known lending platform Celsius have been rampant, and Celsius and other large institutions in crisis have sold assets to raise funds, triggering a decoupling of stETH prices. At present, the exchange rate between stETH and ETH on Curve is roughly maintained at around 0.937. The decoupling of stETH from the price of ETH has caused panic in the market. Some people worry that stETH will follow the footsteps of UST, and the price will fall into a death spiral.

So, what exactly is Celsius’ massive stETH holding? Is the price of stETH at risk of a death spiral?

In order to understand these, let’s first understand the generation mechanism of stETH.

What is stETH? What is Lido?

stETH is a pledge certificate generated by users who pledge ETH through the Lido protocol and participate in the POS of the Ethereum network. Lido is a decentralized, non-custodial staking protocol.

Ethereum will complete the upgrade and merge from POW to POS this year. Before that, a part of the pledged ETH is needed to ensure the security of the network, and the on-chain pledge can obtain certain pledge rewards. After the network is merged, this part of ETH can be withdrawn.

For ordinary users, if they want to directly participate in POS, they will face many restrictions, such as the threshold of the number of pledges (the Ethereum chain needs to pledge at least 32 ETH), the technical threshold and hardware cost of becoming a verification node, and the opportunity cost and cost of pledge locking. Lack of liquidity (users cannot withdraw staked ETH until the mainnet merge is complete).

In order to solve these problems, Lido Protocol has launched a pledge liquidity solution to provide users with pledge services that are easy to operate and can improve capital efficiency. Users can pledge any amount of ETH in Lido to participate in the POS process of Ethereum, receive the voucher stETH, and get the pledge reward (issued in the form of stETH). After Ethereum transitions from POW to POS and realizes the merger (Ethereum 2.0), stETH can be exchanged for ETH at a ratio of 1:1.

How Lido works

The roles involved in Lido mainly include users (Depositor, pledger) and node operator (Validator node operator, verifier). Users delegate the pledged assets to node operators through Lido’s smart contracts.

From the stETH discount: stETH pricing, liquidity and risk

The node operator is responsible for the actual staking work on the chain in the staking agreement, while the user accesses the staking assets and mints or burns the st assets through the staking pool contract.

The pledge pool contract allocates the assets in the pool to the node operator for actual on-chain pledge by verifying the node operator’s address and key, and is responsible for casting the pledge reward into st assets, which are distributed proportionally to the node operator and the Lido Dao treasury and pledgers.

Reasons for the stETH discount

After understanding the generation mechanism of stETH, let’s take a look at why stETH has a discount.

The main reasons for the discount of stETH are:

Compared with ETH, the liquidity of stETH is far from insufficient. In order to make up for this part of the liquidity cost, a discount is generated;

At present, institutions that hold a large number of stETH urgently need to sell stETH in their hands to obtain funds to deal with user withdrawals or supplementary margins to prevent collateral from being liquidated. In the face of huge selling pressure, stETH will inevitably generate further discounts;

Whether Ethereum can merge successfully and on time determines the time when stETH finally obtains ETH liquidity;

Risks of Lido Protocol and Smart Contracts.

Let’s look at it one by one.

The first is the liquidity of stETH.

There are about 12.8 million ETHs pledged on Ethereum, of which about 4.1 million are pledged through Lido, accounting for 32% of the total.

As can be seen from the above introduction, before the implementation of Ethereum 2.0, this part of the ETH pledged by users is not redeemable, and users can only mortgage the stETH held on some DeFi platforms to obtain liquidity, or in the secondary market. Sell ​​stETH.

According to Messari data, as of the end of May, the stETH in circulation was mainly concentrated in the two protocols Aave and Curve, which accounted for two-thirds of the total circulation.

From the stETH discount: stETH pricing, liquidity and risk

For stETH holders who want to sell, the decentralized exchange Curve provides a stETH-ETH liquidity pool where stakers can convert stETH to ETH. Curve’s liquidity pool is currently the market with the best stETH depth in the Dex platform.

However, after entering June, as the price of ETH plummeted, a large amount of liquidity was withdrawn from Curve’s liquidity pool. From May 18th to June 21st, the liquidity of the pool increased from 1.7 billion. The dollar fell to $670 million.

At the same time, more and more stETH is being converted into ETH, resulting in a serious imbalance in the ratio of the two assets in the pool, even reaching the ratio of stETH:ETH=80%:20%.

As of today, there are only about 120,000 ETH in the pool, which means that it can only accept a maximum of 120,000 stETH sell orders (equivalent to USD 133 million). A month ago, the number was 290,000. But know that Celsius alone holds more than 450,000 stETH in Aave. With Curve’s pool alone, it may be difficult to absorb the demand for stETH to be sold in the market.

May 18, 2022:

From the stETH discount: stETH pricing, liquidity and risk

June 21, 2022:

From the stETH discount: stETH pricing, liquidity and risk

As for centralized exchanges, the trading depth is even more negligible. FTX is currently the only centralized exchange that can trade stETH. According to data on Kaiko’s website, in 2022, about 98.5% of stETH’s trading volume will take place on Curve, with almost negligible liquidity on other platforms.

From the stETH discount: stETH pricing, liquidity and risk

When the open market sale is not an option, securing funds through collateral is another option. According to on-chain data, both Celsius and Amber have recently sent large amounts of stETH to FTX addresses.

At the same time, the number of open contracts of FTX increased significantly, and at the same time, the number of open contracts of exchanges such as Binance and Okex decreased due to the plummeting market.

Therefore, a reasonable guess is that Celsius and Amber mortgaged a large amount of stETH or sold it to FTX through over-the-counter transactions. At the same time, FTX hedged the price of this part of stETH by opening a contract to reduce the risk of holding.

From the stETH discount: stETH pricing, liquidity and risk

After looking at the liquidity situation in the market, let’s look at short-term supply and demand.

In the bull market, many institutions holding stETH choose to carry out circular pledge to increase the scale of assets and improve capital efficiency. They pledged stETH on Aave and other platforms to exchange ETH, and then pledged borrowed ETH on Lido to obtain stETH. When the market is rising, there is no problem with this approach, the institution will keep holding it, and the exchange rate between stETH and ETH can remain stable.

From the stETH discount: stETH pricing, liquidity and risk

But when a bear market hits, the pattern becomes problematic. The continuous decline in the value of collateral assets will trigger the requirement of supplementary margin, forcing institutions to sell their assets in exchange for funds.

A large amount of selling demand in a short period of time will have the effect of a run.

From the data on the chain, among the institutional investors of stETH, at least Sanjian, Alameda Research (founded by SBF), Amber and Celsius have sold off recently. The amount of stETH held by smart money addresses on the chain also dropped from 160,000 to 27,800 within a month.

From the stETH discount: stETH pricing, liquidity and risk

A large number of selling orders have been accumulated in a short period of time, and the buying orders have not kept up. The lack of depth caused the market to be smashed through, so further discounts occurred.

Another risk is the Ethereum merger delay.

stETH is a derivative of ETH. To a certain extent, it is similar to ETH futures, because the pledged ETH can only be withdrawn at a certain point in the future, which is after the completion of the merger of the Ethereum network.

If the network merger is delayed, it means the withdrawal of ETH will be delayed, which will further deteriorate the liquidity and the price of stETH will be lower.

The last layer of risk comes from Lido’s smart contracts themselves.

The Lido protocol involves several major contracts such as node operator registration contract, pledge pool contract, Lido Oracle, etc., which control node access, pledge asset access, pledge pool balance calculation and other processes respectively. The security of the contract will undoubtedly also affect To the security of the assets pledged by users. In order to make up for this part of the risk, stETH will also generate a discount.

To sum up the above, it is not surprising that stETH has a discount due to poor liquidity, insufficient buying orders, large and urgent demand for sales, coupled with the uncertainty of the Ethereum network upgrade and the risk of Lido protocol smart contracts.

So the final question is, will the price of stETH fall into a death spiral?

The author thinks not. It can be seen from the mechanism of stETH that its source of value is different from the design of mutual empowerment between UST and LUNA. The fall of Luna will drive the fall of UST, forming a negative feedback. As a stable currency, UST essentially does not have enough collateral to support its value.

However, stETH has strong value support. After the merger of Ethereum, 1 stETH can be exchanged for 1 ETH fixedly. This essentially guarantees the value of stETH, distinguishing it from under-collateralized stablecoins.

Although in the short term, due to the lack of liquidity, stETH and ETH prices have de-pegged, but for long-term ETH-based investors who are not in urgent need of funds, it is very cost-effective to buy stETH at a discount and hold until ETH is unlocked.

Therefore, when the discount reaches a certain level, it will inevitably attract arbitrageurs to enter the market, and then the buying and selling orders will rebalance. When the deleveraging process is completed, speculative players are eliminated, and stETH is back in the hands of long-term investors, I believe its price can also get back on track.

Posted by:CoinYuppie,Reprinted with attribution to:
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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