In- depth analysis of stETH de-anchoring: a false alarm or another encryption crisis?

What is Lido?

Cobie wrote a blog post about Lido in October 2020:

In short, Lido is an autonomous staking pool that tokenizes the Ethereum staked by users.

When the user chooses to stake an Ethereum, Lido will choose a validator and will return a stETH in return. When this ETH obtains the pledge income, the stETH balance held by the user will automatically change to match the balance on the beacon chain. When the Ethereum staff finally announce the next steps, stETH will be automatically released, and the target will also be allowed to be redeemed.

The lack of Ethereum’s own pledge mechanism, the beacon chain that was launched at the end of 2020 but has no specific merger time, are the reasons why Lido is very popular. For users, Lido is undoubtedly the most popular way to stake Ethereum.

The “anchor” of stETH?

For most of its life cycle, stETH and ETH are basically a 1:1 exchange.

While it was quite volatile in the first few months – ranging from 0.92 to 1.02 ETH per stETH, the exchange ratio of stETH to ETH has become more stable as liquidity increases and over time.

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However, the later story is that UST de-pegged and LUNA collapsed, and stETH was also affected to a certain extent. Since then, the price of ethereum has fallen for almost 10 consecutive weeks, by about 50%.

Perhaps because the relatively stable 1:1 conversion ratio between stETH and ETH is unprecedented (or perhaps “pegging” has become a hot topic in ptsd after the UST crash), many people mistakenly believe that stETH is also pegged to ETH.

In fact, stETH is not strictly anchored to ETH, and a 1:1 conversion ratio is not a necessary requirement for Lido. stETH will actually be market priced based on the demand or liquidity of the pledged ETH, rather than a simple peg.

Lido is not the only liquid staking protocol. Judging from other pledge protocols with low utilization and poor liquidity, a liquidity market with a pledge ratio of 1:1 is impossible:

BETH on Binance:

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Ankr’s AETHC:

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The two staking derivatives work in a similar way to Lido, with Ankr launching before Lido and Binance’s BETH a few months later, so it’s fair to say they’ve been around for roughly the same time.

As the chart above shows, AETHC and BETH have basically never traded at an “anchor” price since their inception – BETH fell to as low as 0.85 ETH per BETH, and AETHC fell to 0.80 ETH.

Pledged derivatives are not stablecoins, not even the so-called “algorithmic stability”. Some see them as more akin to Gretscale’s GBTC, or to a futures market where future delivery dates are unknown. Fundamentally, they lock in collateral tokenized rights, which are expected to trade below the price of the underlying asset they lock in.

Reasonable pricing for redemption, arbitrage and staked ETH

Users can quickly mint a stETH on Lido by staking one ETH.

Because of this, stETH should not trade for more than 1 ETH. If stETH used to trade at 1.10 ETH, traders could simply mint 1 stETH for 1 ETH and sell it for 1.10 ETH – they arbitrage this repeatedly until parity is restored.

This “convenient” arbitrage opportunity is currently unrealistic in the other direction.

ETH liquid pledge tokens such as stETH, BETH, RETH, AETHC, etc. cannot be redeemed on eth2 that supports transactions after the merger.

However, the exact timing of the merger has not yet been determined, it may be in October this year, and the possibility of being pushed to the end of this year or early next year is not ruled out. The timing of state transitions and branch updates after the merge is also uncertain, and will largely take up to 6 months after the merge.

Of course, the amount of ETH that can be unstaken at one time is also a limiting factor. If the ETH pledged in various ways is released at the same time, the release team may wait for more than a year.

After all the dust settles, there will be a two-way arbitrage opportunity for liquid collateral currencies – traders can buy 1 stETH with 0.9 ETH, redeem with 1 ETH, and so on.

However, even in a bull market and the possibility of two-way arbitrage already exists, the price of liquid collateral tokens may still be lower than the price of the underlying asset. A reasonable pricing standard is actually a ratio that can effectively weigh the buyer’s risk of redemption/release pledge period against the potential benefits that this risk can bring, and the seller weighs the impact of the release pledge period on himself to determine whether to sell immediately. The dynamic equilibrium point that maximizes the benefits for the entire system.

For now, the lack of a redemption path has resulted in greatly reduced liquidity.

In a bull market, ETH is in high demand, and traders can buy stETH for less than 1ETH as a way to earn extra ETH, so buying stETH at a small discount is attractive. In addition, the demand for liquidity in a bull market is low, and investors are willing to hold assets that can bring returns, so stETH will not face relatively large selling pressure.

However, in a bear market, ETH demand is minimal and the need for liquidity increases rapidly. The demand for long-term holding of such “reflexive” assets has been greatly reduced, and more and more users will choose to sell their pledged ETH positions and prefer short-term holding of ETH.

The discount ratio between stETH and ETH actually represents the relationship between the demand for liquidity by stETH holders and the demand for buying collateralized ETH derivatives at a discount.

Meanwhile, some big players have expressed their near-term need for liquidity by exiting the stETH market.

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Of course, the determination of the discount rate is also subject to smart contract risk, governance risk, beacon chain risk, and whether a merger occurs. While these risks appear to be constants compared to variables such as the willingness of buyers and sellers to demand, people’s assessments of their importance also vary with concerns about market changes.

It appears that macro liquidity preference remains the biggest influencer, while views on mergers have so far been more of a less influential factor.

Who is selling?

While a lot of attention has been focused on the price of stETH due to UST ptsd, stETH has the potential to be a different story.

The most notable question in the stETH discussion right now is: who are the “fixed” sellers?

The answers seem to point to several groups:

  1. Leveraged stakers, identifiable from the chain
  2. Entities that need to process deposit redemptions

leveraged stakers

Investors use Aave to pledge ETH with leverage. The transaction process is as follows:

  1. buy ETH
  2. Stake ETH to mint stETH (or buy stETH on the market)
  3. Deposit new stETH into Aave
  4. Borrow ETH with this deposit
  5. Stake borrowed ETH and mint stETH
  6. Repeat the above operation

Instadapp and other similar products turned this transaction into a “treasury,” attracting sizable deposits to buy leveraged stETH positions.

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Unless traders can provide more collateral for these positions, they have an on-chain liquidation price. At the same time, if you want to deleverage, you need to sell stETH for ETH, which also helps the pricing of stETH.

If on-chain liquidation is triggered, this part of the selling pressure will naturally cause the price of stETH to drop.

CeFi deposit and withdrawal behavior

The second group is less transparent.

There are rumors and on-chain research that entities like Celsius have so-called liquidity problems. Of course, since Celsius is a “CeFi” company, its financial status or fund management strategy will not be fully disclosed.

So it’s all speculation, and it’s impossible for outsiders to really know what’s going on inside Celsius.

But researchers speculate that the current rate of user withdrawals will soon outpace the liquidity that Celsius has.

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There is also speculation about the loss of Celsius’ investment in DeFi. Celsius allegedly lost funds in StakeHound, Badger, and Luna/UST.

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Celsius allegedly used customer deposits to reinvest in DeFi to provide additional yield, during which time they may have lost money through omissions. In addition, they also cooperate with Lido and other illiquid mortgage node operators to mortgage large amounts of ETH, which is not liquid and may take half a year or even a year to redeem.

And for Celsius, even the so-called liquid pledge is not actually liquid because their position size is larger than the available liquidity of stETH.

If Celsius becomes a forced seller of stETH in order to restore liquidity for user withdrawals, this may be the trigger for multiple liquidations. In fact, fear of the event may also be the trigger.

Of course, these are all conjectures. Celsius’ actual financial position, instruments, and customer liabilities are not actually known to outsiders.

While it is unlikely that Celsius will lose customers’ funds entirely, it is theoretically possible for Celsius to end up in such a situation if the redemption date of the assets on the Beacon Chain is nowhere in sight when users request withdrawals.

The way Celsius handles this situation seems extraordinarily important. Using these locked assets to borrow money to repay customers only delays their time as “forced sellers” and makes things worse.

So, who are the “big grievances”?

It is not realistic to know the future price direction of stETH, BETH, AETHC, RETH now.

On the contrary, imagine if the Celsius scam is true, or if the leveraged pledgers on the chain have been unable to provide collateral, etc., then who will be the biggest loser?

Without a doubt, Celsius and its users. Celsius may not be able to process withdrawals for every user, or it may suffer considerable losses due to low-priced sell-offs to fill withdrawal holes before the merger.

PS: If you are from Celsius’ point of view, it may be a good choice to withdraw stETH in private OTC with an appropriate discount to save face and maintain credibility.

Leveraged people are also not immune to bad luck.

Likewise, anyone who wants to exit their stETH position before the state transition on the beacon chain will find it tricky. Just imagine that traders or investors who pledge ETH today (or buy stETH at a “discounted price” today) need to exit after 3 weeks or 3 months. Obviously, the ratio of stETH/ETH cannot be exactly the same as when they entered the market.

After the merger, since each stETH has the same amount of ETH exchanged on the beacon chain, the holders of stETH without leverage can exit the market directly by releasing the mortgage on the beacon chain, and will not suffer losses.

1:1 Is redemption guaranteed?

stETH, BETH, and AETHC can redeem ETH in equal proportions when the Ethereum merger is completed and can be redeemed.

However, there are two possibilities for breaking 1:1 redemption:

  • If you hold 10 stETH today and Lido’s validator is penalized, the losses incurred will be paid for by the stETH holder. For example, 10 stETH may depreciate to 9.5 stETH due to the penalty of the Slash mechanism. The same can happen on Ankr, however, since RocketPool requires validators to post additional collateral, the situation is different.
  • Fatal protocol bug – Whether it’s Lido, RocketPool, Ankr or any other staking pool, a fatal protocol bug could have an impact on their liquid staking protocol.

Although slash rarely occurs on the beacon chain, and most liquid staking protocols also have complete verification nodes, the occurrence of the above two small probability events cannot be ruled out.

Of course, the auditing process of the protocol is certainly very comprehensive – but what is certain is that the vast majority of people in the world probably have audited ptsd.

While these risks may be real, whether minor or severe, their probability of occurrence is extremely remote, and exposure does not change over time.

There are also some delivery risks such as eth2 (whether and when the merger occurs, etc.) and governance risks, which also have no substantial increase or decrease.

PS: If eth2 is not implemented, one might be able to speculate where the staked ETH will go. Since liquidity pledged derivatives only account for 1/3 of all pledged ETH, every cryptocurrency company and exchange has pledged ETH in some way, so it may require some kind of social consensus for final redemption, so to speak is a more complex issue than just talking about staking tokens.

In short, regardless of the above risks, and there is enough ETH to pay, no matter what the stETH/ETH ratio in the market is, the “*ETH” minted in any liquid pledge pool will eventually be redeemed at the price of 1ETH.

Market preferences are quietly changing

For those willing to accept the risk of smart contracts and validators, these situations will present an interesting opportunity. So, how long will traders be willing to hold stETH, and at what price will they be willing to enter?

Mergers and state transitions on the beacon chain may be triggered, and arbitrage will become more attractive. As the expiry date approaches, the perceived price risk is likely to decrease, although still much depends on traders’ sentiment on the dollar price.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/in-depth-analysis-of-steth-de-anchoring-a-false-alarm-or-another-encryption-crisis/
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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