Research

Is the decoupling of Lidos staked ETH another stablecoin collapse

By   Marc Arjoon 16th June 2022

Introduction

Lido is a liquid staking service that allows users to stake ETH and receive a tokenised IOU in return called stETH. This allows users to reap the rewards of staking but still have access to a liquid asset. Lido’s stETH is the most popular liquid staking derivative and has roughly 1/3 of all staked ETH locked up in their contract. In recent months, the Ethereum community has become concerned over the amount of power that Lido has amassed, and the centralisation forces behind it. If a malicious actor controls 33% of staked ETH, then the repercussions could be detrimental, hence the controversy over these liquid staking services. Debates on the risks and rewards of such services have started to become more vibrant online yet no silver bullet solution has been offered.

Historical trading range

Looking back, Lido had the first mover’s advantage and launched in January 2021, one month after Ethereum released its staking implementation. The initial trading periodwas relatively volatile with stETH trading between 0.93 and 1.02 ETH and after a few months and more liquidity, stETH settled at approximately a 1:1 ratio with ETH. However, since the UST de-pegging in May 2022, stETH began trading at a ~2% discount and over the weekend stETH dropped to 0.94 ETH (6% discount) which has caused fears of a "bank run" and possibly a contagion among leveraged entities.


Locked collateral is not a peg

Unlike UST, stETH does not need to trade 1:1 to function correctly, but as Ethereum has not yet enabled withdrawals from staking there are currently no arbitrage opportunities to keep the price in check.

To clarify, this is not similar to the Terra crash as the underlying asset ETH is not directly affected by the market price of stETH so staked ETH continues to secure the network as intended. At this point, Lido’s product can be called premature due to the inability to un-stake making stETH feature incomplete.

Regardless, as stETH is redeemable 1:1 for ETH, it is the market makers (like Celsius) who may be forced to sell their holdings to satisfy redemptions since the underlying ETH is locked up with no withdrawal date in sight. It should be noted that the on-chain data shows that Celsius does indeed have enough assets to match the liabilities in the event that all stETH is redeemed but given the opaqueness of centralised entities this is not certain. Entities such as SwissBorg, BlockFi, Hodlnaut, Abra, Salt Lending and Nexo may also have to fulfil redemptions.

Risks

Although PTSD from UST de-peg is still fresh in the market's mind, it is arguable that stETH should trade at a discount to ETH due to the following:

  • Lido Smart Contract Risk
  • Risk of Liquidity
  • Risk related to Beacon Chain RoadMap
  • Time Horizon Risk

Based on the above, stETH should not trade at 1:1 with ETH on the secondary market.

Those with a long-term time horizon whose P&L are denominated in ETH may see this as a buying opportunity as stETH will eventually become redeemable 1:1 for ETH when withdrawals are enabled. However, those with shorter-term time horizons with USD denominated P&Ls probably need to exit their positions. Arbitrageurs may also be buying stETH at a discount and shorting ETH.

Downward pressure is also worsened by those market participants who have leveraged stETH with a limited time horizon and those at risk of margin calls. Furthermore, this narrative has materially depressed market sentiment as other cryptos have begun to sell-off in response to the fear, uncertainty and doubt.

Conclusion

The latest updates on Ethereum’s testnets have been positive which brings more confidence to those waiting on the Merge. So, when withdrawals are eventually enabled, any discount in stETH will likely be arbitraged away but until that unknown date arrives there will exist some form of discount. This decoupling event will prove to be costly for some and present buying opportunities for others. Either way, this will strengthen the call for regulation of lending platforms and the digital asset ecosystem in general.


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