Staking, pegging and other stuff
This will be short and I didn’t proof-read it so I’m sorry in advance for the plentiful errors. Before I start, want to make the proper disclosures.
Firstly, none of this is financial advice, because I’m not qualified to give financial advice, in fact I’m not really qualified to do anything. They are my personal thoughts, not those of my employer, because I do not have an employer — likely due to my lack of qualifications.
Secondly, I previously helped to build Lido, which is a topic within this post. I don’t work on Lido anymore, and am certainly not writing this on behalf of Lido. It was back in the early days that I contributed. I haven’t worked on it for well over a year and then some. I didn’t even bother showing this post to anyone that does work on Lido — mostly because I couldn’t be bothered changing the post if they noticed some errors.
And finally — I own some LDO, I own some ETH and I own some stETH. So it is very possible that I am very biased and my thoughts on this topic are bad and can be discarded. But I do strive to be as unbiased as possible because winning occurs when you find the right answer, rather than when you shout the wrong answer at a lot of people on the internet repeatedly. Still, I am hopelessly human and with that comes many flaws.
Cobie, please slow down, what is Lido?
Here’s the blog post I published in October 2020 about what Lido was supposed to be: Introducing Lido.
In short, it’s an opinionated coordination protocol for ETH staking. A staking pool, with a tokenized version of your staked ETH.
You stake 1 ETH, and Lido gives you 1 stETH in return. Your ETH is staked with a validator from a set of node operators that Lido chooses. As this ETH earns staking rewards, your stETH balances changes to match that beacon chain balance automatically.
After the ETH devs finally ship the merge and the fork that follows, stETH will be able to be “unstaked” and the underlying ETH can be redeemed.
Since Ethereum designed their staking a bit weird, and with the beacon chain launching in late 2020 but still no concrete date for the merge, Lido became very popular. For users, it’s the most popular way to stake ETH.
Got it? Alright.
stETH “peg”?
For the majority of its lifetime, stETH has traded near enough 1:1 with ETH.
The first few months of stETH’s life were very volatile, ranging from 0.92 to 1.02 ETH per stETH. As liquidity built up, the stETH/ETH pair got increasingly boring over time.
And then the UST depeg occurred, Luna collapsed, and stETH got hit with some contagion from that. Since then, the price of Ethereum is down around 50% — in fact, the last ten weekly candles for Ethereum are red.
Perhaps because of the historically tight trading pairing (and maybe because “pegs” are the latest ptsd hot topic post-UST) people mistakenly see stETH as “pegged” to ETH. Of course, this is not true.
stETH is not pegged to ETH, and it doesn’t require it to trade 1:1 to ETH for Lido (or stETH) to work. stETH trades at market price based on the demand/liquidity for staked ETH, or the lack thereof.
Lido is not the only liquid staking protocol. Taking a look at other, less utilized and less liquid staking derivatives shows quite clearly that a 1:1 liquid staking market is not expected:
Binance’s BETH:
Ankr’s AETHC:
Both of these staking derivatives work in a similar way to Lido. Ankr was launched a little bit before Lido, and Binance’s BETH was launched a few months afterwards. So they have existed for roughly the same amount of time.
And as you can see, neither has traded at “peg” basically ever in their lifetime. BETH dropped as low as 0.85 ETH per BETH. AETHC dropped down to 0.80 ETH.
Staking derivatives are not stablecoins, or even ‘algo-stables’. Some people are describing them as more similar to Greyscale’s GBTC, or to a futures market with an unknown future delivery date. I don’t really know about those comparisons either. Fundamentally, it is tokenised ownership of locked collateral. Trading below parity with its locked underlying asset should be expected.
Redemption, arbs & pricing staked ETH
You can instantly create 1 stETH with 1 ETH by staking it with Lido.
Because of this, stETH should never trade above 1 ETH. If stETH ever traded at 1.10 ETH, traders could simply mint 1 stETH with 1 ETH and sell it for 1.10 ETH — they could repeat this for easy profit until parity was restored.
This instant arbitrage opportunity does not currently exist in the other direction.
None of the ETH liquid staking tokens (stETH, BETH, RETH, AETHC, etc) can be redeemed until after the merge and after transactions are enabled on eth2.
When the merge happens is anybody’s guess. I would probably go for October this year if I were asked to bet, but it could easily get pushed to the end of the year or the start of next. Post-merge, there’s still the wait for a fork for state transitions too. Who knows how long that will take, it could be 6 months after the merge.
And then of course, there is a limit on how much ETH can unstake at a time. If every single ETH staked by any method all unstaked at once, the unstaking queue probably takes over a year.
After all that is done, liquid staking tokens will have the arbitrage opportunity in both directions. A trader could buy 1 stETH for 0.9 ETH, and redeem it for 1 ETH, and repeat.
Still, liquid staking tokens could still be priced below 1:1 even after this arb route opens up outside of a euphoric bull market. The fair price is likely to be a function of how much % gain buyers will want for the risk of holding through the redemption/unstaking period — where sellers will weigh up the implications of waiting the unbonding period for themselves vs. the discount from selling instantly.
Right now, the lack of current redemption path causes a liquidity discount.
In a bull market, demand for ETH is high. Buying stETH with a small discount is attractive, as traders can see buying stETH for sub 1 ETH as a way to earn extra ETH. Also, demand for liquidity in a bull market is lower. There is less selling pressure on stETH, since investors are happy holding their yield-bearing asset.
Yet, in a bear market, demand for ETH evaporates and desire for liquidity becomes quickly apparent. Long-term demand for these typically very reflexive assets in particular drops substantially. More people want to exit their staked ETH positions, and a long-time locked asset is less attractive than a short term ETH position.
The stETH discount to ETH will be a function of how much existing stETH holders need liquidity, vs demand for buying this staked ETH derivative at discounted prices.
And some larger players have been expressing their need for liquidity by exiting stETH recently.
Of course, there’s some other factors too. Discount can price in smart contract risk, governance risk, beacon chain risk, “will the merge happen?” risk, etc. While these risks are much more ‘constant’ than the variables of buyer/seller demand, how people evaluate their importance might change as fear in the markets changes too.
It still seems like the macro liquidity preference is the biggest variable, whereas sentiment regarding the merge was much more of a non-factor thus far.
Forced sellers
While many people are focusing on stETH price as the story, likely due to UST ptsd, I think it is possible that stETH is a symptom pointing to a different story.
The factor of stETH discussions that is probably most notable right now is: who are the forced sellers?
It appears there are a couple of groups:
Leveraged stakers
Entities that require processing deposit redemptions
The first group is identifiable on-chain.
Leveraged stakers
Traders used Aave to “leverage-stake” ETH. The trade looks something like this:
Buy ETH
Stake ETH as stETH (or buy stETH on market)
Deposit new stETH to Aave
Borrow ETH against this deposit
Stake this borrowed ETH as stETH
Repeat
Products like Instadapp (and others) turned this trade into a “vault”, attracting decently sized amounts of deposits into leveraged stETH positions.
Unless traders are able to supply more collateral to these positions, there exists on-chain liquidation prices for them. At the same time, deleveraging these positions requires selling stETH to ETH, which contributes to the pricing of stETH.
These forced sellers could contribute to the stETH price decline materially if their liquidations were triggered, cascading into the further lower liquidation triggers.
CeFi deposit withdrawals
The second group is a little bit more opaque.
There have been rumours and on-chain research that suggests entities like Celsius are having alleged liquidity issues. Of course, since Celsius is a “CeFi” company, we don’t really have a transparent picture of their financial position or treasury management strategy.
As a result, this is entirely speculative, and it’s impossible to really know what is happening internally at Celsius.
But researchers are speculating that the current pace of user withdrawals quickly exceeds the liquid funds that Celsius has.
There is also speculation about previous Celsius losses in DeFi. Celsius allegedly lost funds in StakeHound, Badger and possibly also in Luna/UST.
This research narrative seems to be:
Celsius allegedly used DeFi to yield farm with customer deposits, in order to provide yield. They perhaps lost some funds in exploits and, in addition, they staked a lot of ETH (both using Lido, and directly with non-liquid staking node operators). This staked ETH is illiquid, perhaps for 6 months, perhaps for just over another year.
And to Celsius, even the liquid staking is illiquid, since their position size is larger than the liquidity available for stETH.
If Celsius becomes a forced seller of stETH in order to recover liquidity for user withdrawals, this could perhaps be the event that triggers the liquidation cascade. In fact, even the fear of that event could be the trigger.
Again, this is speculative. We have no idea really what Celsius’ actual financial position is, what tools are available to them, what customer liabilities they have, and so on.
While it seems unlikely that Celsius has lost customer funds entirely, it does seem theoretically possible that Celsius could end up in a scenario where they have users requesting withdrawals, but Celsius has locked those assets on the beacon chain with a unlock date that seems to be continually extending into the future.
How Celsius handles this hypothetical situation could matter a lot. If they are raising debt against these staked assets in order to pay back customers, it might just be delaying their designation as a forced seller, and making the eventual event much worse.
So, who gets fucked?
I won’t pretend to know what happens in the future for stETH price (or BETH, AETHC, RETH and so on).
Instead, I will try to understand who gets fucked in a worst-case scenario: imagine that the Celsius fud is accurate, and the on-chain leveraged stakers can’t post collateral, etc.
Who gets fucked?
Celsius and Celsius depositors obviously get fucked — either they are unable to process withdrawals for everyone until post-merge, or Celsius ends up eating pretty sizeable losses by selling low to process withdrawals prior to merge.
(Side note: if I were Celsius in this alleged position, I would probably exit stETH positions in private OTC at a decent discount in order to save face and maintain some public confidence.)
Leveraged yield farming stakers also obviously get fucked as if their position is liquidated.
And anyone that wanted to exit their stETH position before state transitions on the beacon chain are also inconvenienced: if a trader or investor staked ETH today (or bought “discounted” stETH today) and needed to exit in 3 weeks, or 3 months, it is obviously not guaranteed that the stETH/ETH price would be the same as their entry.
Non-leveraged stETH holders that plan to exit via unstaking on the beacon chain after all the merge-and-etc activities are over are fine, as every stETH has a 1:1 corresponding ETH on the beacon chain.
Are 1:1 redemptions guaranteed?
1 stETH, 1 BETH, 1 AETHC, etc, can each be redeemed for 1 ETH when unstaking is possible on Ethereum post-merge. So, if you have 10 stETH today, you can get 10 ETH back when the eth devs finally do something.
But — what could stop that being true? Two primary things:
Slashing — if you have 10 stETH today and Lido validators experienced some slashing, that loss is socialised amongst stETH holders. stETH rebases upwards with rewards and downwards with slashing. 10 stETH could become 9.5 stETH with a slashing event of some kind. I think this is the same for Ankr. RocketPool requires validators to post additional collateral, so it’s different there.
Critical protocol bugs — if Lido, RocketPool, Ankr, or whoever, had a critical protocol bug, then it is possible that that could also have implications for the redemption of their liquid staking token.
Both of these things are possible, as they always have been. But slashing has been rare on the beacon chain, and well-curated validator sets exist with most liquid staking protocols I think.
Of course, protocols have also been audited extensively too — but am sure the defi exploit of audited protocol ptsd is as strong with you as it is with me.
While these are very real risks (one minor and one severe), both are quite unlikely in my opinion — and the risk of them has not increased or decreased over time.
There are also some smaller risks, such as eth2 delivery risk (will the merge happen, and will it happen any time soon?) and governance risk too. But again, they are not materially increasing or decreasing.
(Side note — If ETH2 was never delivered, one could speculate what happens to the ETH that was staked. Likely would need to be recovered somehow through social consensus, since liquid staking derivatives are only around 1/3rd of all staked ETH, every single crypto company and exchange has exposure to ETH staking in some way. Would be a much larger problem than just staking tokens.)
Anyway, outside of these risks, 1 liquid staking ‘ETH’ from any liquid staking protocol will be redeemable for 1 ETH when unstaking is available on Ethereum in production — no matter the market rate of stETH/ETH at that time.
Approaching state transitions
For those willing to accept the smart contract and validator risks, the situation presents an interesting opportunity: how long are traders willing to hold stETH in order to arb redemption, and at what prices would they step in?
As merge and state transitions on beacon chain get closer, the arb could become more attractive. The perceived price risk could smaller as the time-to-redemption reduces — but it will still heavily depend on traders market sentiment regarding usd prices.
Alright I’m sick of writing now. I need to go play League of Legends. If anything isn’t clear, I’ll reply in the comments. Or perhaps I won’t, depends if I am in a bad mood after I lose this LoL Clash tournament.
pls letter to 18 year old self next :)
So at a 90% of price discount, if you are willing to hold eth long term, you can buy eth now, swap for Seth and still be in profit if eth drops to around $1300. This bear market seems to still be in the infant stages so we will probably see lower eth prices then that over the next couple months.
Best play is probably waiting for further arb or lower eth prices before buying in.