Erik Weijers, 6 months ago

The market risk of the staked Eth token

In today's panicky market conditions, everyone is keeping a close eye on the price of stablecoins. Is USDT (Tether) still close to exactly one dollar? How is USDD doing? In this list of currency pairs there is one which has recently attracted extra attention: staked Eth. Although it is not a stablecoin, a deviation from the price of Ether is a problem in the current market, where large crypto funds like 3AC and Celsius are in big trouble.

How does staked Eth work? Ethereum, as we know, is moving to a Proof-of-stake network: this is called the Merge. Even now, holders of ETH can choose to stake their Ether and receive interest (staking yields). There is just one but: their ETH - including interest - will remain locked up for 6 to 12 months after the Merge. So it could be over a year before depositors see their Ether back. There is now 12.8 million ETH in this so-called ETH 2.0 strike contract: more than 10% of the total amount of ETH in circulation.

What is liquid staking?

Something that's locked up, that's not what financial markets like. So DeFi wouldn't be DeFi if it hadn't come up with a solution: liquid staking protocols. Lido is the biggest. Users stash their ETH there, which Lido puts away to collect staking rewards. In exchange for handing over your Ether, Lido gives you a coin: stEth (staked Eth). That stEth is NOT locked up and is freely tradable. After the Merge (and the subsequent waiting period), 1 stEth can be exchanged for 1 ETH again at Lido. But until then, stEth is a freely tradable currency - without a fixed price. The token can be used again, for example, to stash somewhere else and get yield.

Although stEth is not a stablecoin, it is to be expected that the price of stEth will remain close to the price of Ether. But because of the additional risk, it makes sense that stEth's price would normally be slightly lower. Take the risk is that something is wrong with the software and a hack takes place in the "vault" of, say, Lido. It is insured for this risk for a premium of over 2%. So that 2% is an expected price difference between Ether and stEth, based on this risk alone.

Dumping of stEth and market panic

Another price risk for stEth - and this is relevant to this story - is if the Merge would be delayed for a long time. In that case, many investors would lose patience and would want to get rid of stEth: the expected stakingyields simply do not outweigh the long wait. The price of stEth will then naturally fall. The latter is what has been going on for a while now: stEth dropped to 0.94 ETH on June 11 and now trades around 0.95 ETH.

How liquid is liquid?
What does all this have to do with the current market panic? Loan platforms like Celsius - which recently halted withdrawals (this caused the crypto market to panic) - are paying out interest on their holders' ETH by stakingthese. To still remain liquid and be able to continue paying out their customers, they hold stEth. The problem arises when their holders withdraw their Eth - which happened en masse in recent weeks - and Celsius has to sell its stEth at rapidly falling prices. And that too in a "thin" market. The exchange of Ether and stEth is now done mainly on the Curve pool. The problem is that there is too little Ether in there to absorb large amounts of stEth. Reportedly, crypto hedge fund 3AC has been one of the market participants dumping its stEth. The fund, like Celsius, is in serious trouble and has faced liquidations.

The risk behind this dynamic is that funds like Celsius have borrowed using stEth as collateral. They also have positions that are leveraged. In other words, if prices fall further, they are forced to add money or their position gets liquidated. That, in turn, would cause further price declines.

Given this eerie interplay of market forces, further price declines cannot be ruled out.

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