In-depth Analysis of stETH Decoupling: A False Alarm or Another Crypto Crisis?

Author: Cobie

Original Title: 《Staking, pegging and other stuff》

Compiled by: Paimon, ForesightNews

To begin with, this article is short and unedited, and may contain errors. First, the views expressed in this article should not be considered investment advice and only represent the author's personal opinions. Second, although the author was once part of the early team at Lido, they are no longer working there, so this article does not represent Lido. Finally, due to holding LDO, ETH, and stETH, the author's views may be biased, but they strive to remain impartial to help readers find the right answers.

What is Lido?

Cobie published a blog post introducing Lido in October 2020:

In short, Lido is a decentralized staking pool that tokenizes the Ethereum staked by users.

When a user chooses to stake one Ethereum, Lido selects a validator node and returns stETH as a reward. As this ETH earns staking rewards, the user's stETH balance automatically changes to match the balance on the beacon chain. When Ethereum's developers eventually release the next steps, stETH will be automatically unstaked, and the underlying asset will be redeemable.

The shortcomings of Ethereum's own staking mechanism and the beacon chain, which was launched at the end of 2020 but has yet to announce a specific merge date, are reasons why Lido is very popular. For users, Lido is undoubtedly the most popular way to stake Ethereum.

The "Pegging" of stETH?

For most of its lifecycle, stETH has essentially been exchanged at a 1:1 ratio with ETH.

Although there was significant volatility in the past few months—where the price of each stETH fluctuated between 0.92 and 1.02 ETH—over time, as liquidity increased, the exchange ratio of stETH to ETH has become increasingly stable.

However, the subsequent story involves the unpegging of UST and the collapse of LUNA, which also affected stETH to some extent. Since then, the price of Ethereum has been in a continuous decline for almost 10 weeks, with a drop of about 50%.

Perhaps due to the unprecedented stability of the 1:1 exchange ratio between stETH and ETH (or perhaps because "pegging" has become a hot topic following the UST collapse that triggered people's PTSD), many mistakenly believe that stETH is also pegged to ETH.

In fact, stETH is not strictly pegged to ETH, and the 1:1 exchange ratio is not a requirement of Lido. stETH is actually priced in the market based on the demand or liquidity of staked ETH, rather than simply being pegged.

Lido is not the only liquid staking protocol. Looking at other staking protocols with low utilization and poor liquidity, a 1:1 liquidity market for staking is impossible:

Binance's BETH:

Ankr's AETHC:

These two staking derivatives operate similarly to Lido, with Ankr launching before Lido, and Binance's BETH appearing a few months later, indicating that they have existed for roughly the same amount of time.

As shown in the images, AETHC and BETH have essentially never traded at a "pegged" price since their inception—BETH dropped as low as 0.85 ETH per BETH, while AETHC fell to 0.80 ETH.

Staking derivatives are not stablecoins and do not even reach the so-called "algorithmic stability." Some believe they are more akin to Greyscale's GBTC or similar to futures markets with unknown delivery dates. Fundamentally, they lock in the rights to collateralized tokens, and it is expected that their trading prices will be lower than the prices of the underlying assets they lock.

Redemption, Arbitrage, and Reasonable Pricing of Staked ETH

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

For this reason, the trading price of stETH should not exceed 1 ETH. If stETH were to trade at 1.10 ETH, traders could simply mint 1 stETH by staking 1 ETH and then sell it for 1.10 ETH—repeating this arbitrage until the price returns to parity.

This "convenient" arbitrage opportunity is currently not realistic in the other direction.

stETH, BETH, RETH, AETHC, and other ETH liquid staking tokens cannot be redeemed on eth2, which supports trading after the merge.

However, the exact timing of the merge has not been determined, possibly occurring in October this year, but it could also be pushed to the end of this year or early next year. The timing of the state transition and branch updates after the merge is also uncertain and will likely take up to six months after the merge.

Of course, the amount of ETH that can be unstaked at one time is also a limiting factor. If ETH staked in various ways is unstaked simultaneously, the unbinding queue may take over a year.

Once everything settles, liquid staking tokens will have bidirectional arbitrage opportunities—traders can buy 1 stETH for 0.9 ETH and then redeem it for 1 ETH, repeating this process.

However, even in a bull market, and with the potential for bidirectional arbitrage, the prices of liquid staking tokens may still be lower than the prices of the underlying assets. The reasonable pricing standard is actually a dynamic equilibrium point found by effectively weighing buyers' risks of redemption/unbonding periods against the potential returns that such risks can bring, as well as sellers' considerations of how the unbonding period affects their decision to sell immediately.

Currently, the lack of a redemption path significantly reduces liquidity.

In a bull market, with high demand for ETH, traders being able to purchase stETH at a price below 1 ETH can be an additional way to earn ETH, making it attractive to buy stETH at a small discount. Additionally, in a bull market, the demand for liquidity is lower, and investors are willing to hold income-generating assets, so stETH does not face significant selling pressure.

However, in a bear market, demand for ETH is extremely low, and the demand for liquidity rises rapidly. The demand for holding such "reflexive" assets long-term decreases significantly, leading more users to choose to sell their staked ETH positions and favor short-term holdings of ETH.

The discount rate between stETH and ETH actually represents the relationship between stETH holders' demand for liquidity and the demand for discounted purchases of staked ETH derivatives.

At the same time, some large players have expressed their recent demand for liquidity by exiting the stETH market.

Of course, the determination of the discount rate is also affected by smart contract risks, governance risks, beacon chain risks, and whether the merge occurs. Although these risks may seem like constants compared to variables such as the willingness of buyers and sellers, people's assessments of their importance may change with concerns about market fluctuations.

It appears that macro liquidity preferences remain the largest influencing factor, while views on the merge so far seem to have little impact.

Who is Selling?

While many have focused on the price of stETH due to UST PTSD, stETH may represent a different story.

The most noteworthy question in the current discussions about stETH is: who are the "fixed" sellers?

The answer seems to point to several groups:

1. Leveraged stakers, identifiable on-chain
2. Entities needing to handle deposit redemptions

Leveraged Stakers

Investors use Aave to leverage stake ETH, with the trading process as follows:

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

Instadapp and other similar products have turned this trading process into a "vault," attracting a considerable amount of deposits to buy leveraged stETH positions.

Unless traders can provide more collateral for these positions, they are subject to on-chain liquidation prices. To deleverage, they need to sell stETH for ETH, which also helps with stETH pricing.

If on-chain liquidation is triggered, this 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 indicating that entities like Celsius have liquidity issues. Of course, as Celsius is a "CeFi" company, its financial status or capital management strategies are not fully disclosed to the public.

Therefore, this is purely speculation, and outsiders cannot truly know what is happening inside Celsius.

However, researchers speculate that the current withdrawal rate of users is quickly exceeding the liquidity that Celsius has.

Some also speculate that Celsius has incurred investment losses in DeFi. It is said that Celsius has lost funds in StakeHound, Badger, and Luna/UST.

It is reported that Celsius uses customer deposits for DeFi reinvestment to provide additional returns, during which they may have incurred losses due to oversight. Additionally, they have partnered with Lido and other non-liquid staking node operators to stake a large amount of ETH, which lacks liquidity and may take six months or even a year to redeem.

For Celsius, since their position size exceeds the available liquidity of stETH, even so-called liquid staking does not actually possess liquidity.

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

Of course, these are all speculations. The actual financial status, tools, and customer liabilities of Celsius are not known to outsiders.

While it is unlikely that Celsius will completely lose customer funds, theoretically, if users demand withdrawals and the redemption date for assets on the beacon chain is far off, Celsius could ultimately find itself in such a predicament.

How Celsius handles this situation seems particularly important. Using these locked assets to borrow and repay customers would merely delay their time as "forced sellers" and worsen the eventual outcome.

So, who is the "big loser"?

It is unrealistic to predict the future price trends of stETH, BETH, AETHC, and RETH now.

Instead, consider this: if Celsius's scheme is real, or if leveraged stakers on-chain are indeed unable to provide collateral, who would be the biggest loser?

Without a doubt, it would be Celsius and its users. Celsius may not be able to handle withdrawal requests for every user and could incur significant losses by selling at low prices to fill withdrawal gaps before the merge.

PS: From Celsius's perspective, it might be a good choice to exit stETH in private OTC at an appropriate discount to salvage its reputation and maintain credibility.

Leveraged individuals are also not exempt from misfortune.

Similarly, anyone wanting to exit stETH positions before the state transition on the beacon chain will find it challenging. Imagine traders or investors staking ETH today (or buying stETH at a "discount" today) needing to wait three weeks or three months to exit; the stETH/ETH ratio will clearly not be the same as when they entered.

After the merge, since each stETH will have an equivalent amount of ETH on the beacon chain, non-leveraged stETH holders can exit directly by unbonding on the beacon chain without incurring losses.

Is 1:1 Redemption Guaranteed?

stETH, BETH, and AETHC can be redeemed for ETH at a proportional rate when the Ethereum merge is completed.

However, there are two possible scenarios that could break the 1:1 redemption:

• If today you hold 10 stETH and Lido's validator node is penalized, the resulting loss will be borne by stETH holders. For example, due to penalties from the Slash mechanism, 10 stETH could devalue to 9.5 stETH. This situation could also occur on Ankr, but RocketPool requires validators to post additional collateral, making the situation different.
• A critical protocol bug—whether in Lido, RocketPool, Ankr, or any other staking pool, a critical protocol bug could impact their liquid staking protocols.

Although slashing is rare on the beacon chain and most liquid staking protocols have robust validator nodes, the occurrence of these two low-probability events cannot be ruled out.

Of course, the auditing process for protocols is certainly very thorough—but it is certain that the vast majority of people may have auditing PTSD.

While these risks may exist in varying degrees of severity, their probabilities are extremely low, and over time, the risk exposure does not change.

There are also risks such as the delivery risk of eth2 (whether the merge occurs and the events surrounding the merge) and governance risks, which similarly do not substantially increase or decrease.

PS: If eth2 is not implemented, people may speculate on the fate of staked ETH. Since liquid staking derivatives only account for one-third of all staked ETH, and every cryptocurrency company and exchange has staked ETH in some way, a method that provides social consensus for redemption may be needed, making it a more complex issue than merely discussing staking tokens.

In summary, without considering the above risks and with sufficient ETH available for redemption, regardless of the stETH/ETH ratio in the market, any "ETH" minted in a liquid staking pool will ultimately be redeemed at a price of 1 ETH.

Market Preferences are Quietly Changing

For those willing to accept the risks of smart contracts and validator nodes, 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?

The merge and state transition on the beacon chain may be imminent, making arbitrage more attractive. As the expiration date approaches, although it largely depends on traders' market sentiment towards the dollar price, the perceived price risk is likely to decrease.