Evaluating the Price & Market Impact of stETH
Analyzing stETH’s discount and its ripple effects across DeFI
In the aftermath of the Terra collapse there has been collateral damage extending far into crypto. We saw backed stablecoins like Tether briefly lose their peg, while Janet Yellen has already hinted at more regulation for the space following UST’s crash.
The situation has led the market to reassess the validity of a claim of a staked Ether token (primarily stETH) being equal to native ETH. In this piece we analyze the arguments for and against this 1-to-1 peg as well as the market impact arising from the decline in stETH’s value.
To Peg or Not To Peg?
Lido users can stake their tokens and obtain 1-to-1 “st” derivative tokens representing their staked positions. While this may have led to the belief that assets like stETH are pegged to ETH, this is not really the case. The reality is that there are market forces pushing for an stETH discount — but also a case to be made for it to be at a premium.
Upon UST’s de-pegging, the market appeared to put greater emphasis on the discount, pushing stETH to as low as 0.95 ETH after holding steady around 1 ETH for months.
One factor in favor of stETH’s discount is that it depends on the success of Ethereum’s merge to proof of stake. This implies additional risk for the asset and a dependency on an event that has already been postponed more than once.
Similarly, there is also smart contract risk involved in Lido’s setup that would warrant a discount over ETH.
stETH is also significantly less liquid than regular ETH. This may make it less attractive for large positions as it entails higher slippage to exit out of those positions as we’ll get into later.
On the other hand, stETH is a yield-bearing instrument, which are typically priced at a premium. At the time of writing, if you hold 10 stETH, you would have 10.37 ETH a year later. Following the merge these returns would increase up to 7% — 10% a year, putting additional pressure for a premium to materialize.
By looking at markets for liquid staking tokens for chains live on proof of stake we can get a better picture of the discount/premium dynamics involved. Both sAVAX and stSOL are currently priced at a higher price than their non-yield-bearing counterparts. This suggests that the current stETH discount may be due to the market focusing more on the risk than the future returns in light of Terra’s cataclysm.
stETH’s Market Impact
The amount of Ether staked nearly tripled from May 2021 to May 2022. Throughout this time, Lido’s stETH more than quadrupled.
Lido’s growing share of the market has grown to almost one third of all ETH staked being done so through stETH. This has led to debates around an over-reliance on stETH. Following the recent price drop, it became clear that stETH is large enough to have an impact across not just staking but also throughout the DeFi ecosystem.
Liquidity rushed out of the stETH-ETH pool as fears spread throughout crypto. The pool lost over $2 billion in liquidity between May 11 and 12.
This coincided with prices crashing, which certainly made up for a significant portion of the decrease. However, the ETH value of the liquidity also decreased, pointing to large withdrawals from the pool. By diving deeper into the asset distribution of the pool we observe that liquidity providers opted to exit their positions in ETH.
The large ETH withdrawals led the pool to become imbalanced. At a point over 70% of the stETH-ETH pool was made up simply of stETH. This exacerbated stETH’s decrease as the pool became susceptible to higher slippage.
This caused ripple effects throughout DeFi. Leveraged staking had become an increasingly popular way to amplify returns. This relied on depositing stETH into Aave, borrowing ETH against it and re-staking for more stETH. Protocols like InstaDapp created vaults facilitating this process for users.
The issue is that the strategy assumed a pegged value of stETH and ETH. However, as the price of stETH declined to 0.95 it resulted in those leveraging up to the maximum possible to get liquidated.
Moreover, as the stETH-ETH pool became imbalanced, exiting out of leveraged positions became more expensive. As can be seen in the table above, APRs after slippage became lower than those from simply staking ETH (~3.7%). While the pool has began to stabilize, it highlights the additional risks and assumptions that can arise from composably stacking yield across DeFI.
Final Thoughts
Liquid staking is still in its early days and the market is still figuring out how to treat it. Specifically, market participants are weighing the negative carry due to ETH being locked plus the positive carry from the yield generated, struggling to determine the net effect and corresponding price for stETH. UST’s demise has re-sparked this debate as actors reassess tokens and their intended pegs. This led to brief panic across in the stETH market, with seismic shifts in its liquidity structured and second order effects across popular DeFi strategies.
With staking being a core tenet of most smart contract platforms, it is likely that liquid staking will continue to grow in spite of the short-term conundrum. The reason for this is that liquid staking leverages one of blockchains unique capabilities: composability. Being able to secure the network through a derivative staking token such as stETH, while being able to gain additional utility from it enables several use-cases which so far have been a pillar in DeFi strategies but also have the potential to expand beyond.
