Welcome to Valid Points! So, uh, not sure if you’ve looked out the window at all today… but Ethereum (and DeFi and NFTs) might be on fire. After last month’s $40 billion crash of the Terra blockchain ecosystem, a long list of decentralized finance (DeFi) protocols are facing renewed scrutiny this week from investors who believe the music has stopped for crypto products with risky – and in some cases, outright nonexistent – fundamentals. The “number go up” party is over, retail investors are getting wiped out, and billions in losses have been reported across big name balance sheets – fomenting fears that some of the biggest names in DeFi will be forced to liquidate their assets and dump on the market, pushing prices down even further. Amid the turmoil, Lido Finance’s staked ether (stETH) – an Ethereum-based token representing ETH “staked” on Ethereum’s proof-of-stake Beacon Chain, is being closely watched. stETH, while not exactly “pegged” to the price of actual ETH, has traditionally traded at around the same price because stETH represents a 1:1 claim on ETH staked on the Beacon Chain. Today, stETH – which powers an increasingly large segment of DeFi’s borrowing, lending and casino-lite economy – is trading roughly 7% lower than the price of ETH. For those who held or borrowed stETH on the assumption that it and ETH are synonymous, this is a big haircut. The stETH price drop has fueled some worries on Twitter and elsewhere that Lido is “the next Terra.” What if stETH, which represents around 33% of all staked ether (or around $5 billion), were to drop to zero? Fortunately, such worries aren’t grounded in actual understanding of how stETH works under the hood. In this week’s newsletter, we’ll talk a bit about what’s going on in the markets and what it means for stETH and Ethereum as a whole.
What the heck is going on?
Decentralized finance, which was born on Ethereum and then skyrocketed in popularity with the DeFi summer of 2020, set out to provide users with financial tools outside of the reach of regulators and centralized financial institutions. Coded smart contracts – not written contracts or company-controlled servers – would allow users to trade and transact without intermediaries. Over time, DeFi has grown into a behemoth undergirding the entire crypto economy. But as DeFi success stories like Maker and Uniswap have provided new paradigms for users to borrow, lend and swap digital assets, high-leverage experiments like Olympus and Terra – which promised high yields to users in exchange for their faith in untested investment models – have crashed and burned. Over the past months, as tokens associated with projects like Terra have fallen to zero, DeFi as a whole has also suffered. That suffering accelerated this week. CoinDesk reported Tuesday that crypto markets saw over $1 billion in liquidations in just 24 hours between Monday and Tuesday. As my colleague on CoinDesk’s Markets desk Shaurya Malwa explained, “Liquidation refers to when an exchange forcefully closes a trader’s leveraged position due to a partial or total loss of the trader’s initial margin. It happens when a trader is unable to meet the margin requirements for a leveraged position (fails to have sufficient funds to keep the trade open).” A primary catalyst for this week’s liquidation chaos appears to have been massive sell-offs from Celsius – an investment product that allows users to easily deposit funds in exchange for market-leading yields. Behind the scenes, Celsius was able to offer high yearly returns up to around 20% by deploying user tokens into myriad DeFi protocols. Celsius would reward depositors with the profits it earned from these protocols, and it would shave off a percentage for itself. Celsius was a crypto unicorn – raising $400 million in October from investors who believed it had the potential to revolutionize finance (and profit handsomely) by expanding consumer access to DeFi. It now faces criticism that its fund managers behaved like degens (crypto-speak for “degenerates”), swayed by the same eye-popping returns that pooled retailers into uncertain bets like the ill-fated Terra project. Celsius was never fully transparent with how it deployed user funds behind the scenes, and a wave of sell-offs from the platform this week suggests it, as a result of some risky DeFi investments, is now verging on insolvency.
Celsius and Terra
One of the primary destinations for Celsius’s funds was Anchor – the lending platform that provided users up to 20% per year for deposits of Terra’s dollar-pegged UST stablecoin. The Block reported in May that Celsius deposited around $500 million into Anchor, which it quickly withdrew as Terra started to wobble. While its money was parked in Anchor, Celsius took some of the 20% yield for itself, and then built the rest of the yield into the interest it handed back to depositors. Though Celsius reportedly withdrew from Anchor before UST imploded, the firm’s one-time involvement with the ill-fated Terra project – combined with a broader cooling (and now, crashing) of DeFi markets – has fueled suspicion that Celsius’ DeFi investments may have declined in value so much that the platform no longer has enough money to pay back its depositors. The insolvency narrative seemed especially likely on Sunday, when Celsius sent an email to users informing them that it would be pausing all swaps, transfers and withdrawals in an effort to ensure it would be able to honor its commitments moving forward. Moreover, a wave of recent sell-offs from Celsius suggests some market players that loaned out money to the platforms are now asking for that money back – something one would expect to see during a bear market. It appears likely that, in order to pay off its lenders, Celsius has been forced to sell off some of its largest positions. One of those positions was in stETH.
Understanding stETH
According to blockchain data, Celsius has nearly $500 million of Lido staked ether (stETH) locked up as collateral in stablecoin loans. It’s possible they have more elsewhere in their treasury. The attention on stETH this month stems from the fact that it is no longer trading around 1:1 for ETH. Traditionally, ETH and stETH have traded around parity because each stETH represents a direct claim on ETH that Lido, a decentralized protocol, has staked on the Beacon Chain on behalf of its users. The catch is that while Lido will happily hand out 1 stETH in exchange for 1 ETH, it does not yet allow users to pull their ETH back out of the protocol. This comes down to a limitation with Ethereum itself: ETH staked on the Beacon Chain will be impossible to withdraw until an update following Ethereum’s “Merge” into a proof-of-stake network (today, Ethereum continues to operate using the more energy-intensive proof-of-work consensus mechanism pioneered by Bitcoin). The main point of a “liquid staking” solution like Lido was to provide users a way to stake, secure the network and earn interest for doing so without losing the ability to use and trade staked assets. (It also allows users to participate in staking without the need to put up 32 ETH — which is what’s required if you are setting up a node by yourself.) With so much stETH held by Celsius, there’s some fear that the troubled firm may be forced to sell off its stETH to stay afloat (if it hasn’t done so already). This would have the effect of depressing the overall stETH market. Andrew Thurman of blockchain analytics firm Nansen (and a former CoinDesk colleague) told Decrypt this week that Celsius “sent thousands of stETH to FTX in recent days, presumably to sell, though we can't verify that because it's off-chain … They have likely been especially hard-hit by stETH losing its peg to ETH.” Concerns that Celsius (and other firms) will be forced to dump more stETH, combined with sales from other stETH holders anxious to cash out during the bear market, may have helped to cause stETH to drop 7% below the price of ETH this week. Although stETH and ETH should eventually be interchangeable, some holders appear desperate enough to exit their positions that they’ve been willing to trade stETH at a steep discount.
Can stETH enter a death spiral?
stETH’s uncoupling from ETH has provoked questions as to whether Lido is “the next Terra,” but this is not an apples-to-apples comparison. First off, while UST was “pegged” to the price of $1, stETH was never pegged to the price of ETH. So long as stETH is not redeemable for ETH, there’s nothing guaranteeing the two should sell at the same price until they are interchangeable. “The price of [Lido] staked ETH prices in some risk of not doing the Merge, some risk of [Ethereum not allowing] withdraws, and some opportunity cost of having your ether locked up for along time,” Ben Edgington, product lead at Ethereum development firm ConsenSys, told CoinDesk. According to Edginton, unless you believe ether is going to zero or you think it will never successfully merge into a proof-of-stake network, you can rest easy knowing you can wait it out and eventually trade stETH back for ETH. UST, on the other hand, was supposed to be pegged to exactly one dollar based on a complex dance with Luna, its sister token. But because of the mechanics underpinning this relationship, a drop in UST’s price would cause Luna’s supply to inflate and its price to decrease. And the same thing happened the other way around – when Luna’s price decreased enough, UST ultimately struggled to maintain its $1 peg. READ MORE: The Fall of Terra: A Timeline of the Meteoric Rise and Crash of UST and LUNA The drop in Terra wasn’t merely a case of market sentiment gone bad. It was accelerated by an underlying mechanism that forced UST and Luna into a “death spiral” to zero under certain conditions. The relationship between stETH and ETH does not have the sort of feedback loops that doomed Terra. The people selling stETH at a discount to ETH either need to cash out now (like Celsius needing to pay off loans), or figure ETH’s price will be lower than it is today even after The Merge. Even if it trades at a discount to ETH currently, stETH is unlikely to crash (similar to Terra) unless ether itself crashes.
The price of ETH in PoS
While all of this market talk may feel like a sideshow for an Ethereum protocol-focused newsletter, Edgington explains that the price of ether, which is down 67% year-to-date, becomes relevant in a proof-of-stake system. READ MORE: What is Proof of Stake? As Edgington puts it, “proof of stake is fundamentally different from proof-of-work in terms of its security model. We can put a very clear cost on attacking the chain.” He continued, “The dirty secret of proof of work is that it can be costless to attack the chain, because if you win a 51% attack, you can actually make a profit, assuming that nothing too bad happens to the coin price … smaller chains have come under attack and their coin price has been flat.” In a proof-of-stake system, says Edgington, “an attack would cost a minimum of a third of all ether staked – so that would be like 4 million ETH today.” (Side note – this is around how much Lido controls, though it spreads its stake between different parties responsible for validating the network). In a world where ether has a relatively high price, the cost of attack will also be high – hence why developers like Edgington argue it is more secure. Of course, this also works in the other direction. If the price of ether drops low enough, an attack will be cheaper. - Sam Kessler | 