The major change after the merge of Ethereum is its consensus network will switch from Proof-of-Work to Proof-of-Stake. Compared to PoW, PoS is more energy-efficient and it increases the scalability of Ethereum.
For each Proof-of-Stake network, there will be validators who are responsible for checking the validity of new blocks propagated over the network, and creating and propagating new blocks themselves.
In Ethereum 2.0, to become a validator, users must deposit at least 32 ETH into the smart contract. The Ethereum network will randomly select validators from these stakers in each epoch (in Ethereum 2.0, there will be 1 slot = 12 sec, and 32 slot = 1 epoch). If stakers perform honestly in an epoch, they will receive rewards in $ETH from the network.
However, both the rewards and principles will be locked until the merge. Or even several months after the merge considering the fact that state transition and transaction function will not be immediately available after the merge.
Introducing Lido
The illiquidity issue becomes a severe problem for investors who want to earn stable and attractive rewards from Ethereum 2.0 while maintaining their exposure to the yields from other DeFi protocols. Additionally, there are a considerable amount of retail investors who are unable to meet the 32ETH requirement.
Lido was introduced to solve these issues by providing liquidity for stakers and allowing participation with any amount of $ETH. For each $ETH staked through Lido, staker will receive the same amount of $stETH, which represents the value of staked $ETH on the beacon chain. The balance of $stETH will increase correspondingly as the rewards received on Ethereum 2.0. $stETH holders can redeem the $stETH to $ETH on a 1:1 basis after the transaction function become available.
This mechanism makes $stETH âpegâ $ETH, and provides liquidity to stakers that they can use $stETH in DeFi protocols similarly as they were holding $ETH.
$stETH Is A Derivative
However, âPegâ between $stETH and $ETH is not strict, and Lidoâs system design is far from the swap mechanism between $UST and $Luna.
To better understand the relationship between $stETH and $ETH, I will briefly introduce the Bond market here. In conventional finance, companies use corporate bonds to raise capital from investors, repaying them with principal plus interest when time hits the maturity of the bond. Bond investors can also sell/buy bonds on a secondary market to gain liquidity, so its price is influenced by the demand/liquidity of the market rather than the issuer before its maturity.
Traditionally, bonds are preferred by risk aversion investors since bonds are debt investments. Due to the characteristic of absolute priority, the company must first pay off debtors before paying off preferred shareholders and common shareholders in a dissolution or bankruptcy event. Although there is no bankruptcy protection for crypto investors, $stETH does provide a risk aversion investment opportunity because of the robust usage of $ETH and the reputation of its community.
By analogy $stETH with the bond, the staked $ETH is the principle, the 4% APY provided by Lido is the interest rate and the DeFi protocols are secondary markets. The major difference between $stETH and a corporate bond is its maturity date (merge) is unknown. (Not perpetual bond since perpetual will not pay back principal) Maturity determines the price deduction of a bond as a risk parameter. Since investors can redeem bonds for principal plus interest at maturity, the price of a bond will approach its face value as time gets close to its maturity or vice versa. There are also some other discount factors like Lidoâs contract risk and Lidoâs credibility.
The $stETH should always be priced less than $ETH before the transaction is functional on Ethereum 2.0, and trading at a price below its âparityâ should be expected at the current stage.
We can check the performance of $BETH, a similar project introduced by Binance several weeks after Lido, its parity to $ETH has never hit 1.0 in the past 15 months.
There are also some worries about âdepeggedâ $stETH will lead to a dump of $ETH. Since on-chain DEXs never promise their users can redeem $stETH to $ETH on a 1:1 basis, the price of $stETH will be determined by the liquidity of the pool rather than a fixed algorithm, which means there is no way to generate an infinite amount of $stETH from nowhere as arbitrageurs did to $Luna. The ceiling amount of $stETH on market is also restricted by the total supply of $ETH. I will explain more in the next part about why the price of $stETH will not fall below a certain level.
The crypto market in general
The struggle of 3AC and Celsius last week shows us the power of liquidity in a crypto winter. As FED raised benchmark interest rates three-quarters of a percentage point last week against currently skyrocketing inflation, the liquidity of $USD got further reduced. The high inflation, interest rate, and gas fees are forcing retail investors to sell their risk assets to pay their bills, and the selling pressure on cryptocurrencies is increasing in general.
Institutions have to exit their positions on illiquid assets and prepare enough cash to avoid a potential bank run when the macro market becomes panicked. $stETH specifically, since its liquidity pool on Curve, Aave and Uni are mainly supplied by institutions like FTX and Celsius, the exiting institutions easily destroyed the price parity in an AMM DEX.
The declining price of $stETH also triggered margin calls for leveraged stakers who utilize Aave to repetitively stake ETH into Lido. They are forced to sell other cryptocurrencies at a lower price to pay off the debt, or their $stETH will be liquidated and dumped into the market. Either way, it will put more selling pressure on the crypto market as most $stETH was deposited into the Aave pool.
From the macro level, the financial market (both conventional market and crypto) has partially overreacted to the monetary tightening in the last month and already expected the FED rate hike of 75 basis points in July. The risky assets like cryptocurrencies may face another dump in July when the liquidity of the USD is tightening, but the independency of the FED now is incomparable with the Volcker moment. With Bidenâs approval rating hitting 36% recently (as the new record low), Democrats are most likely to lose two houses in the upcoming midterm election. The political pressure on FED may turn it back to monetary easing very soon to please voters. The market is expected to retain a relatively stable state after 3 rate hikes when the interest rate hits about 3.25%.
Conclusion
The Lido/$stETH system is not close to the Terra, and $stETH âdepegâ should be expected. The price drop of $stETH is basically an imbalance between the supply and demand of liquidity, but it should maintain above a certain negative premium level as the demand for ETH still exists. The downside pressure of the crypto market will stay for a while until the FED interest rate hits 3% or the inflation rate gets back to 2%.
Disclaimer: This research is for information purposes only. It does not constitute investment advice or a recommendation to buy or sell any investment and should not be used in the evaluation of the merits of making any investment decision.
đŠ @SoxPt50
đ 8 July 2022
