After reaching a total market capitalization of US$3 trillion in November 2021, crypto assets have gone through a significant drawdown of around 72% through mid-July this year. This strong correction, driven by a macro risk-off environment, has also been catalyzed by idiosyncrasies specific to the crypto space, such as major centralized crypto lenders becoming insolvent or going through reorganizations, as was the case of Celsius, which recently filed for bankruptcy. Some of the strategies these companies used to generate yields on their customers’ deposits relate to an asset that has made the headlines recently: stETH (staked ether), an ether synthetic offering a liquid staking product that allows users to be part of the consensus layer of Ethereum once it switches to Proof-of-Stake, while also having a derivative version of the network’s native token ready to be used on decentralized applications (DApps). Here we provide an overview of stETH, presenting the novel use case introduced by this crypto asset and discussing its role during the recent crypto shakeout.
Why was stETH created?
Staked ether, or simply stETH, is a synthetic ether (ETH) token issued by Lido Finance, a liquid staking provider which facilitates the participation of ETH investors in Ethereum’s consensus layer as the network shifts from Proof-of-Work (PoW) to Proof-of-Stake (PoS). The full transition to PoS is expected to happen this September in the event called “The Merge.” In order to become a validator on PoS Ethereum, there are minimum computational requirements and a minimum capital investment (32 ETH—around US$52,000 at current prices). Also, there is an opportunity cost when participating in the consensus on the Beacon Chain, the blockchain created for Ethereum’s PoS transition, since ETH has to stay bonded (locked) on PoS validator nodes.
Lido solves these issues by bundling ETH deposited by investors in a pooled staking service and issuing a liquid staking derivative, so that users can be part of Ethereum’s future consensus layer while having a freely tradable ETH certificate, which can be used on-chain, for instance, in decentralized finance (DeFi). Lido generates revenue by charging a 10% fee on top of staking rewards (not on the principal deposit). Since the inception of the Beacon Chain in late 2020, the TVL in Lido has quickly climbed to surpass 4.15M ETH.
stETH combines the value of the initial user deposit and staking rewards accrued over time, meaning the token is, from the ground-up, a yield-bearing asset. As of now, it cannot be used to redeem ETH back from Lido. This is due to withdrawals from the Beacon Chain being currently unavailable. Even after The Merge happens, this functionality will still have to wait for activation on a later hard fork, meaning the ETH synthetic can currently only be exchanged back for ETH in secondary markets, such as Curve’s stETH:ETH pool, one of the largest pools of the decentralized exchange (DEX) by both total value locked (TVL) and daily transacted volume.
FIGURE 1: TVL IN LIDO OVER TIME
Source: Data from Dune Analytics, Lido TVL, accessed July 29, 2022.
stETH and Celsius’ asset-liability mismatch
In June, we documented the story of Celsius, a major centralized crypto lender, which froze withdrawals in its platform “due to extreme market conditions” on June 12. Celsius’ business model was based on lending user funds to third parties in exchange for an annual interest rate, part of which is paid back to its customers in the form of yield on their deposited crypto assets. Celsius also used DeFi protocols to pursue other forms of generating yield. In particular, it staked a significant amount of ETH deposited by users on its platform using Lido, taking the received stETH in turn to borrow assets on DeFi protocols Aave, Compound, and Maker, mainly in the form of stablecoins. In the middle of the recent market correction, this collateral has been put under significant pressure, with the crypto community following closely the loan-to-value (LTV) ratio of Celsius loans, igniting widespread fears of the crypto lender eventually becoming insolvent.
A key issue with the stETH held by Celsius was that even if it were to repay all of their DeFi debt and get back the stETH, they would be unable to convert the entirety of that stETH back to ETH, due to the indefinite lock-up period of ETH in the Beacon Chain. Secondary markets could give them an exit, but with the amount of stETH under their possession, and the available liquidity in DEXs such as Curve at the time, a full exit would be practically infeasible, with Celsius becoming unable to honor withdrawals of real ETH on its platform. Other participants of the crypto market noticed the difficult situation Celsius was in and started a “bank run” on Curve for ETH, which imbalanced the DEX’s liquidity pool for the stETH:ETH pair, creating a discount on stETH’s value to ETH (see Figure 2). As we pointed out, that might have been a major driver for Celsius’ decision to halt customer withdrawals. Their situation worsened since then, with the company recently filing for a Chapter 11 reorganization.
FIGURE 2: PREMIUM/DISCOUNT OF stETH TO ETH OVER TIME
Source: Data from Dune Analytics, ETH:stETH price hourly, accessed July 29, 2022.
stETH has been delivering what it promises to investors, with its main caveat so far being not allowing users to withdraw back their deposited ETH in the Beacon Chain, and the likely risks of Lido becoming too big of a staking pool in Ethereum’s future consensus layer, which raises concerns on how decentralized the network will actually be. This is a topic we follow closely and shall discuss in a future publication. However, it is worth noting that the inability to withdraw the underlying ETH is not forced by Lido, but is actually constrained by the Ethereum roadmap of upgrades. Once PoS is fully activated, and validator withdrawals become available, stETH and ETH will basically become interchangeable in value, with the likelihood of stETH even starting to consistently trade at a premium to ETH, given its yield-bearing nature.
This asset was put in the middle of the recent market unrest by players whose risk management strategies did not account for the inherent illiquidity of the underlying asset they represent. With some of these centralized players going bankrupt, significant leverage has been flushed out of the crypto space, and we believe the market conditions in crypto have become much more healthy. Episodes such as Celsius’ show how products created with one objective can be used in a risky manner by third parties to target other goals, causing cascading effects to the asset class as a whole. We consider this as an important reminder of how risk management is a key aspect of investing in an emerging asset class, something we deeply value in our long-term investment thesis for crypto. To learn more about our views on crypto investing in a diversified portfolio, consider reading our Investment Case for Crypto.
 CoinMarketCap, Ethereum, accessed August 25, 2022.
 On August 25, 2022.
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