Author: @CryptoScott_ETH | @RealResearchDAO

Foreword

The UST depeg crisis has shrouded the entire cryptocurrency industry with a blight of confidence. In addition to worrying about whether stablecoins will be unpegged to USD, people also care about whether the pegging between tokens can be retained. Recently, Celsius, a well-known centralized asset management platform in the United States, was reported that they have lost more than 40,000 ETH of customers a year ago, causing the risk of running on ETH. Most of Celsius' ETH was converted into stETH and revolved in AAVE. If the customer requests to redeem ETH, Celsius will have to convert stETH to ETH, and the risk of running on ETH further triggers the risk of stETH depegging. This article will measure the possibility of stETH’s depeg from ETH.

1. The Core Idea of stETH

Users deposit ETH into Lido Finance, minting stETH 1:1 according to the amount of ETH they deposited in; the ETH collected from the users will then be staked in the hardware node operators through Lido Staking Contract.

Since the principal ETH and the staking rewards cannot be withdrawn before the Merge, the Oracle is used to monitor the amount of ETH mining and slashing in the Beacon Chain. Lido's income will be mining rewards minus slashing, and the income will be used to mint stETH to a 1:1 ratio: 90% will rebase to stETH holders (stETH in their accounts will automatically increase), 5% to the hardware node operators, and 5% to the treasury.

Presently, Lido is the biggest provider of staking services on Ethereum. Although several centralized exchanges such as Kraken, Coinbase, and Binance also offer this service, Lido has 32% of the total tokens staked.

The current annualized interest rate for holding stETH is 4% in stETH. After a 6-8 month waiting period after the Merge of Ethereum, users can exchange ETH at Lido 1:1 with their amount of stETH. Therefore, the core idea of stETH is a bond with a face value of 1 ETH, an annualized coupon rate of 4% ETH, and a maturity date of the Merge, plus a 6-8 month waiting period.

stETH has the right to exchange ETH at a rate of 1:1 in the long run, while UST can only realize its peg to USD through algorithmic arbitrage without any collateral behind it. The UST depeg was triggered by the internal risk of unsustainably high interest subsidy accumulation, while the stETH depeg was a short-term run caused by an external liquidity crisis. Therefore, the fallout of stETH and UST are essentially different.

2. The Pain Points of stETH Liquidation

At present, the largest holder of stETH is AAVE, which holds 48.1% of stETH. The deposit utilization rate of stETH on AAVE is 0%, indicating that there is no loan demand for stETH in the market, and everyone uses AAVE for revolving loans to achieve leverage on their ETH positions.

An example of revolving loan: When Max LTV (Loan to Value) = 69%. Uses 100 USD to purchase asset A as collateral, the maximum loan will be 69 USD; then uses 69 USD to purchase A as collateral, again the loan will be 69*0.69=47.61U, in this way, a total of buying

A = 100 + 1000.69 + 1000.69^2 + … + 100 * 0.69^n = 100/(1-0.69) = 322.58

Maximum leverage ratio of revolving loan = 1 / (1-LTV), the larger the LTV, the greater the leverage ratio.

When the price of the collateral asset drops and the Health Factor is smaller than 1, the liquidator will complete the liquidation arbitrage through flash loans.

Hence we need to pay attention to the pain points of AAVE's stETH liquidation to avoid serial liquidations caused by revolving loans. ETH and USD can be loaned by staking stETH. When stETH is pegged to ETH, lending ETH by collateralizing stETH can minimize the liquidation risk (the numerator and denominator change in the same proportion, and the healthy factor remains unchanged). AAVE currently has 1.33M stETH and 359.11k ETH loaned. Assuming that all ETH borrowing needs are provided by stETH, then the overall collateral rate of stETH to loan ETH is 27% (359.11/1330). That is, an average of 1stETH collateralizes 0.27ETH. The Max LTV of stETH is 69%, which is much higher than 27%, so the stETH loan is composed of ETH and USD.

The first liquidation pain point of ETH-stETH is 0.86, the accumulated liquidation is 20M stETH, the maximum amount of stETH collateralized by lending ETH is 548.48k, and the remaining minimum collateralized amount of stETH for lending USD is 781.52k, so the actual situation is that the ratio of collateralizing stETH to loan USD is higher.

The price of stETH is equal to ETH/Exchange Rate, and the factors driving the price of stETH to fall are the price of ETH and the exchange ratio of ETH-stETH. When collateralizing stETH to lend USD, the AAVE liquidation pain point prices (cumulative liquidation) are: 925 (17M), 860 (41M), 680 (81.3M), 450 (149M), 410 (180M).

To reach the first liquidation pain point (925$), ETH=1000$ is required, and the exchange ratio is above 1.08; when the second liquidation pain point begins, the exchange ratio has little effect. Therefore, stETH liquidations are mainly driven by ETH’s falling prices.

The first liquidation pain point of Ethereum was 1170$, and the cumulative liquidation was 1.03B. Therefore, ETH will have a large-scale liquidation prior to stETH.

3. The Cost of Sniping

Curve is the second largest holder of stETH, so the price of ETH-stETH is mainly driven by Curve's AMM

• Constant Product AMM
  • x*y=k
  • Disadvantage: When deviating from the equilibrium ratio, the slippage is large.
• Constant Sum AMM
  • x+y=D
  • Disadvantage: a certain token in the liquidity pool is fully exchanged
• Curve AMM:
  • Avoid the disadvantages of Constant Product and Constant Sum AMM: Under normal circumstances, the slippage is small, and in extreme cases, the slippage is large. Adjust the extreme range by adjusting the constant sum coefficient.

The A value of ETH-stETH is 50, ETH has 158646, stETH has 503552, and the exchange ratio including transaction fee is 1:1.0377. If you want to increase the exchange ratio to 1.08, assuming that the average exchange rate of ETH to stETH is 1.06, then 48800 stETH need to be sold to Curve.

If we want to reduce the cost of sniping stETH, we need to join the Curve ETH-stETH LP to withdraw from the pool, and the proportion of withdrawal will reduce the number of stETH dumped by the same proportion. If LP withdraws 50% of the pool, only 24,400 stETH needs to be sold. The withdrawal of LP will reduce the arbitrage room of AAVE liquidators to a certain extent, so liquidators have no incentive to cooperate with large investors to withdraw from the pool for arbitrage.

4. Trading Strategies

The Merge will likely happen at the end of Q3 and the beginning of Q4, plus the waiting period from June to August, the cycle is about 1 year. There are two strategies you can adopt to earn a certain return without risk.

4.1 For Those Who Want to Earn More ETH

When the interest rate of ETH is lower than 4%, you can increase your return by revolving loan. The variable interest rate of ETH in AAVE have been below 2% for several months. With a bear market coming, we believe the interest rate will continue to move lower.

Assuming that the LTV in AAVE we use for leverage is 50%, when ETH:stETH=1.07, the health factor is 1.48, and the loan in AAVE will be liquidated when ETH:stETH=1.59. Due to the higher degree of depeg, the higher profit we can take, the probability of the exchange rate being 1.59 is lower, which means that LTV=50% is a relatively safe level.

The exchange rate of ETH to stETH is 1.07 now that you can swap ETH to 1.07stETH, and then deposit them into AAVE as collateral to leverage your stETH position by revolving loan. After the above operations, we can get 2.14stETH with an ETH. When ETH can be redeemed by stETH, this strategy will gain 20.56% ETH.

The lower the interest rate and the higher the exchange rate are, the higher return we can gain.

4.2 For Those Who Want to Earn More USD

If you want to gain a certain return of USD through this crisis, you can buy stETH to earn 4% ETH PoS rewards and exchange rate gain, by shorting (1+4%) ETH in perpetual futures to lock in return.

The higher the exchange rate is, the higher return we can gain.

5. Summary

• The core idea of stETH is a last resort bond with a face value of 1 ETH, with a coupon rate of 4% ETH, and a maturity date of the Merge + 6 to 8 months.
• Currently, AAVE is the largest holder of stETH, holding 48.1% of stETH. A large number of stETH holders have leveraged ETH through AAVE revolving loans. There are two ways to collateralize stETH to lend ETH and collateralize stETH to lend USD.
• The first liquidation exchange rate for collateralized stETH to lend ETH is 0.86, and the liquidation pain point prices (cumulative liquidation) of collateralized stETH to lend USD are: 925 (17M), 860 (41M), 680 (81.3M), 450 (149M) ), 410 (180M).
• AAVE liquidation is controlled by two factors, ETH price and ETH-stETH ratio. The main driving factor is the price of ETH, and ETH has a large-scale liquidation prior to stETH.
• The snipers need to remove the stETH-ETH LP in the Curve together with the whales to reduce the attack cost. After the pool is withdrawn, it is difficult for liquidators to achieve liquidation arbitrage due to insufficient liquidity, which reduces the willingness of liquidators to attack the whales.
• There are several strategies that can be adopted to earn a certain return without risk, creating the continuous purchasing willingness of stETH, which further hinders the depegging of stETH to ETH.

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