37. The decoupling of stETH is underway, and Aave makes billions of dollars potentially vanish at any moment, but it also brings opportunities.

Author's Note

Recently, many people have observed that the Curve stETH/ETH pool has started to decouple, reaching a peak decoupling of 5%. Therefore, I wrote this article to analyze the stETH decoupling event and provide some personal conclusions.

stETH/ETH will definitely decouple, but the degree of decoupling is affected by the progress of the Ethereum merge;
Even if stETH/ETH decouples, there is no need to worry excessively, because Lido's stToken is redeemable at a 1:1 ratio;
There are significant arbitrage opportunities in stETH/ETH, but the time to realize profits may be longer.

I will provide a detailed interpretation of these conclusions after the main text. The main text will chronologically outline the liquidity crisis of stETH/ETH. It is quite labor-intensive, so I hope everyone can like and share to support.

Main Text

First, I need to supplement some background knowledge. lido.fi is a liquidity solution for PoS assets. As we know, in some PoS public chains, you can earn rewards by staking tokens, but the biggest problem with participating in PoS staking is that the corresponding tokens lose liquidity, and it takes time to unlock them even after exiting staking.

Common PoS public chains generally require 14 or 21 days to unlock tokens. Such a long unlocking period makes it very easy for investors to miss trading opportunities. Because of this significant pain point, liquidity solutions have emerged. Lido is one of the more well-known projects.

Currently, Lido supports staking on five networks: Ethereum, Solana, Kusama, Polygon, and Polkadot. The staking rewards range from 4% to 16.5%. Its operational logic is also very simple; it controls the staking process through smart contracts. When a user stakes a token, a stToken is issued to the user as proof.

The stToken has no staking lock-up restrictions and can be freely traded on the open market. Thus, users can enjoy the rewards from node staking while also having unrestricted liquidity. When a price crash occurs, users can choose to sell stTokens to cut losses, avoiding missed trading opportunities due to lock-up.

When the sale of stTokens is excessive and leads to decoupling, arbitrageurs will buy stTokens and redeem them on the Lido website. This can yield significant profits, for example, 1 stSOL = 0.9 SOL. If a user buys 10 stSOL at this time, the cost is 90% of the SOL market price, and then redeems on the Lido website, waiting for the unlock to receive 10 SOL, thus achieving a 10% profit from arbitrage. Because of this logic, stTokens generally hover around a 1:1 ratio, and any decoupling situation will be quickly arbitraged back.

So why has stETH recently experienced significant decoupling and has not returned for a long time? The reason lies in the Ethereum merge. Currently, staked ETH in Lido cannot be redeemed until the Ethereum merge is completed, after which stETH can be freely redeemed for ETH. Therefore, stETH cannot engage in the aforementioned arbitrage to return to the pegged price, which also means that stETH/ETH inherently faces a liquidity crisis.

Origin of the stETH/ETH Liquidity Crisis: Celsius Network

In fact, for a long time after the launch of stETH, there were no significant decoupling events. However, this time, due to another project, Celsius Network, experiencing massive losses, liquidity was withdrawn from the Curve stETH/ETH pool to fulfill customer redemptions, leading to the decoupling of stETH/ETH.

Celsius Network is a large CeFi wealth management platform, relatively well-known in the United States. However, on June 6, the Dirty Bubble incident revealed that Celsius had lost over $70 million in the theft of the custodial platform Stakehound a year ago. Interestingly, during this year, Celsius kept this information "under wraps," and users only learned about such a significant funding gap after the revelation, making Celsius the target of public criticism.

Celsius lost at least 35,000 ETH due to a critical error with Stakehound. After this funding gap was exposed, Celsius's users began to withdraw, but Celsius could not meet the redemption demands because 73% of its ETH was locked in stETH or ETH2, preventing withdrawals before the ETH merge. This forced Celsius to sell its stETH on the secondary market, Curve, to meet user redemption demands.

According to the liquidity of stETH/ETH on Curve on June 6, redeeming all stETH back to ETH at once would cause stETH to decouple to 0.64. Notably, when the exposure occurred on June 6, the amount of stETH in Celsius's wallet was 445,000, but by the time of writing, it had decreased to 409,080, a reduction of 35,920 stETH. These stETH were transferred out of the wallet, and I did not track them, but combined with the drop in the price of stETH/ETH on Curve, I boldly speculate that they were sold on the secondary market.

For those interested in tracking wallets and interactions, you can do so through this link.

https://zapper.fi/account/0x8aceab8167c80cb8b3de7fa6228b889bb1130ee8?tab=dashboard

Escalation of the stETH/ETH Liquidity Crisis: Alameda Research

On June 8, Alameda Research withdrew nearly 50,000 stETH in just a few hours, effectively selling.

Did you think the issue ended here? No, the real problem is still ahead, so please continue reading.

The Time Bomb of the stETH/ETH Liquidity Crisis: Aave

First, I will post a data chart from Nansen.

From the chart, it can be seen that the largest destination for stETH is the Aave lending pool. This lending pool currently holds 1.4 million stETH, with a market value of approximately $2.26 billion.

Friends who frequently engage in DeFi will immediately notice the problem: a pool of over $2 billion with an APY of 0 and a borrowing utilization rate of 0, indicating that this lending pool generates no income at all. So why is there so much capital in it?

That's right, circular borrowing.

Does it sound familiar? It’s back again. The DeFi operation that caused the collapse of Terra UST is back with circular borrowing. Through AAVE and Lido's stETH, billions of leveraged bets were made on the activation of the Ethereum mainnet after the merge.

Stake ETH in Lido to obtain stETH
Deposit stETH into AAVE and borrow ETH
Repeat the above operation

However, there is a problem: you cannot unwind this transaction. Unlike other stTokens, which can be unstaked through the Lido website, stETH is constrained by the mainnet merge, so you cannot unstake stETH.

If the stETH/ETH peg fails, many ETH longs will be completely liquidated.

The entire stETH/ETH situation is no longer simply a liquidity solution issue where the staking token loses liquidity and decouples; it is essentially a liquidation problem of leveraged longs worth billions of dollars.

I can no longer calculate how many times stETH/ETH has been circularly borrowed or how much leverage has been applied. But the entire stETH/ETH has become a ticking time bomb that could explode at any moment.

Once stETH/ETH continues to decouple, it will inevitably trigger panic, and if the panic selling of stETH reaches Aave's liquidation line, this $2.2 billion time bomb will explode, sweeping through the entire market.

Moreover, the most terrifying aspect of this time bomb is that it cannot be dismantled. Due to the irreversibility of stETH, getting off the leverage of stETH/ETH would require selling stETH, but selling stETH would inevitably affect the pegged price of stETH/ETH. However, if one does not exit and only clears the leverage on Aave, they must bear the potential for even greater stETH decoupling losses. StETH holders find themselves in a dilemma.

At this point, a perfect crypto prisoner's dilemma is born.

Now, selling stETH will cause the price of stETH to drop, accelerating the entire stETH explosion;

Now, clearing the stETH leverage while continuing to hold means that if others sell stETH, one will bear the greater risk of stETH decoupling.

There is almost no third option because Lido and the Ethereum PoS mainnet have completely blocked the escape route.

The only choice now is to hold onto a glimmer of hope that this time bomb does not explode before Ethereum completes the merge. Once the Ethereum merge is successfully completed, and stETH can be redeemed at a 1:1 ratio, then this time bomb will truly be defused.

Opportunities Brought by the stETH/ETH Liquidity Crisis

Returning to the three points I made at the beginning of this article, these are the opportunities I believe accompany this liquidity crisis, and I will analyze them one by one.

stETH/ETH will definitely decouple, but the degree of decoupling is affected by the progress of the Ethereum merge

I would describe stETH/ETH as a car carrying a time bomb, with the doors welded shut and speeding down the road. The people inside the car cannot get out, and those outside cannot risk their lives to save them.

As time goes on, the degree of decoupling will accelerate. However, the closer it gets to the finish line (the successful merge of Ethereum), the more likely Vitalik will personally defuse the bomb for you, allowing everyone to escape safely. The faster the Ethereum merge progresses, the quicker the bomb will be defused, and the duration and degree of decoupling will not last long.

However, if the Ethereum merge does not go smoothly, for example, if there are further delays, then the car loaded with bombs will have to keep driving, and the decoupling will become increasingly severe.

Even if stETH/ETH decouples, there is no need to worry excessively, because Lido's stToken is redeemable at a 1:1 ratio;

For those who are not in the car, even if stETH/ETH decouples or even explodes, there is no need to worry. The stToken is completely different from UST; UST is a purely algorithmic stablecoin, and although there are reserves from LFG, it is still not a 100% reserve-backed asset.

Lido's liquidity solution, on the other hand, is a 100% reserve-backed asset. In other words, even if a liquidity crisis erupts, it is due to the Ethereum network's inability to exit staked ETH, rather than a financial crisis caused by a funding gap.

Once the Ethereum mainnet merges, regardless of the price of stETH, it can be redeemed through the protocol at a 1:1 ratio. Of course, at this point, stETH will already be a tainted asset.

There are significant arbitrage opportunities in stETH/ETH, but the time to realize profits may be longer;

Once stETH/ETH decouples, it will lead to a "Crazy Thursday" for Ethereum, where you might be able to buy tainted stETH for a fraction of the price.

For example, suppose stETH/ETH has now dropped to 0.5, then I can now purchase ETH for half the market price, and when the Ethereum mainnet merge is completed, I will make a 100% profit in terms of coin value.

Of course, the Ethereum mainnet merge is not a certain event; it may be completed smoothly, or there may be issues that delay it until next year. All of this is uncertain. Therefore, bottom-fishing for stETH is more akin to purchasing ETH futures bonds, which can only be redeemed once the mainnet merge is successful, so the time to realize such arbitrage opportunities may take a long time.

Alright, this article ends here; I’m exhausted. If you found this article helpful, I hope you can share it or treat me to a coffee. Thank you.

Author: Liu Ye Jing Hong

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