With the recent UST depeg that crashed LUNA along with the entire crypto market, some people are worried about the depegging of stETH from ETH, which currently sits at around a 4% discount. stETH is ETH that is staked on Lido, a liquid staking protocol. What this means is it allows users to reap the benefits of ETH 2.0 staking yields while maintaining a liquid asset. If the price of stETH continues to go down, a liquidation cascade could ensue forcing the price down even lower.
What’s Happening?
After the UST debacle caused fear in the market, farmers wanting liquidity were forced to sell stETH to ETH, which caused the price of stETH to decrease. There is currently $2.8B stETH deposited on Aave, which is used for leverage through what DeFi users call a looping or recursive farming strategy. Essentially, stETH can be used as collateral for ETH loans and from there the ETH loan can be swapped into stETH to add to the existing collateral to create a leveraged position. Through this leveraged strategy, protocols like Instadapp are able to offer 9.7% APY versus the base APY of 3.7% as seen on Lido. Therefore, a stETH-ETH depeg could trigger liquidations to these leveraged users. The stETH/ETH is the largest pool on curve with a TVL of $1.8B and stETH/ETH with recursive farming as the most popular leverage strategy.
Even if stETH depegs 10%, only $100M would get liquidated on Aave, and users who are close to the liquidation threshold of 75% could deleverage or exit completely. If many farmers exit these positions, the depeg will worsen, but most expect long-term ETH investors to come in and restore the peg as they will be able to purchase ETH at a discount. The biggest risk is if these liquidations result in bad debt for Aave, but this is extremely unlikely.
Here was Lido's official statement on Twitter regarding the whole situation:
Lido warned leveraged users about their liquidation risk while ensuring that stETH will be fine long-term because it does not have to have price parity. Although users can’t yet make a 1:1 swap for ETH, this will be a feature once the ETH merge happens. Lido also launched a stETH/WETH pool on Curve with extra LDO incentives to improve the liquidity around the stETH/ETH peg.
Should You Be Worried?
Potential liquidations are a result of using leverage, so this was always a known risk. As Lido stated, stETH does not have to be pegged to ETH for it to function correctly and stETH will always represent a 1:1 claim for ETH on the beacon chain after the ETH 2.0 merge. Therefore, stETH dropping in price could actually present a great opportunity to buy discounted ETH, as long as you are not the one staring at a potential liquidation.
Written by: Zachary Rampone