Lido Increases Liquidity Incentives as stETH Trades at Discount to ETH

UST’s collapse continues to reverberate around crypto markets. 

Curve’s largest pool is out of whack — the stETH pool, which pairs ETH with stETH, a staking derivative of ETH, shows stETH trading at a 2% discount to ETH. 

The imbalance may indicate that investors are dumping illiquid assets, such as a derivative of ETH locked in Ethereum’s proof-of-stake chain, and rushing to cash.

stETH is a token issued by Lido Finance. Users stake their ETH via Lido in exchange for stETH, on a one-to-one basis. Later when Lido unlocks the ETH after withdrawals from Ethereum’s Beacon Chain are live, users should be able to redeem their stETH for their ETH, plus the accrued staking rewards.

In the meantime, users have stETH, an asset to potentially earn yield with, all while also earning staking rewards through Lido. Like many moves in crypto, this one comes with the risk that stETH keeps its peg — something it has done so far thanks to the stETH pool on Curve which is heavily incentivized by Lido. 

Now, there are signs of fragility.

ETH currently consists of 31.7% of the liquidity pool with stETH making up the other 68.3%. The pool has $1.8B in TVL as of May 12. The imbalance in the pool creates the discount as traders appear to be swapping their stETH for ETH. As a general rule when it comes to liquidity pools, the scarcer asset tends to trade at a premium.

It isn’t immediately clear why people are dumping their stETH. “Not sure of the rationale driving this move,” DeFi influencer Degen Spartan tweeted about the pool’s imbalance. 

But the departure from ETH-stETH parity certainly has people talking — users take loans out against stETH in order to increase leverage while also benefiting from ETH staking rewards which will be unlocked after Ethereum’s Merge.

Potential Liquidations

So if stETH’s value collapses relative to ETH, users could get liquidated as the value of their loan increases relative to the collateralized staking derivative  — this may already be happening. For example, a user who borrowed ETH against their stETH got liquidated on Aave.

According to a chart by data provider Parsec Finance, if the price of stETH falls a bit below 0.95 ETH, it will cause over $200M of liquidations on Aave. This number will increase the further stETH falls, in a classic liquidation cascade scenario. 

0xngmi, the founder of DeFi Llama, corroborated the number on Twitter.

LDO Incentives

Lido has taken notice. “We are deploying an additional Curve Finance pool to improve liquidity around the stETH:ETH peg,” the project tweeted on May 12 as concerns about diverging prices circulated. Lido is offering 1M LDO tokens, worth $1.34M at current prices, as incentives for users to provide liquidity to the new pool. 

DeFi influencer 0xHamZ cited a mammoth $33.6M trade of ETH for stETH on Etherscan as evidence that concerns about the staking derivative losing its peg to ETH have passed for the time being. As the trade came after Lido deployed its new pool, it’s possible users were reassured by the move.