Lido staked ether has caused a liquidity crisis in the crypto market
User funds will remain safe unless stETH sells at 15% discount, Instadapp founder Samyak Jain said
Instadapp, a smart wallet built on top of popular DeFi projects such as Uniswap and Maker, is designed to help manage assets for users with little financial or technical background. But in addition to smart contract risk, the ongoing instability in the price of Lido staked ether (stETH) has the potential to wreak havoc.
The company launched Instadapp Lite in March, a platform that allows its users to earn interest by depositing funds into strategy vaults, including swapping ether for stETH. The strategy currently earns a projected 7.79% annualized yield, by applying leverage.
While stETH was expected to trade at the same price as ether, it is not pegged to it and in fact has recently traded at a discount. Ordinarily that’s not a problem, and funds in Instadapp’s vault will remain safe unless stETH diverges in value relative to ETH by -15%, Samyak Jain, founder of Instadapp, said during a Wednesday Twitter spaces interview with MakerDAO.
So far, stETH has remained no more than about -7% relative to ETH, but the gap is wide enough to cause fears of a liquidity crisis in the crypto market. As of Thursday at 11:00 am ET, each stETH trades at about 0.95 ETH.
After TerraUSD (UST) collapsed in May, setting off a broad market decline, demand for stETH dropped substantially as investors seeking liquid assets rushed to sell. That placed significant pressure on liquidity pools where stETH is traded, chiefly the Curve decentralized exchange.
The crux of the problem is that once stETH is minted, it cannot be redeemed until after both the Merge — when the Ethereum blockchain migrates from proof-of-work to proof-of-stake — and a further upgrade that will enable withdrawals expected in the second quarter of 2023. While stETH itself is fully liquid, the ETH backing it is not, and the market therefore applies a discount.
The Lido DAO which administers stETH has tried to mitigate risks by increasing short-term rewards in its LDO governance token tokens.
“The most [Lido] can do is create awareness and provide rewards so that users are willing to buy more stETH in the current market situation,” Jain said. Until then, the stETH price divergence remains a risk.
Despite his concerns, Jain remains optimistic that the price of stETH will recover once the market stabilizes, stating in a blog post that “almost all my ETH holdings are in the form of Lido Staked ETH.”
A second vault in Instadapp Lite generates additional yield by betting on the future price of stETH but allows users to deposit and withdraw in USD Coin (USDC), a stablecoin pegged to the US dollar.
This approach uses the first stETH strategy, by borrowing ETH using USDC as collateral in the Aave money market protocol and buying stETH. The stETH is then supplied to Aave and used to borrow an equal amount of ETH, which is sold back to USDC, and also supplied to Aave. This limits directional price risk on ETH, and uses ETH staking rewards converted back to USDC to generate interest.
“You are able to capitalize on the current market inefficiency by first building a capital allotment, in this case using USDC. [You can utilize] that capital to borrow in ETH and buy stETH at a discounted rate which you can immediately cash out,” he said.
If stETH returns to par with ETH, you can close the position and pocket the extra profits, Jain said.
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