What has gone wrong with Lido Finance?

The Eth 2.0 Merge

One of the biggest anticipated event in Web 3.0 world is called ‘The Merge’. It is when Ethereum moves from a Proof-of-Work to a Proof-of-Stake consensus. Proof-of-Stake (POS), as the name suggests, works when a large number of users stake their Ethereum to validate new blocks and achieve consensus. For POS to work, Ethereum Foundation has asked all interested holders to stake their ethereum to the chain.

Market Cap of Alt L1’s v/s Ethereum was rising in past 18 months(Source: TokenTerminal)

Liquidity Staking

Ethereum 2.0 required that stakers deposit a minimum of 32 ETH to become a validator. For most crypto investors, this would be a difficult threshold to cross (at the time of writing, this was ~$65k)

  1. There is no minimum ETH requirement for investors. ETH would be pooled and given to a LIDO trusted node providers (validator).
  2. While the original ETH deposited gets locked up, LIDO will mint a new token stETH that is directly pegged to ETH ( 1 stETH = 1 ETH). The best thing about stETH is that this token can be used by investors as collateral/yield generating asset on other protocols.
Lido Liquidity Staking Flowchart

stETH wonder

stETH stands for staked ETH token. stETH is minted only when corresponding amount of ETH is locked by LIDO for staking on Ethereum blockchain. This 1-to-1 backing ensures a stETH:ETH peg of 1:1 on paper.

stETH + ETH is the largest pool by TVL (Source: Curve Finance)
LIDO controls over 32% of staked ETH (Source: Dune Analytics)

Lido’s Terra Exposure

With the enormous success of stETH, LIDO started opening up its Liquidity Staking services for other chains.

Ton of videos on LUNA staking using LIDO (Source: Youtube)
Rapid growth in LIDO TVL, thanks to Terra (Source: TokenTerminal)
Sometime in March, staked LUNA was $7.72 billion (Source: Lido Finance website)

The Terra Collapse

Terra’s spectacular collapse meant all those stLUNA’s that were issued against LUNA turned worthless. Thanks to LUNA’s death spiral, over 6 trillion LUNA are currently in circulation.

>$10 billion TVL wiped out in a matter of days (Source: Token Terminal)

Loss of Confidence

In the aftermath of $UST collapse, investors seem to have lost confidence in LIDO. I say this because of two reasons:

  1. LIDO’s dominance in the Ethereum Liquidity Staking business seems to have taken a massive hit. LIDO completely dominated the ETH staking
Lido share in total $eth deposited (Source: Dune Analytics)
LIDO losing market share to Rocketpool after $UST collapse (Source: Dune Analytics)

The de-peg

Starting the 11'th of May, right after $UST collapsed completely, $USDT, a centralized stablecoin started to de-peg. While the world’s attention was on the largest stablecoin, there was a silent de-peg happening elsewhere. The $stETH:$ETH 1:1 peg started to go off-limits. It fell for the next 2 days and went alarmingly close to 0.95 (point where time-bomb activates, more on this in the next section) before it recovered.

The stETH-ETH time-bomb

This takes me to the last section — what happens if $stETH peg goes down further. To answer this, we need to look at all the places where $stETH is deployed in Defi.

1.3 million stETH worth $2.6 billion are used as AAVE collateral (Source: Dune Analytics)
‘Leveraged Ethereum Staking’ — loop goes on and own until you build max Leverage
Collateral Liquidation Analysis (Source: Lido Blog)

The stETH-ETH parity was taken for granted & investors leveraged their $stETH to maximum possible limit with very low margin for error.

Second order effects

Let’s run a scenario here:

  1. A liquidation event is triggered and the liquidator gets the assets ($stETH in this case) at an average 6% discount.
  2. Liquidator will most likely go to CURVE to swap $stETH:$ETH and realize instant profits. Since there is a constant selling pressure on $stETH, Liquidator is happy exiting his position as quickly as possible. This will add an additional $260 million to the Curve pool that is already short on Ethereum

Conclusion

To conclude, here are my key observations about LIDO

  1. A big beneficiary of Eth 2.0 merge
  2. Overstretched itself by dipping into the explosive growth of Terra
  3. Lost 50% of TVL and market confidence post Terra debacle
  4. Losing market share for its core ETH liquid staking business
  5. Risky environment is making people dump $stETH for $ETH at a discount
  6. LIDO incentives are not enough to reduce ‘fear’ among investors
  7. ‘stETH’ collateral has built a ‘leveraged Ethereum Staking’ Model on Aave
  8. Potential for mass liquidations and $stETH trading at deep discount to $ETH if $BTC falls further
  9. All the above is making Defi even more fragile in the current scenario

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Defipi Guy

Defipi Guy

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Defi investor and researcher. Macro analyst. Believe in first principles thinking. Believe in humility, open-mindedness and long term positive sum games.