Bad bets on 'safe' tokens are fueling the crypto crash

Staked ether is the latest token to cause a liquidity crisis in the crypto market.

A piggy bank with money going in and out

The stETH token was supposed to be equal in value to ether. But that peg started to erode.

Illustration: Christopher T. Fong/Protocol

Three Arrows Capital, one of the biggest crypto hedge funds, is facing questions about its solvency amid a broader market meltdown.

The latest challenge involves staked ether, or stETH, a token on the Lido Finance network. The episode is the latest example of complex crypto derivatives once considered relatively safe — bets that have turned out quite differently in a broad crypto downturn. A dive into the mechanics of staked ether reveals how things can go wrong so quickly in crypto markets.

What’s at stake

Staking is a common concept in DeFi — essentially pledging a token and tying it up with smart contracts so it can’t be spent or sold, usually in exchange for earning an interest-like yield. It’s become a big part of Ethereum’s upcoming move to proof of stake, known as the Merge. Part of that involves letting investors stake ether to earn rewards on the new Beacon Chain.

Staking on the new chain locks up an investor’s ether until the Merge is complete. It also requires 32 ETH, or nearly $40,000 at recent prices, to participate. Lido created stETH to let smaller investors get in on staking rewards without the 32 ETH minimum, which in theory creates a more liquid market — it also lets them reinvest that stETH, which is otherwise locked up in so-called “liquid staking.”

Some DeFi investors have taken this risk to another level by engaging in a recursive trade by depositing ETH, getting stETH, then depositing stETH as collateral on a lending protocol such as Aave in order to borrow more ETH, and then go back to Lido to get more stETH.

This stETH token has become popular in DeFi, with the protocol grabbing 32% of all the ether staked on the Beacon Chain. And like UST, the stablecoin of the Terra network, it was until recently considered a relatively common and less risky trade in the risky world of crypto investing. In stETH’s case, this was due to the popularity of ether as the second-largest token and the widely expected finality of Ethereum’s Merge coming this year.

Investors just had to believe that the Merge would happen soon, and that in the meantime they could trade back out to ETH if they needed to. But the Merge now looks like it may happen later than expected because of technical challenges, another development that may have spooked investors in addition to the general market downturn.

Like UST, stETH also presented a liquidity problem once investors started to run for the exits, because unlike some other forms of crypto staking, the underlying ether tokens can’t be unlocked. And like UST, much of its liquidity was on Curve, a decentralized exchange focusing on liquidity between stablecoins and other similar coins with little slippage in trading.

The stETH token was supposed to be equal in value to ether. But that peg started to erode during the Terra collapse and was lately down about 6%. With investors looking for liquidity, selling pressure on stETH has increased.

That has also placed pressure on the Curve liquidity pool where stETH is traded. Typically such a pool would show a 50/50 split for stable assets, in this case a balance between stETH and ETH. Instead, more than 80% of the ETH/stETH pool is now stETH, indicating that investors are unloading stETH.

Enough arrows in the quiver?

Three Arrows Capital, which has invested in Avalanche, BlockFi and Polkadot and had $10 billion in assets in March per crypto analytics firm Nansen, was liquidated by top lending firms for at least $400 million, according to The Block, throwing its solvency into question.

One of the firm’s holdings was staked ether. Three Arrows withdrew more than 80,000 stETH from decentralized lending service Aave. It then traded 38,900 of stETH for ether, at more than a 5% discount to the cost of ether, according to Nansen.

Three Arrows co-founder Zhu Su tweeted a cryptic message Tuesday about trying to resolve problems. “We are in the process of communicating with relevant parties and fully committed to working this out,” he wrote.

The firm, also known as 3AC, has faced several challenges in recent weeks, including the Terra crisis. 3AC bought UST in an effort to prop up the network, which ultimately collapsed. The firm did not respond to a request for comment.

Celsius has also faced a liquidity crunch. The lending company announced on Sunday night that it had stopped all withdrawals, swaps and transfers. It is now reportedly seeking financial support and a possible restructuring.

The staked ether issue is Celsius’ latest challenge. Celsius had offered staking of various tokens for its customers, paying 6-8% on ether. It’s not clear what portion of its customers’ ether was in stETH, but Celsius itself had at least 409,000 stETH, worth roughly $463 million, in its wallets. With the imbalance in the Curve stETH pool noted above, unwinding that position could be difficult.

Alameda Research, the crypto trading firm founded by FTX CEO Sam Bankman-Fried, also reportedly recently sold 50,615 stETH, according to Coindesk.

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