Everything You Need To Know About stETH

As we know it is very important to always have a strategy when it comes to DeFi investments, and you can start by learning and getting the knowledge you need.

We are closer and closer to “The Merge”: Ethereum, after long years of research, is making its biggest upgrade yet transitioning from Proof of Work (PoW) to Proof of Stake(PoS). As a result, we saw the advent of a new market: the market of staking pools offering conveniences to individual holders to stake their ETH. 

There are many options for staking ETH. 

  • Solo-staking, doing everything at home by yourself, using a custodian, like a centralized exchange that takes ETH and stakes in your behalf
  • Liquid staking pools, services which try to offer the most convenient way to stake ETH by fixing some of the hurdles of solo and custodian staking. 

In this post we will focus on the last option, particularly in stETH from Lido

Most of these liquid staking services offer, in return for the users deposits, a token that represents how much ETH a user has staked in the service. But before delving into staking pools we need to answer the question in everyone's mind:

How does Ethereum PoS work?

Proof of Stake is a mechanism in which token holders lock or stake their coins to vote on blocks to safely move the chain forward. This mechanism replaces the electricity intensive PoW and the miners with validators who must decide which transactions to include

In short, Ethereum users that want to provide security for the blockchain and get returns must stake 32 ETH to the beacon chain. 

These users get rewarded for making the chain move forward with ETH inflation and in the future, once the Merge happens, they will also get transaction fees that currently accrue to miners.

What are the risks?

Stakers don't get returns for free, they provide a service for the network and are responsible for validating the chain correctly. They need to have 32 ETH to stake, and this limits small holders from participating in PoS. 

Staking while simple in principle requires some technical knowledge to avoid losses. Stakers might get slashed, meaning they could lose a part of their coins and be expelled from the network  as a validator, if:

  •  they have misconfigured their machine
  • they do some actions that could be seen as an attack from the point of view of the network. 

For example, voting for two different blocks in the same epoch would mean that they support two different versions of the chain, something that's known as a double spend attack. 

Also, the network penalizes being offline and stakers need a consistent setup to avoid losses due inactivity.  

Lastly, and more importantly, the 32 ETH cannot be withdrawn from the beacon chain until one fork after the merge. This limit puts a high opportunity cost on holders that might want to try to stake but cannot be sure if they would like to do so for such a long time or if it would be technically viable to do so without the ability to access their funds or even take profits on the stake.

All these challenges make solo-staking a complex undertaking that's not for everyone

This is the reason why staking pools and derivative staking tokens have come forth to offer to stake in the name of their holders in exchange for a fee of the staking profits.

Staking pools to the rescue.

Staking service providers, such as exchanges, DAOs or professional enterprises, offer to fix these problems for holders. They:

  •  take care of technical issues
  • are assumed to be professionals in the service they provide minimizing the chances of losses due slashing or inactivity and 
  • can offer instant redemption of the staked amount by providing a token. 

But how can the token be redeemed if the ETH cannot be withdrawn from the beacon chain?

The simplest solution is to let people freely trade these tokens that represent a claim on withdrawn ETH in the future. By nature of market pricing the token will trade at some discount or premium depending on the demand to stake with the particular provider that issued such tokens.

If I staked one ETH, maybe there will be some other market participant that would like to stake and wait until withdrawals are enabled in the beacon chain and we converge on some price. 

Multiple staking pools will offer different fee models and the demand to stake with one or other provider might not be the same due perceived or real risk. 

This means that there will be a dispersion of staked ETH tokens derivatives, one for each provider and each token will have a different market price

Since the demand for each provider will be different users who try to withdraw their stake from one pool might find that there is no liquidity for them to exit, or could find a steep discount for someone else to take their staked ETH token. 

This is a less than ideal situation. If I deposit 1 ETH I would prefer to withdraw exactly 1 ETH plus profits at any moment. It's expected that one provider that offers the most liquid token derivative takes the lion's share of the market by offering users the easiest way to deposit and, mainly, get out their stake, whenever they want.

Enter Lido

One of the most popular staking providers for Ethereum has been Lido

Users can deposit whatever amount of ETH they want in exchange for stETH tokens. 

stETH represents the combined value of all initial deposits and staking rewards accrued by Lido. stETH is a rebalancing token that once a day changes to match the total stake.
In simple terms users mint stETH when depositing ETH and will get ETH back according to the amount of stETH burnt once withdrawals from the beacon chain are enabled. 

Lido charges 10% of the beacon chain rewards as a fee. Lido has attracted a lot of participation with over 4m ETH staked through them. 

As more holders stake with the same provider and liquidity between ETH and stETH increases, more and more users get incentivized to use Lido thanks to the possibility of entering and getting out of their stake at their convenience. 

This has increased the utility of stETH in DeFi and it's expected that it will continue to grow as demand to stake increases. 

What can be done with stETH in Defi?

The deep liquidity of stETH has made it an attractive token for DeFi. Many users don't just hold stETH but take advantage of the token to earn extra profits assuming some extra risk. 

  1. The first is providing liquidity to automated market maker for swapping between ETH and stETH. The Curve pool has attracted a lot of capital since its inception and has come to be the leading place to swap stETH, LP providers also receive incentives in the form of LDO. There are also pools in Balancer and Uniswap v3
  1. Lending protocols have integrated stETH too. The Maker protocol offers users the possibility of minting Dai using stETH as collateral and even integrated Curve ETH/stETH LP tokens as another option. AAVE has support for stETH as collateral, allowing users to borrow all supported tokens with it. 

The DeFi offerings for stETH will continue to expand as the Merge gets closer and people feel more comfortable staking their ETH. We will continue to pay attention to the new developments to let you know how to best deploy your capital into DeFi.

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June 3, 2022

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