As stETH/ETH “decoupling” takes place, is it a disaster or an opportunity for Ethereum bulls?

Compiled and edited by: Mary Liu

The stETH/ETH “decoupling” is the latest event to catch the attention of crypto traders.

stETH is a derivative token backed by ETH 1:1. Users who stake ETH on the Lido Finance platform will receive stETH in return. stETH can be used in many ecosystem applications such as Curve , AAVE , and Sushiswap . Users are able to benefit from the annualized yields (APR) of these protocols while continuing to receive staking rewards on their Ethereum .

For most of its history, stETH has traded at par with ETH - the price drop began with the Luna/UST crash, and in the past 24 hours, the stETH/ETH ratio fell to 5% for the second time this month, and at the time of writing, the spread has recovered slightly to 3.9%.

How stETH/ETH continues to fluctuate, and what this means for Ethereum holders, will likely draw increasing attention in the coming days.

This post is divided into three parts:

• What is the relationship between stETH and ETH (not "pegged")?
  

• Latest on-chain activity
  

• Who are the market participants and predict their behavior
  

stETH: ETH, what is the right price?

A common misconception about stETH is that the price must be “pegged” to ETH and the game theory for market participants is similar to UST.

This is wrong.

stETH is pegged to ETH in a different way than stablecoins are pegged to their underlying collateral. There is no “necessity” for stETH to be tightly correlated to the price of ETH. It doesn’t matter if it fluctuates 90% below the price of ETH or 50% above it. Don’t lose confidence because of price movements.

stETH is fully backed by ETH on the beacon chain, and if the value of stETH drops further, this is not necessarily a problem for current holders. Each token is backed by 1 ETH, and the underlying collateral will be available when the redemption date takes effect. In summary, the factors that affect the price are:

• Low liquidity discount, because stETH can only be redeemed after the merger.
  

• Traders are eager to earn the staking yield (currently 4.0%).
  

• Some risk premium, as Lido has smart contracts and governance based on Ethereum staking.
  

Whether it is worth buying stETH now and getting back ETH after the merger depends entirely on personal evaluation.

In reality, the price is determined by the marginal seller or buyer, and Curve's main liquidity pool only has $1.2 billion worth of stETH and ETH. Selling stETH for ETH at a price of about $200 million, with no buyers on the other side, will basically break the Curve AMM function and cause the stETH price to drop significantly.

Curve works by putting quantities of two assets in a pool where traders can sell them. But because the seller is large, the pool becomes unbalanced. An unbalanced pool means that one of the assets, in this case stETH, becomes increasingly illiquid. Therefore, it becomes harder to sell because there is not enough ETH liquidity to fulfill a stETH sell order at the current price.

Who is selling and causing the stETH price to fall, and why?

Recently, a well-known entity sold nearly $100 million in stETH to ETH. Since it is impossible to know the exact identity, and I don’t want to speculate - let’s assume that this entity is “Alamo Research”.

When it comes to bank runs, there are the usual “suspects” who are thought to always be one step ahead. The initial drop began with the UST decoupling event, when another actor, who we assume to be “Jumping Capital”, dumped $51 million of stETH into ETH and UST to defend the $1 price.

Sellers may also be larger holders like Celsius who have to sell their stETH to cover ETH withdrawals for their clients. It’s hard to tell exactly how dire their situation is, but among those I’ve spoken to, there’s a legitimate fear that they’ll run out of funds — either sell now or get ahead of the curve.

Judging from the data, there are quite a few bargain hunters in the 100-1,000 stETH range, but so far, almost all transactions above 1,000 stETH are sellers.

Who is trapped? Who buys?

There are two groups of stETH holders that appear to be at risk:

• Entities like Celsius have to sell stETH for ETH to pay customer withdrawals (at prices that are getting worse).
  

• For leveraged liquidity miners (such as Instadapp Lite vaults), cascading liquidations will begin approaching 0.85.
  

It’s hard to know how much trouble there is, such as the Instadapp vault. Users can force themselves to deleverage and pay a 15% penalty (this function has been called multiple times in the past few hours). Previously, the Instadapp team was able to borrow USDC to cover the vault, and could do so multiple times to reduce liquidations.

stETH Liquidation Price

For long-term ETH bulls, the current situation presents an interesting dilemma and opportunity.

The current market sentiment is very bad, and there seems to be a significant risk of cascading liquidations, which will continue to push the price of stETH lower (theoretically, to the 0.65 range). It makes sense to wait for this opportunity because arbitrage is so simple - as visibility of Ethereum mergers and withdrawals increases, the price of stETH will remain very good as long as nothing catastrophic happens.

The question is when to enter a stETH position.

Buying now will at best "earn" a few percentage points, while waiting may allow for a better opportunity (e.g. 0.70 to 0.98). A big drop could be a precursor, because if one is bullish on ETH, buying stETH at a discount is the easiest smart decision you can imagine.

If you don’t plan to sell your ETH, then the merge won’t happen and redemptions will never be possible, which is equivalent to the entire market being so bad that ETH is worth nothing anyway.

The only question is: when will the buyers come in?