In the Recent Crypto Market Meltdown, What Role Did Lido's stETH Play? - Ep. 370

Hasu, strategic advisor to Lido, and Tarun Chitra, founder of Gauntlet, explain everything about staked ETH, aka stETH, how it should be priced, Lido’s market dominance, and much more.

Show highlights:

the role of Lido, what stETH is, and what its benefits are
whether Ethereum’s lack of delegated proof of stake contributes to the need for stETH
why stETH is not mispriced and why it doesn’t necessarily have to be worth 1 ETH
the inherent risks associated with stETH
how there was not enough liquidity to handle all the liquidations, especially in automated vaults on, for instance, Instadapp
how automated market makers work and what Curve’s amplification factor is
whether 3AC and Celsius had a significant impact on the stETH/ETH “de-peg”
how does the Merge affect the liquidity of stETH
Hasu’s and Tarun’s level of confidence that the Merge will happen this year and whether it will be a success
what will happen to the price of stETH after the redemptions are enabled
why Lido has achieved such a level of dominance
how Lido decreases the cost of staking and helps improve the security of the Ethereum blockchain
whether there is going to be a “winner take all” in the liquid staking derivatives market
how liquidity fragmentation can cause the system to blow up
why LDO tokenholders might not have the same incentives as ETH tokenholders
what is Lido’s new dual governance model and what is it trying to achieve
whether Lido should self limit its market dominance
how Lido coordinates validators and the role of the LDO token in this coordination
what are the lessons to be learned from the stETH situation
how governance is a liability to DeFi protocols

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EPISODE LINKS

Episode Transcript

Laura Shin:

Hi, everyone. Welcome to Unchained, your no-hype resource for all things crypto. I’m your host, Laura Shin, author of The Cryptopians. I started covering crypto seven years ago, and as a senior editor at Forbes, was the first mainstream media reporter to cover cryptocurrency full-time.

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Today’s topic is staked ETH. My guests are Hasu, strategy lead at Flashbots and strategic advisor to Lido, and Tarun Chitra, founder of Gauntlet. Welcome, Hasu and Tarun.

Hasu:

Hey, Laura and Tarun. Nice to meet you. Thanks for having me.

Tarun Chitra:

Hey. Great to be back.

Laura Shin:

This is actually going to be the first in a two-part series on staked ETH or stETH/Lido since there are a couple big issues regarding it that I felt should be separated out into their own shows. Today’s show mostly focuses on stETH’s role in recent events, such as those involving Celsius and Three Arrows, though we also get into issues with Lido’s power and proposals to address that. Tarun and Hasu, before we dive into some of these recent issues around stETH, let’s make sure people understand what it even is and why people have been wanting it, meaning what it is they do with it. So, Hasu, why don’t you start with a description?

Hasu:

Sure. So, staking in its native form on Ethereum has a few problems, right? So, for one, there’s operational complexity. Users want to stake their ETH but not run the hardware, missed attestations get slashed, et cetera. Then there’s the cost. Staking is only possible in multiples of 32 ETH, and even in the bear market that’s still a lot of money for a lot of people that they might not have lying around, and the third problem is liquidity. So, if you stake, you have to lock up your capital and cannot use it in DeFi at the same time, and this is a problem especially because the Beacon Chain right now is a one-way street. So, people can only stake, but they cannot unstake, and unstaking is only becoming available in the update after the Merge, which is called Cappella, and that’s expected to be around 8 to 9 months out.

So, Lido is a decentralized liquid staking protocol, and it works in the following way. So, users give their ETH to Lido, and then Lido gives it to 1 of 29 professional node operators who stake it on their behalf. Lido issues the users a token that represents the stake on the Beacon Chain, and this token is called staked ETH. After withdrawals on the Beacon Chain are enabled, from that point on users can take one staked ETH and redeem it for one ETH, and the reason that this token is so useful and Lido has been very popular to date is that this staked ETH is like a somewhat sort of inferior form of ETH itself. It’s like a token that people can use to represent their stake and you can use it in DeFi. They can trade out of it, which wouldn’t be possible otherwise, and they can collateralize it in lending markets, like Aave or MakerDAO. So, in many ways, users have found this to be better than running their own hardware and staking directly.

Laura Shin:

Yeah, and just to be clear, oftentimes when they get the staked ETH, they deposit to Aave in order to borrow more ETH, stake that, and then get more stETH, et cetera. So, one question that I wanted to ask here is, you know, you were talking about how part of the reason for this is because people want to be able to have liquidity on the ether that they stake, and I was just wondering also because there are other systems that use delegated proof-of-stake. Does Ethereum’s lack of delegated proof-of-stake contribute to the need for staked ETH or is that not the case?

Tarun Chitra:

Yeah. I mean, I think one important piece to remember about this is that there’s sort of a philosophical bias in the Ethereum 2 community against any form of delegation. I think the long-term goal of that research community was to have sort of a one-person, one-node type of version of the world where everyone was running their own validator. They had their own keys. Of course, I think in practice things got much more complicated, and we started to observe basically exchanges offering sort of staked ETH products, like centralized exchanges, like Binance and Coinbase, where basically if you left Ethereum on exchange, then they would delegate it and run a validator and give you some or most of the yield, and I think effectively Lido wanted to make a decentralized version of that possible, and of course there’s multiple versions of staking derivatives now, but Lido has sort of the dominant market share. If we look right now it’s like a little over 90 percent of staking derivatives are in Lido, but I think one of the most main things was exchanges started to aggregate this power and it became clear that there needed to be some sort of decentralized alternative, and the decentralized alternative’s main value proposition over the centralized version was that you could use it in DeFi in different ways, and so, I think that the genesis does sort of stem from that and that is sort of, you know, I think one of the reasons…it is effectively an indirect form of delegation. It boils down to the sort of philosophical divide amongst Ethereum 2 researchers to whether it’s better to have delegation or not.

Laura Shin:

Yeah, and I guess since Ethereum doesn’t really have governance, maybe even delegated proof-of-stake wouldn’t even make sense. Let’s now talk about the reason why stETH has been in the news so much. One of the main issues is that people feel that stETH has been mispriced for much of its lifetime. The price of stETH has basically been the same as the price of ETH, sometimes maybe a little bit less, like 0.99 or 0.98 ETH, but once the issues with Terra began a little over a month ago, then it began falling a little bit, and then once the problems with Celsius and Three Arrows kicked off, it really took a dive, and now it’s at more kind of like 0.94 or 0.95 ETH. Why do you think that is?

Hasu:

For one, I think we can say that staked ETH has not been mispriced to date, and I can give an explanation for that. So, one staked ETH, as we said, can be redeemed for ETH when the withdrawals become available, and sort of this is what we would call the primary market exchange rate, and then what you described sort of is the secondary market exchange rate, the price at which staked ETH holders can sell it before withdrawals become enabled, and so, staked ETH is a rebasing asset. That’s something we should also mention, so meaning it’s balance goes up over time. So, if the staking yield were 5 percent, then after one year of holding staked ETH, then you would have in your account 1.05 staked ETH and then you can use it and redeem it for 1.05 ETH. So, if withdrawals were enabled today, then I think we could straightforwardly say that one staked ETH must always be worth one ETH, right, because there’s like a no upcharge condition. Like, if it were like more valuable, then people would sort of create more staked ETH and sell it, and if it were less valuable, then people would withdraw the ETH and sell that instead, right? So, but there would always be arbitrage to what’s the price of one.

So, now…but this is not yet possible to withdraw, right? So, instead we have several market forces acting on this exchange rate between staked ETH and ETH, and the biggest one is sort of the fact that it is a yield bearing asset. So, and this is sort of a market force that pushes staked ETH to trade above ETH. Why? Because if you stake it today, then you can redeem it for more in the future. So, that’s one reason like for staked ETH to trade above one ETH, and then you have a couple reasons why it should trade below one ETH, and that’s sort of…there’s risk inherent to Lido, mainly technical risk and governance risk, and then you have risk inherent to Ethereum and the Merge, so whether they can execute it on the timeline that we all expect. And finally, you have liquidity risk. So, that sort of you need to sell your staked ETH at any time before withdrawal has become available but sort of the price is somewhere where you have to sell it at a discount, right, and depending on the current market conditions, sort of these market forces are stronger or weaker than one another. So, before sort of the recent market downturn, staked ETH has indeed been trading at one ETH. Why? Because investors were sort of favoring this yield that they could get from staking more than the risks and especially sort of this cost of liquidity, and then the market turned, and all of a sudden, this is what always happens in every market sort of when there’s a downturn, investors and market participants really start to favor liquidity, right? They want to be in the most liquid assets where they can be the safest and they can sort of sit out the storm and react to any market conditions, and so, I would say this paired with, and we already alluded to it, but a lot of forced selling from parties that were also owning staked ETH and got liquidated.

So, this then sort of caused, yeah, basically selling from staked ETH into ETH and sort of pushed the price downward, but that doesn’t mean that it was mispriced before. In fact, you can sort of easily see why that’s not the case because if staked ETH, and this is what some people argue, should always trade below one ETH, then anyone who would want to join the Beacon Chain and start staking should always buy staked ETH on the market and stake that way and never stake directly, but if they did that, then they would just arbitrage the price of staked ETH until it is one ETH again. So, we can see basically whenever there’s excess demand to join the Beacon Chain, then the two should be exactly priced 1 to 1, and when then there’s sort of a drop in demand to stake and people, for example, favor liquidity or the risk goes up of 2 or of Lido, then you have these other market forces that push it down and there’s no way to arbitrage it back up because withdrawals are not yet enabled. So, in a nutshell, that would be my explanation for how staked ETH trades against ETH in various market conditions.

Laura Shin:

Tarun, do you agree with that?

Tarun Chitra:

I think that’s sort of like the correct maybe like the zero order or first order model. There’s some second order effects which actually were kind of the scary part / why I didn’t sleep for, oh, a lot of days and was pushing all these, you know, we at Gauntlet were pushing a lot of governance proposals to try to like scare people into reducing their leverage, but basically I think while that is true in sort of this idealized case of like really high liquidity, this indirect way of kind of closing the arbitrage loop, a lot of people who were participating in this market were mainly participating in a quite over levered way. So, there were certainly like a few sort of people who offered vaults where you could deposit ETH and they would go, basically mint staked ETH, borrow ETH against a staked ETH, and recurse that a certain amount of times, and they sort of hard coded a lot of their assumptions about like how much leverage is okay. So, if you think the price is always at one or very close to one, then you could basically say, hey, I can like take a lot of leverage. If you think it actually has some volatility and might actually go down to 0.94, you might say, okay, maybe I’ll only take 2x leverage.

Now, the problem with some of these vaults and the one that was the scariest and was the closest to having the most cascading liquidations failures when Three Arrows made that 30,000 staked ETH sale was Instadapp, and so, Instadapp has this vault that basically was a little bit reckless with how much leverage it allowed people to take because it really basically made this assumption that staked ETH to ETH would like never go below 0.97, and I mean, there was this moment right after the Three Arrows staked ETH trade where the net liquidity for selling staked ETH…so if there’s like a liquidation, someone will basically buy the staked ETH collateral from Aave and then sell it somewhere, and staked ETH’s dominant liquidity is on-chain, and it’s mainly in Curve, there is a bit in Uniswap, and most of that comes due to a combination of like how incentives are constructed, and you know, where the Lido governance token and the Curve governance tokens are sort of provided as incentives, and there was a really crazy point where like basically there wasn’t enough liquidity in the Curve pool to handle all of the liquidations if you had this thing where Instadapp got liquidated and right below Instadapp, basically if you assumed the liquidator immediately sells all the Instadapp positions, they basically trigger sort of a cascade of like some other positions now, like the price goes down.

Say it was at 0.94. Instadapp gets liquidated. When it gets liquidated, they sell it on Curve, and the price goes down to 0.93, and then when it’s at 0.93 there’s some other loans in Aave that get liquidated, and there was definitely a huge contagion risk there, and most of that had to do with the fact that the market’s belief in this kind of low volatility of this price meant that people overleveraged themselves, and some of the reason this liquidity risk got priced incorrectly to some extent was basically because people weren’t accounting for the fact that like the amount of leverage being used was really high, and I think that impact, you know, obviously has stuck with the minds of people who are purchasing staked ETHs, which is why it kind of has not been…I mean, there’s a lot of bids from 0.93 up nowadays, but it doesn’t seem like there’s…there’s definitely people who realize that there are these like extremely scary automated vault strategies that basically are quite reckless and the end users I think don’t realize that they’re kind of in this sort of precarious position.

Hasu:

Yeah.

Laura Shin:

Yeah. I would imagine that plus the general macro environment altogether just suddenly has everybody sort of, you know, pulling up the drawbridges and being like, oh, you know, I’m not going to do these risky things. JR on Twitter asked, was stable swap or stETH/ETH Curve, ETH Curve pool, a good, automated market maker choice for an asset that “shouldn’t” trade 1 to 1? So, I’m not sure how this Curve pool, how it was set up, but like was it something where the assumptions were that it would always be 1 to 1, or…?

Tarun Chitra:

So, I mean, it does assume you’re sort of mean reverting around some points. So, it’s an automated market maker that…so, Curve is sort of, I think the simplest way to think about it is there’s…the two most simple types of automated market makers are one, which is sort of a constant price. So, people put in reserves of asset A and asset B, and you say, hey, asset B always costs five units of asset A, and then basically people can buy until, you know, there’s only asset A left or only asset B left, and that’s sort of a linear automated market maker. It’s not…it gives you a fixed price. You have no price impact, and it’s good for things that should be kept at roughly a constant price. On the other hand, you have something like Uniswap where you have this sort of constant product type of formula, and that constant product formula, the price is based on the ratio of the amount of reserves in the pool. So, like on each trade, the reserves are going, you know, one side of the reserve’s sort of gaining, the one that’s sort of less in the demand, and the one that’s depleting is the one that’s more in demand, and Curve is sort of an average of the two of them. It combines this very flat. It doesn’t move the price, at least within some range piece, and then moves the price a lot when you’re outside. Effectively, I think there is to some extent some bias in Curve to where it’s kind of staying near the center point. However, some of the trade sizes we saw were large enough that I think we got outside of the kind of flat region. So, there’s a parameter in the Curve system called an amplification factor, which controls effectively how big does a trade have to be until the price starts moving really fast? And I think that was actually being monitored and to some extent adjusted, probably not as frequently as it should have been. Long story short is I think you could imagine if Curve’s amplification factor was adjusted more frequently and the incentives were adjusted, it could’ve been fine. I think it just, things sort of happened quite fast, and I’m not, I wouldn’t make the argument that Uniswap v3 would be better for sure because you would have to still have people constantly adjusting the ranges in Uniswap v3, and in a kind of crisis time, if no one actually does that in time, then like someone makes a trade and then there’s no liquidity on the other side. So, I think like the dialectic here is there’s not really one best design here. It’s better to actually have many different AMMs providing liquidity, and it’s just that in the case of Lido, it mainly was Curve.

Hasu:

Yeah. So, I think I would like to connect a few dots here. So, from Tarun’s previous answer. You made a very good point, which is that sort of the pricing model that sort of I laid out for like staked ETH versus ETH is correct, but it wasn’t the pricing model that the whole market used, and it’s very important that people understand why a certain asset should, like trades a certain way and how it should trade under certain market conditions, right, because otherwise they just make financial decisions that could be bad for them or in the case of cascading liquidations be bad for the entire ecosystem. That’s the first dot, and the second is sort of Lido has been incentivizing liquidity around certain price points or like putting incentives on certain pools. Why? They did this in order to provide this service for staked ETH holders to, you know, have the liquidity and sell their ETH when they want to, right? So, they want to ensure that there’s a liquid market, and then the second dot is the right curve design.

So, the goal of the perfect pricing curve is basically to predict where the market maker in that case should be deploying liquidity, right, at what price points they should sort of reserve and put their inventory and sort of make it available for sale, and so, I think how all of this fits together is basically that the Curve pool hasn’t been, you know, as good at sort of reacting to when the market conditions changed, according to the pricing model, and the fair price for staked ETH was starting to be sort of below one, and so, I think a different, like using a more flexible AMM, like Uniswap v3 I think would’ve made it easier to sort of just shift where prices should be coded because what Lido should in fact do is not incentivize liquidity at the peak. They should incentivize liquidity at whatever is the fair market price at the time, at least that’s my view because I think that’s where they get sort of the most, yeah, liquidity for their value, right, because if they were deploying it below the market price, then it wouldn’t be very effective for anyone who needs that liquidity right now, and if they were deploying it above the fair point, then it could be arbitraged down to what the fair price is. So, I think they are always incentivized to maximize liquidity around what the current fair price is, and in order for that, using the right AMM and the right curve design, it’s very important.

Laura Shin:

Earlier we were talking about how we had all these cascading liquidations, especially exacerbated by some of these automated vaults, like by Instadapp and stuff, and I just, you know, sort of need to address one of the elephants in the room, which is that, Hasu, you host a podcast with Su Zhu, one of the partners behind Three Arrows capital. So, I don’t know if there’s anything you can either reveal about that situation and its effect on the market, or your relationship to 3AC or anything like that.

Hasu:

So, like everyone else, I learned about the Three Arrows situation from the media. I haven’t talked to Su since. Yeah. So, I think if I had to guess like the connection to this is that both Three Arrows and Celsius were both large owners of staked ETH like, as were many others, but I don’t think it contributed in any way, so the staked ETH price deviating from one contributed in any way to, you know, how all of this played out. If anything I think sort of the causality here is reversed because both Celsius and Three Arrows became large sellers of staked ETH, and as Tarun was pointing out earlier, they had to sell several hundred thousand staked ETH into the market. So, that would be my take on the situation.

Laura Shin:

But I don’t understand. I thought…wouldn’t that then lower the price of stETH? So, why is it that you don’t think that that contributed to not being…?

Hasu:

Oh. So, I’m saying that the reason that the price declined was in part due to their forced selling.

Laura Shin:

Oh, right. Right.

Hasu:

Yeah.

Laura Shin:

Oh, okay. For some reason I misheard you and I thought you said it the opposite way. So, obviously we don’t really quite know the full state of everything now with either of those companies, but assuming that they both still have some staked ETH, then do you imagine it’s more likely that they might be forced to sell even more of it to try to recover some liquidity for their users or LPs, and then, you know, are we basically looking at another potential depression of the price in the near future?

Hasu:

I don’t know if they have any more staked ETH. I haven’t been following the situation. Tarun, do you know?

Tarun Chitra:

I think some of their wallets have a little bit, but nowhere near as much as the Sunday, June 12, that was like the kind of crazy like in 4 a.m. roughly Eastern time, that was like when that huge sale happened, and then there was just a ton of bots trading right after that.

Hasu:

What I heard about Three Arrows as well that they are entirely out of liquid assets, and so, staked ETH would be a liquid asset and sort of liquid assets would be investments that they made that are somehow locked up or subject to vesting schedules, right? So, I don’t think staked ETH would be affected by that.

Laura Shin:

And what about Celsius?

Tarun Chitra:

They do still have some staked ETH, but mainly because a lot of it is locked up as collateral. Their strategies, at least the ones that we’ve spent time analyzing, they don’t just lever up on staked ETH directly. They borrow stablecoins and they borrow other assets. That was why they were quite close to being liquidated actually because the ETH price drop was more deadly to them than the staked ETH/ETH ratio because they borrowed a lot of stablecoins and farmed in other places. So, Celsius was a little more, ironically, probably less systemic risk to staked ETH itself but like more systemic risk to the overall all DeFi protocols whereas I think the Three Arrows and sort of Instadapp falls were very like concentrated in the staked ETH type of thing, but yeah, I mean Celsius was really farming anything and everything that had…I had not heard of some of these protocols that they were putting their capital, putting their users’ capital in I guess.

Laura Shin:

Oh, dear. Oh, dear. Okay. So, in a moment we’re going to talk about a whole host of other related issues, starting with the Merge, but first a quick word from the sponsors who make this show possible.

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Back to my conversation with Hasu and Tarun. Okay. So, as we were discussing earlier, once the Merge happens, that’s actually not going to, you know, immediately affect the liquidity of stETH. I think you said it will still be locked up for like 8 or 9 months.

Hasu:

Yeah. So, I think that the hard fork that would enable withdrawals is scheduled to be around six months after the Merge. So, basically it’s time to the Merge plus six months, and you know, most people are estimating that to be around 8 to 9 months.

Laura Shin:

Okay. So, let’s talk a little bit about how uncertainty about the Merge has also been affecting either the price of stETH or just some of these issues that we’re seeing. This is like a quick lightning round. What’s your level of confidence that the Merge will happen in the next few months?

Hasu:

I would say like 70 percent that it happens by October.

Tarun Chitra:

I’m perhaps more pessimistic. I actually think it’ll be early next year, not this year.

Laura Shin:

Okay, and for both of you, what’s the level of confidence that you have that the Merge will go smoothly?

Hasu:

I think pretty high. If they do decide to go through with it, then I think the amount of testing that we’re seeing and the amount of preparation we’re…make me pretty confident that…I think it can get delayed, as Tarun was saying, but I think if they do go through with it, then it’ll most likely go smoothly.

Laura Shin:

And so, on a range of 1 to 10, 10 being extremely confident, 1 being not confident, how confident are you that it will go smoothly?

Hasu:

7 to 8.

Tarun Chitra:

I’m somewhat more pessimistic also. One thing I do think is maybe being underweighted probability-wise is just like the fact that miners really enjoy keeping the PoW fork alive, like keeping the current chain alive, removing the difficulty bomb and just continue mining on the existing chain. I know that’s not, it might not be the most likely scenario, but I don’t think it’s as low a probability as, you know, if I were to read kind of Twitter sentiment.

Hasu:

You know, I have a counter take on that, which is I think the more that miners do something adversarial around the Merge, the sooner the Merge will happen, not later.

Laura Shin:

Wait, I’m sorry. The more that miners do what?

Hasu:

The more miners engage in adversarial behavior around the Merge, I think the more likely are Ethereum core developers to pull the Merge ahead instead of pushing it out. That would be my take based on conversations with them.

Tarun Chitra:

Right. I just, I’m not sure how easy it is to gauge whether they’d actually be doing that. I mean, obviously they’d have to collude to do it to some extent and make a new client upgrade and stuff on their own, but I just think like the probability of that happening is like weighted way too low to me, but I think like testing wise, I mean the fact that they already got one of the testnets converted is actually a good sign. I’m just still a little more, I just think like, yeah, the miner adversarial behavior I think is maybe being somewhat underestimated. So, I think my confidence is probably like a less than Hasu, but like 6 or 7.

Laura Shin:

Yeah. After reporting on my book and how the ether classic thing went down, I would definitely say it does not take a big group of people, yeah, because back at that time, you know, most people in Ethereum really did support the hard fork actually, at least as far as I can tell, and I definitely think as we’ve seen that it was certainly a minority, but that’s all you need really. So, after stakers are able to withdraw their staked ETH, after the Merge, how do you expect them to behave in terms of the withdrawing? Do you expect to see that everybody will want to withdraw, or do you think it’ll be kind of a slower type of withdrawal, or how do you see that playing out?

Hasu:

No. Quite the opposite, I think. So, not after withdrawals are enabled, but I think, first of all, like after the Merge, I think the demand to stake will go up. Why? Because right now stakers on the Beacon Chain, only on the Beacon Chain block subsidy, but after the Merge, Beacon Chain will be responsible for ordering Ethereum itself, right? So, it will be on on transaction fees and MEV on top. So, you can expect the staking yield to go up quite a bit from where it is today. So, I think that will, and I mean, also sort of reducing this entire uncertainty around will the Merge happen and what time will it happen? I think sort of confidence in Ethereum’s ability to execute on major upgrades will go way up, sort of making investors more optimistic about the longevity of the project. So, I would expect sort of actually like much more stake to come in after the Merge, and then, yeah, it doesn’t really make sense that there would be large withdrawals, unless in fact staked ETH at the time is then trading like below one ETH. As we said, there are market conditions where it can trade below one ETH, and if that happens, then the arbitrage will ensure that staked ETH is being bought up on the market at a discount, and then withdrawn, and then the ETH is put out and sold in order to make a profit. So, that’s when you should expect withdrawals to happen, but if staked ETH is trading anywhere near to one ETH then I don’t see any reason why there should be any withdrawals.

Tarun Chitra:

I think one sort of important thing that will be true is just like how liquidity incentivization works around the withdrawal event. So, if, you know, there’s A, multiple AMMs with, you know, greater than 20-plus percent of the overall liquidity so that, you know, you have one that’s maybe like a Curve pool that’s good for when you’re in kind of the mean reverting phase, and then you have something that’s more like Uniswap v3 for that phase, and you have incentivized liquidity accurately between the two of those, I think you could actually be quite fine, even if people are unlevering because there is one other impact which is upon the Merge, people who were really levered may actually want to lower their leverage in staked ETH terms and increase it in ETH, raw ETH terms, depending on what yield opportunities exist post-Merge, which there might be yield opportunities that are specialized to ETH2 at launch that basically, you know, you can’t access with staked ETH.

So, that would be a condition I would say like provided the liquidity incentivization is diffuse enough and can cover sort of these sort of automated rebalancing strategies, I think it should be relatively safe. I don’t, yeah, to kind of the same as Hasu’s point, I don’t really expect people to just like rush to the exit all at the same time, unless, yeah, unless there’s really some real reason to redeem for your raw ETH immediately. I think there will be a lot of people who do it just to test it and see just, you know…like imagine you’ve had, you minted staked ETH at the genesis, like of course you’re going to redeem some to see if it’s working correctly, right, like at the end of the day. So, there’s certainly going to be some amount of that, but I would, the only people I’d be worried about are people who are like automated vault strategies that have, you know, significant amount of TVL and they try to redeem because there’s some new yield form.

Laura Shin:

And so, what do you guys expect to happen to the price of stETH after people can withdraw their ETH?

Hasu:

Well, I mean after that the point, the prices are sort of tethered at 1 to 1 due to arbitrage, right? So, as we already touched on earlier, so if staked ETH are trading above one ETH, then people should mint more of it and sell it, bringing the price back down, and if staked ETH are trading below one ETH, then people should buy it on the market and withdrawal the ETH and sell it, bringing the price up. So, sort of leaving out sort of more nuanced sort of points like there being like a withdrawal queue then I would say that the price is like, absent sort of this nuance, the prices are tethered 1 to 1, same as you would expect with something like USDC or WBTC where arbitragers are basically always keeping, you know, the price of these in line with the underlying.

Laura Shin:

So, another potential issue with staked ETH is how dominant Lido is in particular, and as Tarun mentioned earlier, Lido’s market share of all staked ETH on the Beacon Chain is about 91 percent of all of the staked ETH derivatives. So, why do you think that level of dominance has happened?

Hasu:

Well, first of all, I would say sort of the 91 percent number is sort of a bit misleading. I think what I would look at is sort of the overall share of Lido on the Beacon Chain, right, which is around 32 percent at the time of recording, I believe. So, first of all, I would think, there’s like two lenses basically to look at this from. The first is Lido’s impact on Ethereum security, and the second is then looking at the counterfactual, so what if Lido didn’t exist? And so, starting with the first one, I think there are some arguments that you can make that Lido is in fact very good for Ethereum’s security. Why? Because Lido dramatically lowers the cost of staking, right, by making it more accessible and by making it more liquid, and so on. So, in equilibrium with Lido in existence, staking is much cheaper, and as a result, the total amount of stake that secures Ethereum in proof-of-stake is going to be much higher. So, any outside attacker to Ethereum, you know, has a much higher cost basically to bring the system down, and then you can also argue that sort of Lido is bad for Ethereum’s security in other ways, mainly that it introduces one more layer of sort of principal agent relationship, right, because these stakers, they give Lido the ETH and Lido then distributes it to different node operators. So, if you compared this to a world without Lido, then stakers would directly choose the node operator. So, there’s like one more layer basically of intermediation between that, and so, you could say, and I think the popular argument goes like this, Lido can exert soft power on these node operators in order to do certain things that can be bad for Ethereum.

So, that is sort of the first lens that I look at it from, and then second lens is what if Lido didn’t exist? So, almost from the start, I have been operating under this assumption that sort of the winner in liquid staking…so, first of all, that liquid staking is superior to any other form of staking, and the users, like all things equal, would always prefer it because they want the lowest cost of staking, and liquid staking providers can provide that, and then between liquid staking providers, and this includes large exchanges, there’s going to be a large winner take most effect because as a user, why should you ever not stake with the largest provider that is sort of the most secure, the most liquid, the most accepted in DeFi protocols, has the best, sort of the best loan to value ratios, and so on, right?

So, basically the market leader always has the most chance to attract the next deposit that comes into the picture, and so, going from this assumption, I was thinking, okay, so there is going to be one big winner from this. So, what do we do? Like, we really have to make sure that like a group of centralized exchanges, or what worried me even more, is like the USDC version of liquid staking that is sort of custodied and highly regulated. So, same as like we saw this in stablecoins, right? Tether had a big start, but then USDC just started to crowd it out completely, and I was worried that the exact same thing would happen to liquid staking. So, my approach was, okay, so we really need to make sure if there’s going to be one large winner, and I found this outcome to be like exceedingly likely, that we ensure that this winner is the most decentralized that it can be, and this sort of really motivated me to choose Lido and support them very actively, so both that Lido can win this market but also that I and others sort of exert pressure on Lido and really do the necessary research in order to make it as decentralized as possible.

Laura Shin:

So, it sounds like you are not super concerned about its dominance amongst the liquid staking providers. Tarun, are you at all?

Tarun Chitra:

So, like actually before Lido existed, I wrote this paper with Alex Evans from, well, now Bain I guess, about staking derivatives because, you know, like everything in crypto, people in Proof-of-Stake Land, Cosmos came up with all the ideas first, but never implemented them first, and staking derivatives actually like originated in the Cosmos ecosystem far before Ethereum, it sort of showed up in Ethereum, and the main result of this paper is just that staking derivatives do one thing, they democratize access to opportunities, but they also have these deleveraging spirals. So, there’s like this tradeoff. You kind of like want to balance the two of like, hey, small stakers or smaller participants can get like equal access to yield, but also like, hey, there’s a ton of weird leverage games that happen in the system, and you want to kind of like tune this system via a combination of incentives and sort of AMM fees and other things to make it stable.

From that lens, I think having a dominant provider that has the most liquidity does actually make sense. I would say the thing I’m more, somewhat more worried about is that the, it’s not…and Hasu of course can probably talk a little bit more about the dual governance structure that’s being thought of, but I do think Lido as a governance token does seem somewhat, a bit scary if you believe that Ethereum should effectively not have like on-chain governance for its existence. Now, I’m not saying that…I’m not even sure that’s a universally accepted truth in Ethereum Land, but certainly of course if you ask Vitalik he would say it shouldn’t have that, and so, I think that’s sort of where I think some of the weirdness comes in.

I think the centralized entities and centralized sort of staked ETH narrative is definitely true. I mean, it’s pretty clear that a lot, like you know, hey, it’s only 35 percent of the market that’s in staking derivatives. So, the rest is somewhere, and the rest of that is not at like, hey, I’m in my basement like running a validation node. Like, that’s definitely not making up 65 percent. Most of that is at like Binance and other places that offer this already. Although, of course Binance’s is not the USDC. It’s more the USDT of this analogy. The interesting thing was that the Binance staking derivative crashed price wise significantly far before the staked ETH price change, and there was a while I think probably like January through March where people really thought there would basically be like some sort of parity trade between the centralized staked ETH derivatives and the sort of real ones, and it turned out that was not totally true, and people were sort of a little more reckless on centralized exchanges.

So, I think it’s actually quite good to have a dominant source of liquidity. I actually think the liquidity fragmentation, even that paper from March 2020 does show that if you have liquidity fragmentation, you have way more of these sort of like tail events that kind of can blow the system up, and we already see liquidity fragmentation not causing these different assets that theoretically should be sort of like hard to be anywhere near each other.

Laura Shin:

Oh, that’s interesting, having more liquidity fragmentation causes more scenarios where the system blows up?

Tarun Chitra:

Yeah, and…

Laura Shin:

That’s so counterintuitive.

Tarun Chitra:

It’s like if you think about people who are taking…one way of viewing a staking derivative is also as like basically sort of a collateralized loan, and from that lens, there’s sort of some liquidation condition, whether it’s getting slashed or whether it’s, you know, something that causes the thing to go under, and in that case, the idea is like you have, it’s exactly what we saw with Aave. Like, you have these cascades, and you know, if there’s not enough liquidity, the cascades happen faster because like the price is changing faster, right? So, there’s sort of this natural, again, tradeoff, and this is why it’s quite important to incentivize liquidity in multiple venues but for the same asset. So, I just generally think like these are the vignettes that we’ve seen in practice that represent this thing that like, you know, theoretically existed. So, like you know, two years later, you could say that like, hey, a lot of those kind of predictions came true, but yeah, I’m not so worried about the dominance as much as like the governance aspect of Lido.

Laura Shin:

Okay. Yeah. So, let’s talk about that because, you know, as you mentioned, people have been pointing out that the owners of the Lido token, LDO, may not always have the same incentives either as stakers do or even just normal Ethereum holders, or even the same interest as Ethereum itself, and so, Lido did recently float a proposal to reduce the power of governance over Lido, and one of the ways it’s proposing to do this is through a process called ossification. You guys, I tried reading this proposal and I was like, granted, I was falling asleep, so maybe that didn’t help, but please explain this.

Hasu:

Yeah.

Laura Shin:

This, I mean, it just sort of feels like you’re limiting the amount that people can do via governance, but that was as far as I got. So, maybe you want to talk about it more, especially you, Hasu.

Hasu:

You got it exactly right. Ossification means limiting the amount that people can do via governance but let me start at an earlier point. So, stakers give ETH to Lido, and then Lido gives it to node operators, we covered this, and this is the principal agent problem because sort of you have this one intermediary who might not be at all times incentivized to act in the best interest of the agent, which is stakers, and you have this both, even if Lido were just on Ethereum, you would have this problem, but it’s sort of further exacerbated by the fact that Lido also is on other blockchains and they share the same governance token. So, right now I think Lido, so Ethereum is like 95 percent or more of Lido’s revenue. So, really like all of Lido’s focus is on Ethereum, but there’s no guarantee that this is always going to be the case. So, we need to make sure that sort of the LDO holders sort of that, they don’t sort of mix incentives across different chains, right? What’s best for Lido, if Lido’s on many chains, might not be the best for Ethereum that is just its own chain.

So, I think it’s important, for one, to sort of disentangle the governance of Lido on Ethereum, from Lido on Solana, and from Lido on Polkadot, and so on, and there are generally two solutions to that problem, so that principal agent problem, and the first is the one that you mentioned, it’s ossification. So, if the agent doesn’t, like they cannot do anything wrong, like they literally cannot make a proposal that would hurt stakers, then that’s of course way preferable, right? So, we can see in this whole debate that Lido may not want to do anything or the owners may not want to do anything that’s bad for stakers, but just the fact that they cannot prove it to them and to the Ethereum developers is sort of a problem that currently hinders, you know, them growing further, right? So, we can see that sort of this ability for governance to do something bad is a major problem for the customers, but also for Lido itself, and so, they are really aligned in removing the ability to do anything bad, and the way that they want to do this is, first, remove any levers that would allow them to do something bad, and where that is not possible yet, for example, because Ethereum itself, Ethereum’s staking contracts, so if the Merge hasn’t happened, withdrawals aren’t finalized, so Ethereum’s contracts themselves are not yet ossified.

So, what Lido wants to do in the meantime is introduce a dual governance model, and what this dual governance model does is it allows the same as today LDO holders to make proposals in governance and vote for them, but then the stake ETH holders can veto any decision that the LDO holders want to make, and so, this way, if there were a decision that is about to pass on-chain, then stake ETH holders can say, wait a minute. This is not in our best interest, and so, we are going to block this proposal, and then it doesn’t get enacted on-chain, and so, yeah, what this basically does is it prevents sort of the most adversarial outcomes against stake ETH holders, at least that’s our hope, because they can always just prevent a proposal from going on-chain, and to Tarun’s point, I’m not sure if this is on-chain governance. I mean, it’s not like sort of we are making any proposals to how Ethereum should be changed, right? It’s more like Ethereum holders can have a say in what Lido is not to do. So, I think I would like delineate a veto, right, from on-chain governance in that case. I’m curious to hear what you think.

Tarun Chitra:

Yeah. I mean, I think the interesting thing about this sort of bear market, like if we take like the first bear market of Ethereum, it was like the DAO hack happened. If we take the second sort of big bear market, it was like, hey, we had the ICO boom, but like no one could figure out what to do with it, but then over that bear market, we kind of developed DAOs that actually worked. A lot of the improvements that have been made were to like the structure of how DAO contracts work and like what types of proposals were allowed and like how execution of things on-chain worked. Obviously, some of this happened on other chains, but in Ethereum Land, I think some of the standards and norms were codified, things were able to operate, and what I think we’re seeing now is a lot of these like dual class DAO type structures. Like, Optimism has this sort of dual class DAO where they effectively have something that’s like a House of Representatives and a Senate in some ways, and I kind of feel like adding this veto is effectively doing the same thing. It’s like it’s this different form of like how do we have like dual class governance? It’s still sort of a form of on-chain governance. I just think it like has more checks and balances I suppose.

Laura Shin:

That’s interesting. One other thing that I wanted to ask about here was, so at the time that we’re recording, I should reveal to people, Friday, June 28, Lido just released a proposal on whether or not it should limit the amount of staked ETH that it should account for, like the percentage of…staked ETH. By the time that this episode comes out, this vote will have been decided. So, since, you know, the vote will be over by then, it might be interesting as a historical artifact to hear how each of you kind of think about this proposal. You know, do you guys think that Lido should self-limit? How do you determine what the limit should be et cetera?

Hasu:

Well, I think, so for one, it’s not a guaranteed…I don’t think the proposal is necessarily over because it’s a two-stage proposal. I believe there’s one week of voting whether Lido should self-limit, and if the answer to that is yes, then there’s another week of voting how it should self-limit.

Laura Shin:

Oh, got it. Oh, got it. Yeah. I just looked at the first…

Hasu:

The first week. Yeah.

Laura Shin:

Deadline. Okay. So, maybe part of the vote will have been decided, but not the rest.

Hasu:

Yeah. So, I mean, I definitely, I have laid out my case why I think Lido should definitely not self-limit. I think the market for liquid staking is winner take most, and there are outcomes for Ethereum that are much worse, like USDC of liquid staking taking the market I think, or as Tarun was saying, fragmentation if it were to exist also, has way more edge cases. So, I think what we…so my approach from the start has been to support the most decentralized and liquid staking provider. You know, that’s what I would continue to do, and so, I am voting not to self-limit, but instead to ossify Lido as much as possible, and enact this dual governance model.

Tarun Chitra:

I don’t know if self-limiting actually will work because one other thing that’s quite important is that Lido staked ETH actually can be used in other protocols, and I don’t think we’ve even gotten to confidence in any of the other providers. I mean, so there was a very famous incident with Celsius where they had a lot of ETH, had this staked ETH provider called Stakehound, and then they had this, I wouldn’t even call it a hack, I would call it a little more like incompetence because of the way they published their BLS sort of file, but there hasn’t been a lot of like faith in other staking providers yet, and I’m not saying that can’t happen, but I feel like if you impose a cap, you will probably move most of that ETH to centralized exchanges and not to other staking providers simply because of the track record so far, and because people are skittish. So, I just don’t think that caps are that like necessarily…I think they have all these kind of second order effects that might not mean that they kind of end up being useless or like don’t help that much.

Laura Shin:

So, it sounds like you also think that this proposal’s a bad idea.

Tarun Chitra:

I don’t think it’s necessarily a bad idea fully. I just kind of am not, I’m not…I’m kind of 50/50 on it, and like I could see why you would do it from a social scalability point of view perhaps, but I could also see second order effects being bad, and I have no clue how you would choose what percent you want to make it. Do you make it the BFT threshold of one-third? Do you make it like somewhere below that because of like slashing communication limits? Like, there’s like all sorts of both theoretical numbers of thresholds where you would maybe cut it off versus like practical ones, like how much liquidity can you actually incentivize if you only have X percent of the market share? And I think like that type of analysis hasn’t also been done, so I’m sort of indifferent. I kind of, I agree with Hasu though, ossification seems better. I just think we have to find some protocols that haven’t been able to successfully do that, and maybe this will be the first that can really ossify itself.

Laura Shin:

Yeah. I have to say the one thing about that is that I just think about so many kinds of different emergency situations that can come up, and as new developments happen, like wouldn’t there just naturally be changes that would need to be incorporated? So, maybe I just didn’t understand the proposal, like I said earlier. Does it account for that?

Hasu:

It’s…so, yes, basically. I mean, it’s two steps for like a new proposal to go on-chain after this dual governance system has been put in place. For one, if LDO governance want to change Lido, then they have to make a proposal, and then there’s a time lock. So, I don’t know what is the kind of proposal…it’s like one month I think, so plenty of time for the community to review the proposal, and then before it goes on-chain, staked ETH holders have the ability to veto the proposal and prevent it from going on-chain. So, but if they don’t veto, then it just passes like it normally would. So, Lido can still be upgraded. It just cannot be upgraded in ways that would be clearly bad for staked ETH holders.

Laura Shin:

Yeah. I just wonder, like I said, if there’s some kind of emergency, whatever, some kind of bug.

Hasu:

Oh, you mean for Lido? If Lido needs basically the ability to react quickly to upgrade its protocol to protect stakers, yeah.

Laura Shin:

Yeah. Then how do they handle that?

Hasu:

That is basically sort of the tradeoff that you always have whenever you have a time lock, right? So, a time lock protects the users of the protocol from the operator going rogue, but a time lock that is too long sort of fails to protect them from forces of nature basically where the operator could protect them. So, I think we have seen some ideas around that where, for example, what if sufficiently many stakers voted in favor of the proposal? Then, you know, it would pass immediately. So, I’d have to look up what is the current thinking around this in the proposal and then get back to you.

Tarun Chitra:

Another aspect of this that I think hasn’t been totally deviated is there’s some sort of like off-chain logic that theoretically Lido governance controls that is not really sort of true for staked ETH in the sense that there’s the assignment mechanism which assigns which validator is getting which block, sort of like a pool, like this threshold signature thing. There’s sort of the queueing model of like how do you do withdrawals? Hold you rebalance withdrawals? Like, what if one validator has a million ETH and one has 100 ETH? How do you like divide up…? And someone wants to withdraw 1,000 ETH. Do you take it all from the million? Do you take some from the million, some from the 100? Like, there’s all these like nuance things.

Those things are not core to Ethereum, right? Those things are core to how Lido coordinates validators. Those things can be voted on sort of separately from things that are core to Ethereum, and so, that somehow…I don’t know exactly what the correct abstraction line is, but I suspect that LDO the token will be allowed to respond to these sort, what I’ll call off-chain, but like these coordination mechanisms for the people who are participating in Lido as operators. That might still have a sort of like not ossified state, or like a less ossified state, like, and I suspect that will be one of the things that kind of either emergently happens due to some, you know, as the validator set grows or something like that happens or not.

Hasu:

Yeah.

Laura Shin:

Hasu?

Hasu:

I think that makes a lot of sense, not just at Lido but just in general, I think whenever you have on-chain governance. So, on-chain governance is basically a liability to your protocol, and so, you want to limit it as much as you can. That’s what we meant with ossification. So, if you can, for example, say that only a certain parameter in your protocol can be subject to governance, but for example, not replacing the entire contract. We’re not changing any parameters that don’t need changing, then that’s always preferable. So, I think, yeah, these are like two efforts that are going in parallel. So, ossifying as much as possible, and then for what cannot be ossified, just provide checks and balance for the users of the protocol.

Laura Shin:

Okay. So, for final question of the show, why don’t we just have each of you talk about what you think are kind of the main takeaways that people can learn from kind of all the recent events involving staked ETH, especially in terms of users who are trying to figure out should I use one of these like good staking protocols? If so, what should I do with the staked ETH, you know? Et cetera. Yeah. If you could just talk about how you think about these things, that’d be great.

Tarun Chitra:

So, I think like what the main lessons we learned are, A, liquidity optimization for derivatives is quite important. It needs to adjust with both the leverage in the system and sort of the types of users in the system, and I think like obviously that’s improving over time, but you know, of course, you know, these tail cases are the times you learn where you’re caught naked the most. I think the other thing that’s important to reason about is sort of the fact that, A, there’s so much uncertainty in the Merge time. I think like, you know, I think it would be irresponsible to say, hey, like the Merge is definitely happening by X, like some people like to say. I’d just basically like say if there’s some variance in that time, expected time to Merge, then there’s also some variance in your yield because your notion of when you realize that yield now has some variance in it, right?

So, that has to get priced in somehow, and I think that because of that, these derivatives at least offer you some way of earning some income, you know, via like providing liquidity to these Curve pools or lending in Aave that it kind of at least partially compensates for this like time risk, this variance and time risk, and so, I think that is a reason they’re, from a financial standpoint, strictly better than the centralized versions because the centralized versions can’t really escape the exchange. Like, maybe Binance will make it so that you can use it on BSC or something, but like I just don’t see this compensation factor coming from the centralized entities, and if that can be the moat for the decentralized ones, that’s probably the like best long-term outcome, but I also just think sometimes especially Ethereum developers are a little irresponsible with their like statements because there’s just a lot of investors who don’t read the Ethereum 2 Roadmap. They’re not like reading the GitHub issues. They’re not reading the pull requests. They’re just like, oh, like this guy on Twitter said it’s happening in March. I’m going to go buy a bunch.

Hasu:

Yeah. I mean, it’s…

Tarun Chitra:

And then like you saw that with Su, like you know what I mean? He was like, he would just like tweet this stuff, and like I was like, you know, somehow like people…there needs to be some form of like structured PR about things with uncertain timelines that isn’t just like, yeah, it’ll be done by August.

Hasu:

Yeah. Exactly. I mean, it’s not the statements that they make, it’s the lack of statements, right? So, you have this huge demand from the community, from media, and from investors to sort of get confidence levers on when the Merge is going to happen, how is going, what are the remaining roadblocks, but there’s just, as Tarun says, no structured PR around this. I mean, they could just put something on the website, and you know, update it occasionally when new information comes up, and have some kind of official stance, but so, the absence of an official stance is sort of what creates this, you know, confusion I think, and yeah. So, I think that’s one takeaway. I think there are some takeaways for different participants.

So, I think if you’re a holder of staked ETH, then I think, I mean this was a reminder to be careful with your use of leverage. I mean, crypto is so volatile that every cycle, just a ton of people get just blown out from using leverage irresponsibly, and I mean, I would argue that you don’t need to use leverage at all, unless you like really, really know what you’re doing, and then you need a good pricing model. So, that’s sort of the next takeaway, that it turns out like a lot of people actually don’t understand where staked ETH should trade in relation to ETH and sort of what are sort of the forces that push it down?

Then if you’re a holder of ETH, then I think now sort of the discount is like at less than 3 percent at the time of recording, but it used to be at like 6, 7 percent. So, if you’re a holder of ETH and you have been looking to stake and maybe you haven’t made the jump, then I think for many this has just represented like an opportunity to buy ETH practically at a discount, right, because if you’re an ETH holder and you’re willing to…you don’t need to sell for one year and you can just sit out the price volatility, then at some point this was like a 10, 15 percent free yield for you basically, right, because you were buying it at a discount, but then you also get the staking yield on top. So, the staking yield worth 5 percent and then the discount was 7 percent and you would get 12 percent in ETH dominated for waiting one year, right?

So, cleaned up for any risks that you incur in the meantime, and then the final takeaway from me is, and this is like all…like this is like one of my favorite topics at all in crypto, which is governance is a liability to any protocol, especially DeFi protocols because it makes it more expensive for customers to trust you, and so, you want to reduce it as much as possible, right, and so, to me this just validates like in a massive way sort of the whole, you know, reasons why we use blockchains in the first place because in the real world, companies are spending so much money in creating trust with their customers because they cannot prove to them that they cannot misbehave, right, but blockchains allow you and smart contracts allow you to prove in an incredibly cheap way that like your business is going to do exactly what it says it’s going to do, and to me this is just, I mean this whole saga to me is just like just further validation that blockchains are incredible technology.

Laura Shin:

All right. Well, this has been an incredibly fascinating discussion. Thank you both so much. Where can people learn more about each of you and your work?

Hasu:

I would say come follow me on Twitter. I am hasufl, and yeah, you can check out my articles, everything’s on Twitter, and yeah, also make sure to check out my podcast. It’s called Uncommon Core.

Tarun Chitra:

Yeah, and I think Twitter is also probably the best place. It’s tarunchitra, and yeah, a lot of my work and research is also online, and yeah. So, I’m happy to…but I try to talk about it on Twitter a lot. So, that’s probably the easiest place to find it.

Laura Shin:

Okay. Yeah, and you can also listen to Tarun on The Chopping Block here at Unchained. All right, you guys. It has been such a pleasure having you. Thank you so much.

Tarun Chitra:

Thanks.

Hasu:

Yeah. Thank you so much, Laura, and thanks, Tarun.

Laura Shin:

Thanks so much for joining us today. To learn more about Hasu, Tarun, and all these issues around staked ETH, check out the show notes for this episode. Unchained is produced by me, Laura Shin, with help from Anthony Yoon, Matt Pilchard, Juan Aranovich, Pam Majumdar, Shashank, and CLK Transcription. Thanks for listening.

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EPISODE LINKS

Hasu:

Tarun:

stETH

Lido

Bear Market:

Episode Transcript