Ethereum staking firm Lido Finance, whose derivative products are a component in the crisis currently engulfing firms like Celsius and Three Arrows Capital, saw the writing on the wall and tried to “nudge” some big players to unwind their leveraged positions, but many didn’t.
The leverage concerns became most apparent after Lido became integrated with decentralized finance (DeFi) giant Aave in March of this year, explained Jacob Blish, head of business development and partnerships at Lido Finance. The situation raised fundamental questions about the extent to which a decentralized platform like Lido should intervene in its users’ appetite for risk, he said.
“When we saw the leverage issue was starting to really come to a head, we tried to take a few initiatives and ended up spending a few million dollars to allow some larger players to unwind,” said Blish. “But a lot of people still didn’t unwind.”
Blish pointed out it’s not Lido’s job to police how much return users can have. “We’re not your parents,” he said. “I guess we didn’t think how much leverage would be taken out. We wanted Aave, and as soon as we got Aave, leverage just kind of kicked off. And leverage is a hell of a drug, as they say.”
After the Luna collapse, Celsius froze all withdrawals, causing a domino effect in the market that saw a broad crypto selloff and numerous job cuts by some larger companies, including Coinbase. Meanwhile, insolvency rumors are also beginning to emerge around crypto hedge fund Three Arrows Capital.
Lido Finance, a decentralized autonomous organization (DAO), allows supporters of Ethereum who pledged ether (ETH) ahead of the blockchain’s merge to proof of stake (PoS) to use the assets they locked up. It is the largest of the Ethereum staking services.
Lido provides those users with a derivative token called stETH which can be swapped back for ETH on a 1:1 basis, but only once the transition to PoS is complete. In the meantime, stETH combines the value of the initial staking deposit with staking rewards which accrue daily in a token that can earn further yield on DeFi platforms like Aave, Curve, and SushiSwap.
‘Folded leverage’
Unfortunately, stETH has become a focus of heavy leverage, and as crypto markets have quickly flipped from a risk-on to risk-off, firms chasing returns without having properly hedged—as is the case with Celsius—have ended up in a bind.
Adding layers of complexity and risk, users of Lido’s liquid staking products started creating so-called “revolving loans,” where stETH attained by staking ETH at Lido would be deposited in Aave and used as collateral to borrow additional ETH. This process was then continually repeated.
“Once we were listed on Aave, that really opened up the opportunity for what we call folded leverage or cycle leverage, where you do that a few times to really ramp up your risk and reward,” Blish said.
Despite the obvious risk attached to something like this, it becomes a complex issue that can’t be simply resolved.
“If we impose limits, what if Aave doesn’t?” asked Blish. “Or if we and Aave do, but some third party doesn’t, what happens then?…And all we can do is help nudge to provide some space, and as much education on the risks that come with these strategies as we can. But at the end of the day, DeFi is about choosing your own adventure,” he added.
A worry for many crypto natives is that Celsius and the situation with Lido’s liquid staking product will be viewed by the outside world, and particularly by regulators, as somehow analogous to the recent blowup of the Terra Luna stablecoin and DeFi platform.
PTSD from Terra
Blish pointed out the obvious differentiator here is that Terra Luna was not collateralized, whereas every stETH token in existence is backed fully by 1 ETH. Indeed, the whole idea of stETH “de-pegging” is a common misnomer, he added.
“People have been stuck on the idea of a peg,” Blish said. “That’s probably PTSD from what happened with Terra Luna, where it was supposed to be pegged under all circumstances,” he noted. “For us, we call it an exchange rate. Really what it comes down to is, you’re discounting future cash flows compared to your need for liquidity today.”
Since true unbonding is not available until the Ethereum merge has happened—thus allowing withdrawals from the Beacon Chain—this has created a liquidity squeeze on the popular DeFi platform Curve.
“Players such as Celsius or Three Arrows Capital that were basically over leveraged or over exposed have seen their clients want to withdraw their money, and there’s an obligation to provide that liquidity,” he said. “When that happens in mass across the entire market, and you’re adding retail and other players in the space—all trying to go against this one-way exit—that’s where this exchange rate conversation really started becoming a problem.”
‘Nothing’s Pegging’
Others in the staking space are taking stock of the unraveling situation at Celsius. For instance, Konstantin Richter, CEO of rival staking services firm Blockdaemon, has concluded that institutional-grade liquid staking should only be done in a tightly controlled environment, with full know-your-customer (KYC) and limits on the amount firms can borrow against the pool.
“We believe that you need pools that are fully insured and guaranteed,” Richter said in an interview. “Lido is a much larger player and really a consumer product and has a lot of different complexity to adhere to. And I think they’re doing a good job. People talk about ‘de-pegging,’ but that’s really the wrong word. Nothing’s pegging; everything’s backed one to one.”
On the subject of Celsius’s woes, Richter said the firm has been a cornerstone of the crypto landscape for a long time and that people should resist assuming malicious intent.
“It’s very hard to prepare any business for a market environment like the one we’re currently experiencing. You can’t expect firms to have a crystal ball,” he said. “What I would say is it’s actually remarkable that the DeFi platforms are all holding up and resolving themselves without having to get bailed out,” he added.
