Staking Ether: A Risky Trade

Along with bitcoin price, prices for Ethereum’s ether also jumped last week.

Depending on your data source, the world’s second biggest cryptocurrency’s price posted weekly gains of anywhere between 13% (at Messari) to 20% (at Coinmarketcap and CoinGecko).

Underlying that price increase was a corresponding surge in market valuations for tokens at liquid staking derivatives (LSD) platforms. Such venues multiply trading volumes and supply by offering staked versions of cryptocurrencies in exchange for crypto deposits. For example, Lido finance, the biggest such venue, offers staked ether tokens (stETH) for ether deposited on its platform.

Ether proponents argue that a diminished supply of the digital asset after its Merge will increase yields for staked tokens and drive prices of the underlying ether upwards by reducing supply.

But that thesis ignores the possibility of a collapse in the rickety staked token ecosystem. It is characterized by the same points of failure present in most crypto systems: centralization, leverage, and regulatory uncertainty.

Staking Ether: A Risky Trade  

I have written about the trade of staking ether earlier. As of this writing, 13.28% of ether’s total supply is staked across various platforms.

In previous interviews, Ethereum developers have said that the Shanghai Upgrade, which is supposed to occur sometime at the end of this quarter, will increase that figure because it will allow flexibility in staking and withdrawal of ether. Currently, investors have had to lock up their ether on its blockchain for as long as two years.

But investors will not have much market choice for the activity. According to data from Kaiko Research, the ecosystem for staked ether is dominated by three platforms – Lido, Coinbase, and Binance.

Together, these three players have cornered more than 48% of the staking market. Lido finance, a staking platform with generous funding from venture capitalists who own its governance token, is the pack’s leader with an almost 30% share of the ether staking market.

The chances of this situation changing anytime soon are remote since staking ether is an expensive proposition that requires an initial investment of 32 ETH or roughly $50,000, based on today’s prices for the cryptocurrency.

Red Flags in Staking Ether

Two out of the three platforms listed above are unregulated, meaning they are not required to follow Know Your Customer (KYC) and Anti-money laundering (AML) rules. For example, you do not need to produce identification information to stake ether at Lido finance.

Charges at Coinbase, the only regulated platform offering staked ether services, can be as high as 25%. This means that the exchange will take a quarter of your yield as fees for its services. That’s not a very profitable transaction for investors.

The other two platforms – Lido and Binance – charge less but their promise of yields is predicated on leverage and demand from an unproven ecosystem that is constantly teetering into scandals. The influence of these platforms reaches across the ethereum ecosystem and into places like MakerDAO, which holds a significant portion of its collateral in stETH and ETH.

Staking platforms have added another layer of risk to the trade by selling wrapped versions of their staked tokens to investors. These wrapped tokens circulate on other platforms, broadening the reach of staked tokens and, also, the possibility of contagion. Recursive trading strategies, such as using stETH to buy ETH or using it as collateral for ETH loans, are common and further amplify the danger of a fallout.   

Questionable Fundamentals   

The problems at Binance are already too well-known to enumerate. Lido also has questionable fundamentals. It is purportedly run by a decentralized autonomous organization (DAO) – a flimsy crypto construct that is supposed to replace actual corporate governance and accountability. [Some have hypothesized that Lido’s increasing share of the staked ether market could convert it into a governance protocol for Ethereum itself].  

Lido’s governance token, LDO, also jumped in price last week. But it is debatable whether its price is driven by normal market forces of supply and demand. The entire supply of LDO – amounting to a billion dollar – is pre-mined and its current distribution – sixty percent of tokens divided between 15 wallets – does not inspire much confidence.

Investors in the well-funded platform receive a generous percentage of the token and include a bunch of dubious entities, a list that includes the likes of FTX, Three Arrows Capital, and iFinex – the organization behind controversial stablecoin Tether. [The company has deleted references to these companies in the revised page making this announcement].  

A Problem of Pegs and Regulation  

Then, there’s the problem of volatility that afflicts most crypto tokens. The promise of staked tokens is that they track the price of the underlying token, in this case Ethereum, on a 1:1 basis or, at least, close to that ratio.

But staked ether tokens available in the market have repeatedly lost their peg. stETH also played a starring role in the early days of the crisis that afflicted the crypto ecosystem last June. That none of the platforms is audited for governance controls by reputable firms adds to their problems.

Underscoring the price problem is regulatory uncertainty for ether – the underlying asset for derivatives. In previous interviews, SEC chief Gary Gensler has indicated that ether’s move to proof of stake could convert it into a security. If the SEC ends up filing a case ether for sale of unregistered securities, as it has done against many crypto entities in recent times, the structure of the entire ether staking industry could collapse.

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