Notes 5/24: Lido’s stETH Liquidity Problem

Lido’s stETH token has a liquidity problem.

Lido uses the token to ensure liquidity for staked ether locked at validators. Thus, stETH acts as an ether substitute in transactions on decentralized finance (DeFi) even as the actual token resides inside a staking smart contract. The promise here is that stETH price will mirror that of ether.   

But stETH does not have the liquidity of ether. [Actually, both tokens function in a highly illiquid ecosystem but that is a different matter altogether]. stETH’s supply is buttressed by the decentralized platform Curve’s stETH-ETH liquidity pool.

On that platform, about 1.2 billion stETH are locked in the stETH-ETH smart contract, according to research firm Kaiko’s Riyad Carey. The token’s availability, away from decentralized platforms, is 300 times less. Users have taken out 137k ETH and 145k stETH from Curve since April 1 this year, according to research firm Kaiko’s Riyad Carey.

Liquidity Pool Operations

Why is this important?

To understand the reason, it is important to know how such pools work.

As its name indicates, a liquidity pool provides liquidity to users. Typically, market makers like large institutional firms are responsible for this function in traditional finance. Liquidity pools use automated market makers (AMM) in the form of smart contracts.

Users can deposit their tokens for trading pairs into smart contracts and earn rewards for contributing to boosting crypto liquidity. Those rewards are discounted from the ones offered at staking services. But the overall takings are boosted by a portion of the transaction fees that the platform shares with users.

Fewer Rewards and Less Liquidity

Declining DeFi liquidity means that there are fewer users and less fees to share. This far, investors in the stETH-ETH pool have been counting on rewards from the Lido DAO, says Carey. “…without them (Lido’s rewards) it would not be economically rational to provide liquidity in this pool,” he said.

The accelerating pace of withdrawals from Curve’s liquidity pool since April means that the number of rewards for users have declined in the stETH-ETH pool. That affects stETH’s overall liquidity because the platform’s pool accounts for the biggest share of the token.

A Future Imbalance

An implicit assumption in the stETH-ETH pool is that prices for both tokens should mirror each other. When they lose this peg, users will withdraw their tokens. It has happened before.

For now, the liquidity pool has equal numbers of ether and stETH. That is, it is balanced.

But that situation will not last for long. A recent pump apart, rewards emanating from the Lido DAO will decline in the future. The platform’s future itself is shaky because investors are selling off its governance token, LDO. Given prevailing circumstances, it is only a matter of time that the steady stream of withdrawals turns into a flood

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