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Kaiko

Conor Ryder, CFA
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Jun 15

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11 min read
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CELSIUS REACHES BOILING POINT


A DATA-DRIVEN LOOK AT STETH, A LIQUID DERIVATIVE OF ETH THAT’S BECOME NOT SO
LIQUID

Subscribe to Kaiko’s weekly research newsletters here.

If you weren’t aware by now, crypto markets are crashing and certain companies
that have taken on excessive risk are facing the consequences. Celsius, one of
the largest centralized lending platforms managing some $12 billion in assets,
announced on Sunday that they were pausing all withdrawals, spreading widespread
panic that the company was insolvent. Three Arrows Capital (3AC) have also been
rumoured today to be fighting their way through solvency. How did such large
companies that are intertwined with the industry’s biggest market participants
end up in a Lehman-esque position? A combination of poor risk management,
bearish market conditions, and a derivative of Ethereum created a perfect storm
with potentially devastating consequences.

Let’s dial back a bit and take a data-driven look at how an Ethereum derivative
triggered several billion dollars of liquidity problems.


WHAT IS STETH?

Later this year, the Ethereum network will transition its mainchain from
proof-of-work to proof-of-stake in a process known as the Merge. Ahead of the
Merge, investors have the ability to stake ETH in order to secure the new
proof-of-stake chain, which in turn earns them yield. However, this yield comes
at the cost of illiquidity, as stakers can’t access their staked ETH until the
network completes its transition, which skeptics fear might not even happen this
year. Staking directly via Ethereum also comes at the hefty entry requirement of
32 ETH in order to be a validator on the new chain.

Enter Lido: a decentralized staking platform that introduced a liquid solution
to Ethereum staking. Lido offers a similar yield to staking directly on Ethereum
(~4% APR) without the 32 ETH requirement, and also offers a 1:1 redeemable token
in the form of stETH. Staked ETH (stETH) is fully redeemable via Lido after the
Ethereum merge is complete, providing stakers with all the benefits to staking
on Ethereum without many of the drawbacks, such as illiquidity and high barriers
to entry. stETH can also serve additional functions, such as lending, staking
(yes, you can stake stETH), and trading.

Today, there are more than 4 million ETH staked in Lido, making it the single
largest staking service accounting for around 32% of all staked ETH.


STETH CURVE POOL

In order to support the increased demand for stETH, the decentralized exchange
Curve introduced a liquidity pool for the stETH-ETH pair so that investors could
easily convert their ETH to stETH at a reasonable rate, or earn a yield in the
form of CRV tokens by providing liquidity to the pool. However, the meteoric
rise of Lido/stETH along with the collapse of Terra led to some issues with the
stETH-ETH exchange rate. In May, stETH began trading at a discount to ETH of 5%,
generating an initial fluttering of concern. Last week, this discount emerged
again, triggering the start of Celsius’ liquidity problems.



This discount emerged in the aftermath of the Terra collapse as investors
flocked to safe havens. stETH is a derivative of ETH, thus not as liquid across
markets, which caused investors to panic exchange their stETH for ETH,
withdrawing ETH from the Curve liquidity pool and leaving an imbalance between
the two assets. The pool is currently the most unbalanced it’s ever been at
about 80% stETH and 20% ETH.




IMPLICATIONS OF A STETH DISCOUNT

Unlike TerraUSD, stETH does not need to maintain its peg. stETH is merely a 1:1
token representation of the amount of ETH a user has staked in Lido. As a
decentralized staking service, Lido has no choice but to honor stETH redemptions
after the Merge.

The problem with a stETH discount thus centers around liquidity. In normal
market conditions, the stETH-ETH liquidity pool enabled efficient swaps between
assets, providing stakers the ability to easily cash out into ETH if they wanted
to exit their stETH position.

It was only the combination of a discount and poor market conditions which posed
grave problems for a lender like Celsius, which manages funds on behalf of
clients. After the extremely bearish price action of the last month and news of
their possible exposure to Terra became public, Celsius users increasingly
sought redemptions. However, it soon became clear that Celsius would struggle to
meet these redemptions due to the lack of liquidity in their ETH holdings.

While it is not fully clear exactly how much of Celsius’ ETH holdings are
wrapped up in stETH, estimates are at around $475m based on public wallet
information provided by Dune Analytics. The platform has since halted all
withdrawals, all but confirming investor fears.

Despite being wholly centralized, Celsius has its own token — CEL — offered as
rewards to users of the platform. CEL perpetual futures markets reacted near
instantaneously to the announcement, with open interest spiking and funding
rates plummeting, indicating investors were loading up on short positions
anticipating the platform’s full collapse.



CEL’s price has already suffered heavily since the start of the year due to all
around bearish market conditions, but prices collapsed to just $.17 following
the announcement.



This kind of reaction from the market implies Celisus must be limited in their
options to deal with these solvency issues. Which begs the question, what
options do they have available?


1) WAIT FOR ETHEREUM MERGE AND REDEEM STETH 1:1 FOR ETH

This clearly isn’t an option for Celsius or any other group facing solvency
issues. That’s exactly why the stETH discount only really matters if you need
immediate liquidity, if you’re a long term holder of stETH in a safe liquidity
position, you aren’t paying attention to the discount as you can redeem 1:1 for
ETH once the merge happens.




2) SELL STETH ON OPEN MARKET AND PAY OFF REDEMPTIONS

First port of call if you need the liquidity is to actually examine whether
selling stETH on the open market is an option. First, let’s look at the total
value locked on the decentralized exchange Curve, which posses by far the most
liquid stETH market.


MAY 18TH 2022




JUNE 15TH 2022



Today, there are only 116k of ETH available (~$130m) to sell stETH for, but
doing so for the kind of liquidity Celsius would need would absolutely crash the
exchange rate between the pair. We can see above that liquidity was more readily
available a month ago before the flight to safety took place after the Terra
collapse, with 291m ETH available in the Curve pool.

For example, selling 100,000 units of stETH for ETH on Curve would result in an
exchange rate of just .84 (which is just 1/4 of the total amount Celsius is
reported to hold).



Next we can look at whether selling stETH on centralized exchanges is an option.
We can look at the market depth on FTX, the only spot market for stETH on
exchanges, to see if there is sufficient liquidity available to support a large
sell order of stETH.

We can clearly see that the market depth on FTX couldn’t handle an order of the
magnitude that Celsius would need without nuking the price of stETH.



Using 2% market depth as the gauge for available stETH liquidity on centralized
exchanges, we observed only $300k worth of stETH liquidity on FTX before June
11th. It’s worth noting that only half of that liquidity is actually available
on the sell side in the form of bid depth. That number dropped to less than $50k
after the Celisus fear hit the market and stETH holders have now dried up
virtually all the available stETH liquidity they could find on centralized
exchanges.

To give an idea of the losses a sale of only $100k worth of stETH on FTX would
incur, I’ve charted the slippage for the stETH-USD pair on the exchange and we
can see that selling even $100k worth on FTX has become completely unfeasible.
Slippage for the pair has increased to 3.5%, which added on top of a stETH
discount of roughly 5% to the price of ETH, means selling stETH on a centralized
exchange results in a loss of 8.5% for a $100k order.



The spot volumes we’ve observed on FTX in the last few days indicate that this
wasn’t the option taken by Celsius with most of their ~$475m worth of stETH, for
the aforementioned reasons. Daily trade volume topped out at $10m and has since
fluctuated between $1m and $5m, presumably due to the lack of liquidity.



Overall, stETH trading activity is dominated by Curve, which accounted for 98.5%
of total trade volume in 2022. stETH is offered on other decentralized
exchanges, such as Uniswap and Sushiswap, although volumes and liquidity are
nowhere near as high.



Buy/sell volumes offer interesting insights into the nature of the volume within
the Curve pool with regards to swapping stETH and ETH for each other. Since a
few days in late May, the pool swap action appears to be quite evenly
distributed which could indicate some investors are happy to buy into stETH at
the present discount in order to capture the profits once it can be redeemed 1:1
for ETH. The amount of stETH sold suggests that there are also plenty of
desperate sellers willing to accept the discount. Celsius and 3AC could very
well be offloading smaller amounts of stETH for ETH, despite liquidity
conditions making it difficult to get rid of everything.




3) USE THE STETH OR OTHER RESERVES AS COLLATERAL OR PAYMENT FOR OTC AGREEMENT

We’ve seen that companies facing solvency issues can’t afford to wait for the
Ethereum merge to redeem their stETH, and they can’t sell large amounts of their
stETH on centralized or decentralized exchanges. This only really leaves one
option to avoid complete insolvency: using the stETH as collateral or payment,
likely in some form of over the counter (OTC) contract with an exchange or
market maker.

Over the last week we’ve seen this play out in real time with not only Celsius,
but also Amber Group, a crypto trading platform, who have both been spotted
sending large amounts of stETH and other reserves to FTX. Charted below are the
mint and burns from the Curve stETH-ETH pool where we observed a large amount of
burns occurring last week in both stETH and ETH, indicating liquidity has been
withdrawn from the Curve pool en masse.



Interestingly, a larger amount of stETH was burned from the pool, suggesting
that users were willing to lock in stETH discounts, either for long term
holdings or to swap it for ETH. Some on-chain findings below discovered that a
wallet belonging to Amber Group burnt over $150M worth of stETH from the Curve
pool over the last few days.



That stETH was then sent to FTX, who have purportedly now become the biggest
non-smart contract holder of stETH after these large deposits from Celsius and
Amber. As I pointed out earlier though, these volumes never hit the spot markets
as such large transactions would be easy to spot.

For me, that leaves an OTC deal as the only avenue to get a return in the form
of liquidity for your stETH. The problem with OTC deals is that they are
off-chain transactions by nature and therefore impossible to find. So that
leaves us in a speculatory position in determining how the stETH was handled,
but the Ethereum futures markets on FTX do show some interesting trends that may
offer some insights.



We observed a sharp increase in open interest on FTX while open interest across
other exchanges fell as the Ethereum price crashed. When the price of an asset
crashes we usually observe open interest falling as a result of increased
liquidations, closing out futures contracts, as well as the impacts of the price
decrease on the actual open interest figure itself. Seeing open interest
denominated in USD rising in the face of downward price action on FTX is
interesting in itself, but when you factor in the massive stETH and ETH deposits
the exchange has received over the last few days the trend is even more
intriguing.


THEORIES:

 1. Celsius could be engaging in an OTC transaction through FTX to either use or
    swap their stETH and entering into short ETH positions on the perpetual
    future market, which would allow them to profit if ETH fell lower by closing
    out the contract at a lower price. Pausing withdrawals offers them the only
    chance they have of being solvent and profiting off this position at a later
    stage.
 2. Another theory could simply be that FTX or some market maker is taking in
    stETH from Celsius at a significant discount in order to profit once stETH
    is redeemable 1:1 for ETH. They might have used short futures positions on
    ETH via FTX to hedge any price exposure, ensuring that their profit comes
    solely from the difference in price between stETH and ETH and their losses
    are limited due to their hedged ETH position.

All in all, what happens after FTX received this large influx of stETH and ETH
is anyone’s guess. Using our data we can safely say that Celsius couldn’t have
sold all of their stETH on centralized or decentralized exchanges, and as a
result likely had/will have to resort to an OTC type transaction in an effort to
remain solvent. Even if they do survive this onslaught, I don’t see how anyone
can trust the likes of Celsius to keep their assets safe going forward. Perhaps
in a few years time we will look back on this as a watershed moment for
decentralized finance adoption, but that’s probably just the optimist in me.




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