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  • Writer's pictureVeronica Irwin

The flight to safety is fueling crypto’s crash

Good morning, and welcome to Protocol Fintech. This Thursday: the staked ether crisis explained, Block joins the FTA and Kraken has a crack-up over diversity.


Co-byline with Tomio Geron

DeFi in a downturn

The theory of decentralized finance was that it would be resilient during market shocks. In practice, it’s been proving remarkably brittle. Three Arrows Capital, one of the biggest crypto hedge funds, is facing questions about its solvency amid a broader market meltdown. And DeFi lender Celsius has reportedly hired law firm Akin Gump Strauss Hauer & Feld to help keep the company afloat.

There are connections to the earlier meltdown of Terra’s UST stablecoin, and also echoes of it: A crypto asset perceived as safe proved anything but, upending once-profitable bets that didn’t account for the risk of a market downturn.

A crypto derivative is at the center of the current disaster. A dive into the mechanics of that token, known as staked ether or stETH, reveals how things can go wrong so quickly in crypto markets.

  • Staking is a common concept in DeFi — essentially pledging a token and tying it up with smart contracts so it can’t be spent or sold, usually in exchange for earning an interest-like yield. It’s become a big part of Ethereum’s upcoming move to proof of stake, known as the Merge. Part of that involves letting investors stake ether to earn rewards on the new Beacon Chain.

  • Staking on Beacon locks up an investor’s ether until the Merge is complete. It also requires 32 ETH, or nearly $40,000 at recent prices, to participate. Lido Finance, a DeFi protocol, created stETH to let smaller investors get in on staking rewards without the 32 ETH minimum and without locking it up as tightly.

  • This stETH token has become popular in DeFi, with the protocol grabbing 32% of all the ether staked on the Beacon Chain. Some crypto investors figured out ways to swap ETH for stETH and back again profitably.

  • That wasn’t a problem as long as investors believed that the Merge would happen soon, and that in the meantime they could trade back out to ETH if needed. But the Merge now looks like it may happen later than expected because of technical challenges, another development that may have spooked investors in addition to the general market downturn.

Once investors started to run for the exits, things spiraled. Now stETH has a liquidity problem.

  • The stETH token was supposed to be equal in value to ether. But that peg started to erode during the Terra collapse and was lately down about 6%. With investors looking for liquidity, selling pressure on stETH has increased.

  • Celsius halted trading and withdrawals earlier this week amid what it called “extreme market conditions.” The company is discussing multiple options with attorneys, ranging from seeking more investor capital to undergoing a complete financial restructuring. Though the company markets itself as similar to a bank, it operates more like a hedge fund, holding upwards of $11 billion in assets in May.

  • The company has not only suffered from the cryptocurrency bear market hitting all blockchain projects; it’s also dragged the value of ether down with it. The company held an undisclosed amount of UST, and so was exposed to the Terra collapse. But the stETH crisis hit it hardest.

  • It’s not alone: Three Arrows Capital, which had $10 billion in assets in March per crypto analytics firm Nansen, was liquidated by top lending firms for at least $400 million, according to The Block, throwing its solvency into question. One of the firm’s holdings was staked ether, which it recently sold at a discount. Co-founder Zhu Su tweeted a cryptic message Tuesday that the firm was “in the process of communicating with relevant parties and fully committed to working this out.”

Unwinding these bets could be difficult. Curve, another DeFi protocol, normally shows a balance between regular and staked ether in its liquidity pool, but the pool is now skewed 80/20 toward stETH. Alameda Research, the crypto trading firm founded by FTX CEO Sam Bankman-Fried, also reportedly recently sold 50,615 stETH, according to Coindesk. The value of all staked ether has dropped from more than $10 billion in April to about $4 billion. And it may be just one of many cautionary tales to come.

— Tomio Geron (email | twitter) and Veronica Irwin (email | twitter)

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