Mid June market overview.
Macro in the Driver's Seat
It’s been another action-packed month in both traditional and crypto markets. Macroeconomic events continue to drive asset prices across global markets. Here are some key highlights:
Interest rates increased 75 bps after the June 15 Fed meeting
May year-over-year (YoY) Consumer Price Index1 (CPI) increased to 8.6%
Oil and gas prices continue to rise, with Americans paying on average $5 at the pump
Russia demands payment for oil in Rubles – and gets it
While global markets brace for the worst, crypto — a nascent and risky asset class — is no exception. The total crypto market cap fell below $1 trillion for the first time since January 2021, when the price of Bitcoin was at $33k. As of June 15, 2022, the price of Bitcoin is $21.7k, and the total crypto market cap is roughly $929B. While macro conditions continue to put pressure on traditional financial markets, crypto has its own unique set of incremental drivers impacting price action and volatility. We will elaborate on one such specific price driver - stETH, a liquid staking derivative, in the section below.
Ethereum Merge Updates
Public Testnet Merge Paves Way for ETH Merge
The Ethereum Foundation successfully merged the Ropsten 2 test network to Proof-of-Stake 3 (PoS) on June 8, 2022, marking the first public testnet to successfully complete the Merge. Testnets, like Ropsten, are blockchain networks that developers use to test out smart contracts before deploying them onto the mainnet.
Why does it matter?
The Ropsten merge is significant because it is the first public testnet to complete the Merge and will provide valuable information to core developers on Ethereum (“ETH”). Prior to the Ropsten merge, the Kiln 4 testnet that was launched with separate Proof-of-Work 5 (PoW) and PoS chains successfully went through the Merge on March 15, 2022. Successful testnet merges are positive signs for the implementation on the Ethereum mainnet expected in Q3 2022.
What is the Merge?
The Merge transitions the Ethereum mainnet from PoW to PoS. When the Ethereum mainnet undergoes the Merge, miners will no longer earn rewards for producing blocks. Instead, the network will begin paying validators transaction fees and staking rewards.
Block rewards paid to miners or validators are a combination of protocol inflation (newly minted ETH) and transaction fees. Currently, ETH staking only rewards stakers with protocol inflation, as transaction fees are still being paid to miners. Merging the Ethereum mainnet to PoS is expected to increase staking yields from roughly 5% to 10% as transaction fees start being paid to stakers, in addition to validators.
Following a successful mainnet merge, it is believed that the number of validators will increase significantly as investors look to capture higher yields. Below is a table from the Ethereum Foundation’s Github showing the protocol inflation based on the number of validators. The ETH supply has an inflation rate of approximately 4% or 4.7M ETH per year according to Coin Metrics and is burning roughly 2.3M ETH per year due to EIP-1559. With ~400,000 validators currently on the network, the number of validators would need to increase over 300x to achieve an annual issuance of over 2M ETH – less than half of the total issuance today. Additionally, it is less than the amount of ETH currently burned on an annualized basis that could cause the supply of Ethereum to become deflationary.
Despite improvements to staking yield, energy consumption, and protocol inflation, the Merge will not reduce transaction fees. Fee reduction will come later when shard chains are implemented in 2023.
What comes next?
After the Ropsten testnet merge, the Ethereum Core Development team has two more testnets to merge later this fall – Goerli and Sepolia – before the final mainnet merge ( Paris upgrade). Following the Ethereum mainnet merge, withdrawals of staked ETH will become available after the Shanghai Hard Fork implementation of EIP-4895.
Tentative Timeline:
3/15/2022: Successful Kiln testnet merge
6/8/2022: Successful Ropsten testnet merge
Est. ~Q3 2022: Goerli testnet merge
Est. ~Q3 2022: Sepolia testnet merge
Est. ~Q3/Q4 2022: The Ethereum Mainnet Merge (Paris upgrade)
Est. ~Q2 2023: Staked ETH withdrawals enabled (Shanghai Hard Fork EIP-4895)
Staked ETH and Celsius' Woes
Despite a successful merge of Ethereum’s Ropsten testnet, rumors of the mainnet merge possibly being delayed spread on news that the difficulty bomb would be pushed back another two months. While this does not guarantee the Merge will be delayed, fears of further delays contributed to Lido’s liquid staked Ether (“stETH”) trading at a 5% discount to regular ETH, which historically traded 1:1 with ETH8.
What is stETH?
Liquid staking emerged as a synthetic way for users to access their ETH while earning staking rewards. Currently, when regular ETH is staked to the Beacon Chain, the staked ETH is irredeemable until 6-12 months after the Merge, which is expected to happen ~Q3/Q4 2022. On the other hand, liquid staking works by issuing collateral tokens in exchange for ETH deposits: when you deposit ETH onto a liquid staking protocol, you get a token that represents a future claim on the ETH after the Merge happens.
The largest and most popular liquid staking protocol, Lido Finance, began experiencing sustained instability in its stETH:ETH ratio, with trading dropping to as low as .96 ETH per 1 stETH as of June 13, 2022.
Lido Finance is responsible for about 32% of the total staked ETH, or over 4.1 million ETH. Lido’s popularity resulted in its collateral token – stETH – becoming the primary staked ETH collateral asset widely used across decentralized finance (DeFi) protocols like Aave. This created opportunities for investors to use leverage to put on their staked ETH positions.
For example:
Stake 10 ETH on Lido Finance and receive 10 stETH
Collateralize 10 stETH on Aave and borrow 5 ETH
Deposit the 5 ETH borrowed from Aave into Lido for 5 more stETH
Add 5 more stETH to Aave Collateral
Repeat
Below is a chart that shows how $1k of stETH collateral could be turned into ~$3.3k worth of ETH collateral through recursive borrowing:
This type of recursive borrowing strategy has the potential to significantly increase yields, but makes the position much more difficult to unwind. During bull markets, stETH trades at a 1:1 ratio with ETH; so there usually is a reduced risk of liquidation. However, during broad market sell-offs, assets like stETH have much less liquidity than ETH, making ETH the generally preferred option and perpetuating the stETH:ETH discount.
Why is the stETH discount significant?
There has been buzz about Celsius and its alleged impending insolvency around its stETH positions - but how exactly does this impact ETH’s price? Celsius is a centralized finance (“CeFi”) platform that allows users to deposit funds in exchange for access to high yields. Celsius aimed to provide these yields by deploying assets into DeFi protocols such as Aave, and levering up positions like the one above. On June 3, 2022, one of Celsius's largest wallets had about $1.2bn debt borrowed on Aave against roughly 445k of stETH as collateral.
Celsius’ outsized position in stETH meant it had to compete for liquidity with every other stETH holder as the market sold off and investors attempted to unwind the trade back to ETH. In addition to large leveraged stETH positions, Celsius also has leveraged wrapped BTC ( wBTC, a synthetic ERC20 version of Bitcoin that can be used on Ethereum) positions that it has topped up with collateral to prevent liquidation. While wBTC’s ratio to BTC is still intact, it faces a similar problem to stETH – less liquidity compared to the token to which it is correlated. Selling out of these positions would be nearly impossible without incurring large slippage costs. In fact, on June 13, 2022, a wallet address sold 95k ETH at market price on Uniswap, momentarily pushing the price down to $950 – 20% lower than other exchanges. If Celsius wanted to sell out of its stETH position at once, the company could face a discount of ~70%.
Instead, Celsius appears to be topping up collateral on its leveraged positions to avoid liquidation and high slippage costs from trading. Starting June 12, Celsius paused user withdrawals, hopefully giving the company time to rebalance its assets and determine how to honor its users’ withdrawal requests. The $12B startup has a mission to provide easy access to DeFi lending yields and as a result, is likely attracting users with lower risk tolerances. News of potential insolvency for the company likely spooked many retail investors, worsening the market sell-off in crypto.
