Thread by Michael Bentley

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A lot is being said about the stETH/ETH price peg right now.

Here's some thoughts on how we got here, and what can be done in future to prevent similar issues arising.
Across DeFi right now there is an enormous long position on stETH and an enormous short position on ETH, both of which are kind of stuck.

If the stETH/ETH price peg fails for a time, then liquidations could trigger more volatility in the markets.
The leverage situation is the result of yield farmers depositing stETH as collateral, borrowing ETH against it, staking that ETH to get more stETH, and redepositing, over and over.
This strategy has been sold as low risk with a high yield.

Leveraged staking takes advantage of high APYs on stETH and low borrow costs of ETH.

These positions also appear (on the surface) to be immune from health score declines, since 1 ETH = 1 stETH.
Unfortunately, there are some nuances to this strategy that a lot of people may have missed.

These have led to a one-way build up of a multi-billlion $ bubble that is now coming under pressure.

Here are some of the reasons why this has happened.
First, many leveraged stakers do not realise that they are taking out a short position on ETH.

When you borrow ETH and stake it, you are effectively borrowing ETH and selling it for stETH.

I.e. users are long stETH and short ETH.
How do we know this?

Because people coming to @eulerfinance have questioned why they need to use the one-click Short function to do leveraged staking.
If users do not realise the underlying nature of the leveraged staking trade, it seems likely they may also not understand its risks.

Leveraged staking sounds so much nicer than shorting ETH.
Second, many leveraged stakers do not realise that their position is quite hard to unwind.

When you stake ETH, you cannot unstake it.

So the only way to unwind the ETH short is to buy more ETH. People need funds in reserve to do this.
Third, users of this strategy on Aave will notice that they do not earn a supply APY. Why is this?

It is because stETH has been made unavailable for borrowing, preventing people from taking the other side of the leveraged staking strategy.
One reason for this is perhaps because stETH is a rebasing token, and these can sometimes play funny on a lending protocol if interest rates aren't accounted for carefully.

See old AMPL discussion:
governance.aave.com/t/arc-raise-ampls-max-interest-rate/5996
Another reason, however, is because the architects of the proposal to list stETH did not think, like with ETH, that there would be much demand for borrowing stETH.

governance.aave.com/t/arc-add-support-for-steth-lido/5793/5
Unfortunately, preventing shorting probably gave many people a false sense of security.

By only allowing people to go long stETH and short ETH, but not the other way around, a bubble was created, meaning there is now a pent up demand for borrowing stETH in order to hedge.
This can be seen on @eulerfinance where some people, at least, are now seemingly hedging against stETH/ETH price depeg.


This highlights the importance of enabling counter trades on leveraged products from the very beggining.

Had there been the ability to counter trade the leveraged stakers, then people may have taken on board less leverage, leading to lower systemic risk for DeFi as a whole.
Contrary to what the architects of the proposal on Aave thought, it seems borrowers *are* prepared to pay wstETH lenders a generous APY for the privelege of taking the other side of the leveraged staking position.
For lenders unconcerned about stETH/ETH price depeg, this creates some interesting yield opportunities on @eulerfinance.

4x leveraged staking (short on ETH/long on wstETH) earns upto 50%+:

4x 4% lido APY
4x 13% variable rate supply APY
an EUL distribution on ETH borrowing
There are risks involved here as always. Smart contract risks, market risks, price oracle risks, and so on.

However, the risks are largely the same types of risks as those being taken by stETH leveraged stakers on Aave earning 12-16% APY.
So, where does the extra yield come from (a good question to ask at all times)?

It comes from people counter-trading leveraged staking, betting against stETH.

It is higher yielding on Euler, because Euler is one of the few places on-chain where people can borrow stETH.
If stETH were to depeg from ETH in a flash crash, leveraged stakers on @eulerfinance might find that the Uniswap TWAP oracle actually helps limit their potential for being liquidated.

Only a sustained depeg on Uniswap would lead to a meaningful change in health score.
And the wstETH/WETH oracle on Uni v3 is pretty difficult to move, by the way, thanks to a recent commitment to strengthening of the price oracle for arbitrageurs:


Also worth pointing out that in the event of liquidation, bonuses tend to be lower on Euler than other lending protocols, thanks to the novel Dutch-liquidation system it uses.

This makes liquidation generally a lot less painful for borrowers.


Overall, there are 2 main lessons to be learned:

1) users need to be more aware of the nature of their trades (are they short/long/leveraged etc.)

2) protocols should try to ensure that the market can express itself with counter trade options to avoid build up of systemic risk.
Check out the wstETH market on Euler here:

app.euler.finance/market/0x7f39c581f595b53c5cb19bd0b3f8da6c935e2ca0
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