What is Staked ETH (stETH)?

With Ethereum’s Merge fast approaching and the launch of staked ETH (stETH) on Layer 2 networks like Optimism imminent, our short guide serves as an introduction to the most popular liquid staking derivative for ETH. Read on to learn more!

stETH Explained

As a token that represents staked ether in Lido, stETH combines the value of the initial ETH deposit and the difference between staking rewards and penalties. As a rebasealbe token, staking rewards are accumulated (minus a 10% fee that goes to Lido) and your stETH balance will increase over time.

The APR for holding stETH is currently around 4%, but this will increase post-merge with the projected returns ranging from 5.67% to 8.2% depending on network capacity.

Source: Lido

Currently, Ethereum is still secured by Proof-of-Work miners, which will be phased out and replaced with Proof-of-Stake during the upcoming Merge in September. When the transition to Proof-of-Stake is complete, validators will replace miners in Ethereum’s consensus mechanism and take on the role of block proposers, receiving rewards in the form of priority fees and potential Maximal Extractable Value rewards, both of which will boost the estimated APR for stETH holders.

However, there are certain barriers to becoming a validator:

  • At least 32 ETH is required to solo stake, worth almost $60,000 at the time of writing,

  • As well as the capital outlay in ETH, maintaining a validator and ensuring it remains online is necessary to avoid slashing (where some of your stake is burned if you go offline or fail to validate transactions).

Liquid staking providers, such as Lido and Rocketpool, lower the barriers for participating in consensus by allowing any ETH holder to deposit their ETH into a pool and receive a liquid staking derivative in return, i.e., stETH in the case of Lido. When a user makes an ETH deposit, stETH tokens are minted in the same proportion, meaning if you deposit 1 ETH, you’ll receive 1 stETH in return. Since you can always deposit ETH to get stETH, the liquid staking derivative should not ever trade above 1 ETH.

However, looking at the price of ETH-stETH over time, we see that the value of the liquid staking derivative has sometimes diverged from 1 ETH and still trades slightly below parity. The reason for this is that stETH is not pegged to ETH, but trades at a market price based on the demand and liquidity for stETH.

For example, those stETH holders who need some liquidity will sell, pushing the price below parity and presents an opportunity for arbitrage traders to come in and buy up stETH (if they believe the Merge will be successful and are bullish on ETH). With the blowup of Terra and then Celsius, selling pressure and liquidations pushed the exchange rate to all-time lows (below 0.94 ETH). Although stETH has recovered since then, it is still trading below parity.

Source: Dune Analytics

However, there’s currently no way to capitalize off of the arbitrage trade described above until stETH can be redeemed for ETH, which will only be possible once withdrawals are enabled for the Proof-of-Stake chain in the hard fork following the Merge (estimated to be around 6-12 months after the Merge). It’s also important to note that once withdrawals are enabled, there’s a limit on how much ETH can be unstaked at a time and users will have to wait in the exit queue.

Now you should have a good understanding of what stETH is, we’ll list some risks that are present:

  • If Lido validators experienced some slashing (a punishment mechanism for validators that are offline or submit incorrect results) post-merge, then your stETH balance may decrease.

  • There’s also smart contract risk associated with Lido. If there’s a critical bug, then the one-to-one redemption for ETH may not be guaranteed.

  • Finally, there’s also a small risk that the Merge may not be executed on-time or successful, in which case, stETH holders will have to wait longer to earn higher yields or redeem for ETH.

What is the Utility of stETH?

Apart from earning staking yields, stETH can be used in the same way as ETH in the DeFi ecosystem. Because of its composability, stETH (or in some cases wrapped stETH) can be used in popular DeFi applications like:

  • Aave: as collateral to take out a loan,

  • Curve: as a liquidity provider,

  • or in Yearn to earn additional yield.

Other applications can be found on Lido’s website here.

When wrapping stETH, the balance remains fixed to be compatible with some DeFi protocols, such as Uniswap. To account for the accumulated rewards, an underlying share system is used so that when you unwrap the token, your stETH balance will be higher than before.

As shown in the pie chart below, the most popular ways to utilize stETH are to supply the token in Aave’s lending market or to provide liquidity to the ETH/stETH pool on Curve. Since in theory 1 stETH = 1 ETH, supplying liquidity to the Curve pool has a much lower risk of impermanent loss. Liquidity Providers (LPs) participating in this pool will receive the steCRV LP token, which represents a share of the liquidity pool, and can then be deposited into Yearn’s stETH vault to earn an additional yield.

Source: Dune Analytics

As well as the use cases presented above, DeFi products can be built on top of stETH. One notable example is IndexCoop’s icETH (short for interest compounding ETH). As a tokenized strategy that enhances staking returns, icETH multiplies the staking rate for stETH and amplifies staking returns by up to 2.5x. To purchase icETH, you can use Argent’s mobile wallet or IndexCoop’s app.

Lido’s liquid staking derivative currently exists on Layer 2s like Aztec and zkSync as wrapped stETH (wstETH), but will soon become available on Arbitrum and Optimism, unlocking even more potential use cases. Given that the price of stETH closely tracks the price of ETH, it’s possible that once the liquidity on Optimism is sufficient, then we could potentially see stETH added as a new collateral type on Perp v2 in the future!

A translation of this article is available in Español, thanks to the help of our Perpvangelists!

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