Celsius Reaches Boiling Point

A data-driven look at stETH, a liquid derivative of ETH that’s become not so liquid

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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.