Ethereum: The StETH Peg Is The Wrong Arbitrage Play

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ozgurdonmaz

When I last covered Ethereum (ETH-USD) a little over a month ago, a key component in the long-awaited Proof of Stake chain merge had been delayed. Out of a desire to not re-write that article, for those who pay less attention to the technical aspect of blockchains: Ethereum is primarily a PoW (Proof of Work) consensus blockchain. However, there is a parallel Ethereum chain already that runs a PoS (Proof of Stake) consensus instead. The PoS chain is called the Beacon Chain. What developers and market participants have been waiting to see completed is the joining of Ethereum’s PoW mainnet with the PoS Beacon Chain. The completion of which has been referred to as “The Merge.” The Merge now has a new target date of September 19th.

Lido Finance Arbitrage

A major part of transitioning to a Proof of Stake mechanism requires ETH validators to stake their assets before the merge is actually completed. This helps to secure the Beacon Chain pre-merge as mainnet validators currently have a vested interest in mining on the proof of work chain. Following the merge, there will be no incentive for proof of work mining. Thus, staking ETH on Beacon Chain becomes the only way to generate rewards from ETH transactions post-merge. The catch for those who want to participate by staking their ETH pre-merge is those tokens are locked until after the merge is finalized. And there are now over 13.1 million ETH tokens staked on Beacon:

Staked ETH (Dune Analytics)

At 11% of ETH’s total supply, that’s a lot of liquidity to lockup without an exact date that the tokens can be un-staked. Hence, the excitement for a completed merge. What has helped traders and DeFi participants continue their trading activity is Lido Finance (LDO-USD). Lido Finance is a DeFi protocol that offers liquidity for staked ETH. On the Ethereum chain, ETH holders can stake their tokens to the Beacon Chain through Lido and then mint a derivative of their ETH called “Lido Staked ETH,” or stETH. stETH is intended to be pegged to the underlying asset on a 1:1 basis.

Holders of stETH can then redeem those ETH derivatives for real ETH when the merge is over and the underlying Ethereum on the network can be un-staked. Lido users would benefit from this model because they can lockup their ETH on the new chain and then continue to participate in other DeFi activities by using their stETH derivatives in trades. This has led to an explosion in activity through Lido as that protocol has gone from roughly 10% of staked ETH deposits on Beacon a year ago to over 31% now.

Staked Ethereum on Beacon (Dune Analytics)

What makes the Lido situation interesting is there is now an arbitrage opportunity because the stETH peg has gone under 1.

stETH to ETH Peg (CoinMarketCap)

While the stETH peg has always fluctuated, from October of last year through April of this year, the peg was stable and very close to 1:1. Volatility picked up when crypto funds started blowing up earlier this year. Coupled with what was surely a run on customer assets before withdrawals were halted, Celsius (CEL-USD) collapsed because it had significant exposure to stETH. During the crypto contagion meltdown that claimed Celsius, stETH traded down to a 7% discount against ETH.

The current discount is roughly 2%. The opportunity this peg now presents DeFi players is essentially the chance to claim 1.0 ETH when un-staking is available post-merge by buying stETH for 0.98 ETH now. With a new target date for “The Merge,” we have renewed speculation on the best way to trade it as a catalyst. Though the gap has closed since mid-June, some believe buying Lido Staked ETH still provides a valuable pricing arbitrage opportunity for ETH merge traders.

Capturing ETH Aribtrage

While the deeper discount in stETH didn’t last very long, I don’t think the current discount is large enough to justify an stETH position purely for the value gap. I take that view for two main reasons. The first is that even if the merge goes off without issue, stETH can’t actually be redeemed for ETH immediately. ETH withdrawals won’t be enabled until another upgrade after the merge takes place according to Ethereum.org:

Withdrawals are planned for the Shanghai upgrade, the next major upgrade following The Merge. This means that newly issued ETH, though accumulating on the Beacon Chain, will remain locked and illiquid for at least 6-12 months following The Merge.

Essentially, anybody buying stETH under the assumption they will be able to immediately redeem it for ETH in late September following a successful merge of mainnet and Beacon is mistaken.

The second reason I think stETH is the wrong way to play pricing arbitrage in Ethereum is that it isn’t the deepest discount in Ethereum derivatives. There is a far better pricing arbitrage in the Grayscale Ethereum trust (OTCQX:ETHE); shares of which closed at a 28% discount to net asset value on Monday.

ETHE Premium Rate Trend (Grayscale)

As ETH was finding its footing a bit over the last few weeks, the discount rate in ETHE shares moved from 35% in June to 25% a few days ago. In my view, if you’re bullish Ethereum, the best arbitrage opportunity is in ETHE shares rather than in stETH.

While ETHE shares lack redemption for Ethereum, stETH also lacks redemption for Ethereum until after a post-merger upgrade. If the past timeline of “The Merge” has been any indication, the Ethereum development team will likely take its time with the Shanghai upgrade after the merge has been completed. This means redemption could take as long as a year, at minimum.

A Different Kind of Risk

A legitimate advantage stETH has over ETHE shares is stETH can be swapped at all hours. The DeFi market never closes while ETHE shares are at the mercy of standard market hours. This can make entering or exiting an Ethereum position more challenging if a trend reversal happens when the equity market is closed. But if you’re not looking for an Ethereum derivative that offers DeFi liquidity, ETHE has far more upside as an arbitrage play simply because the price discount to the net asset value is so much larger than the stETH peg arbitrage.

There are reasons to get stETH through Lido Finance if you’re a long term believer in the Ethereum network. Having liquidity while ETH has been staked allows for on-chain DeFi activity. There are other risks that come with that approach, however. We’ve seen numerous instances of funds getting hacked from DeFi protocols through the years and there is always the risk of human error with keys leading to total loss of funds. The point is, if you’re purely looking for ETH arb, ETHE is probably the better opportunity than stETH as we approach the merge.

Summary

Ethereum, like many cryptos, has struggled in recent sessions. While we’ve experienced a nice rally from $1,040 to $1,600 in the last two weeks, the short term direction isn’t yet clear as Ethereum just gave up $1,500 Monday night. A deeper pullback could be necessary to set up a more sustainable bear market rally continuation after a consolidation period.

Of course, the bear market rally could also be over already and fresh lows could be coming. Furthermore, the Ethereum merger could ultimately be a “buy the rumor, sell the fact” event. And that’s if it even happens in mid-September at all. We could also simply be dealing with volatility leading up to Wednesday’s FOMC. While I’m still personally long both ETH directly in a cold storage wallet and Grayscale’s ETHE shares through a retirement account, I wouldn’t totally rule out a better entry in the days ahead.