In the rapidly evolving landscape of decentralized finance, where innovation and experimentation continue to reshape traditional financial paradigms, a notable development has emerged in the form Ethereum liquid staking derivatives backed stablecoins. These hybrid financial instruments present a unique proposition: the fusion of the inherently secure infrastructure of Ethereum's blockchain with the potential stability of staking derivatives.
This article explores the feasibility of considering such stablecoins as risk-free rate products, delving into both quantitative and qualitative aspects of their structure, performance, and relevance within the broader DeFi ecosystem. Through a detailed analysis of their composability potential, and adherence to critical criteria for risk-free rate assets, we aim to ascertain whether these stablecoins can indeed serve as dependable benchmarks within the ever-expanding realm of DeFi.
Let’s start by presenting a quick overview of the ongoing state of LST markets. Currently 11.5M or 47.5% of staked ETH are in the form of LSTs, and the top 3 issuers account for around 92% of total ETH deposited in liquid staking protocols, with around 75% deposited in Lido.
Lido’s stETH is by far the dominant LST market and appears to become profitable with a continuous growth in net revenue. With over half of the stETH supply held in Aave, Curve, and Lido’s wrapped stETH contract, this indicates that the asset is embraced by both investors and DeFi applications.
Similarly to many other fields of DeFi, such as decentralized exchanges with Uniswap or lending markets with AAVE, Lido benefited from the strongest catalyst in innovative and rapidly evolving environments, the first mover advantage. By launching their ETH staking solution right after the deployment of the Beacon chain and starting their incentive campaign at the dawn of bull market it allowed the project to gather a wide loyal user base of stakers who did not withdrawn their assets from the platform after the merge despite a 60% decrease in ETH market price.
Again, similarly to many other fields of DeFi, the overwhelming dominance of a player doesn’t prevent many smaller alternatives to scale and offer competitive features and yields. Once the first mover advantage is attributed, the second best catalyst resides in composability.
Composability forecast
With 24.1 million ETH deposited into the staking contract, the value of staked ETH alone would be the equivalent of a top-five cryptocurrency by market capitalization in its own right. Staked ETH is thus the first yield-bearing instrument to reach significant scale in DeFi. Currently, around half of the total staked ETH are deposited on LST protocols such as Lido, Rocketpool, Coinbase and more.
Thriving for efficiency and fighting against idle liquidity, numerous DEXs now harness the yield bearing properties of LSTs to enhance the APRs available for their liquidity providers, inherently raising questions like would LSTs ETH become the standard pairing assets for DeFi liquidity.
Empirically, major LSTs have a track record of accurately replicating ETH prices, moreover their wrappers such as wstETH open doors for great composability with existing AMMs designs. Balancer pioneered this narrative with the core pool program directing more emissions toward yield bearing pairs and redistributing the fees generated as voting incentives to feed the protocol governance flywheel.
In traditional finance, yield-bearing assets such as sovereign treasury bonds or mortgages have entire industry verticals and products built around them: derivatives, rehypothecation, inverse instruments, and on and on.
EigenLayer is the first step in the derivatives scope building up around ETH. It’s a protocol built introducing restaking, a new primitive in cryptoeconomic security. This primitive enables the reuse of ETH on the consensus layer. Users that stake ETH natively or with a liquid staking token (LST) can opt-in to EigenLayer smart contracts to restake their ETH or LST and extend cryptoeconomic security to additional applications on the network to earn additional rewards.
EigenLayer restaking protocol mechanisms
However, Vitalik Buterin warns us about the boundaries of composability of staked ETH with his blog post “Don’t overload Ethereum consensus”. He states that protocols utilizing technologies like restaking should not be created with the intention of relying on a fork or re-org of Ethereum in order to recoup potential losses that they may suffer, which he describes as “recruiting the Ethereum validator set, and perhaps even the Ethereum social consensus”.
Instead, it is possible to build alternative products creating verticals for liquid staking derivatives, such as CDP stablecoins. In fact, that type of financial instrument shows various similarities with traditional finance risk free rates products used as industry benchmarks. This sector is pioneered by projects like Lybra, Gravita, or Raft.
Defining criteria for assets that can be considered for risk-free rate financial products is essential for maintaining the integrity and stability of financial markets. Here are the key criteria that I would consider:
Credit Risk: The asset should have negligible credit risk, meaning that the issuer of the asset is highly unlikely to default on its obligations. Typically, assets issued by governments with strong creditworthiness are considered for risk-free rates, as they have the ability to meet their financial commitments.
However, since the purpose of this article is to assess the legitimacy of DeFi products to be considered risk-free rates, and since this label is nothing but theoretical, we can consider Ethereum proof of stake staking wrappers as resilient collaterals to issue overcollateralized stablecoin assets.
Based on historical data, a stablecoin backed by a stETH CDP with a collateral ratio of 150% deposited on August 30th 2022 experienced a lowest health ratio of 1.11 over the course of one year, while the current health ratio stands at approximately 165%. This is not taking in account the auto compounding of native LST yield.
Liquidity: The asset should be highly liquid, allowing it to be easily bought or sold in the market without significantly impacting its price. Liquidity ensures that the risk-free rate can be reliably observed and used as a benchmark across various financial transactions.
In the realm of LST backed stablecoin, Raft’s R counterparts liquidity on decentralized exchanges could absorb more than half of the stablecoin supply. Furthermore, there exist several AMMs flywheels that enhance the efficiency of LST backed stablecoins, such as crvUSD LLAMA employing concentrated liquidity and dynamic liquidations to increase the stablecoin’s resilience.
Market Size: The asset's market should be sufficiently large to accommodate a wide range of investors and transactions. This prevents manipulation of the risk-free rate and ensures that the rate is reflective of the broader market sentiment. Considering that the stablecoin market is the highest volume generating cryptocurrency market and given its central role in the ecosystem, it seems quite obvious that the studied product corresponds to this criteria.
Maturity Spectrum: The asset should be available across various maturities, ranging from short-term to long-term. This helps in constructing a yield curve that serves as a benchmark for pricing other financial instruments with different maturity profiles.
The government backed risk free rate products are often bonds which require maturity/duration parameters while DeFi CDP style risk free rates are designed with perpetual maturity. However it can serve as a benchmark for pricing interest rates of DeFi lending instruments.
Stable Value: The asset's value should be relatively stable and not subject to extreme fluctuations. Stability is crucial to ensure that the risk-free rate provides a consistent reference point for valuation.
Curve’s stablecoin crvUSD, backed in majority by LSTs wstETH and frxETH is among the most capital efficient of the decentralized stablecoins, with a ratio of 82%. Furthermore, we can observe in the following graph that it tends to maintain a stronger peg compared to a sample of centralized and decentralized stablecoins.
Transparency: The asset's pricing and market-related information should be transparent and readily available to market participants. Transparency enhances credibility and ensures that the risk-free rate calculation is based on accurate and reliable data.
Censorship resistance of blockchain based applications is the highest level of transparency available for financial products, block explorers and analytics tools allows retail and institutional users to crunch a limitless amount of data and track every market participant's actions. Moreover, oracle solutions’ accuracy has gone a long way to offer the smoothest and manipulation resistant price feeds.
Minimal Reinvestment Risk: The asset's cash flows, such as interest payments or coupons, should be easily reinvested at rates that are closely aligned with the risk-free rate itself. This reduces the impact of reinvestment risk on the overall returns.
In the case of a LST backed stablecoin, considering the CDP structure of the investment product, the frequency of the auto compounding of native yield bearing collaterals contributes to offset negative volatility and increase APR, thus the reinvestment risk should be assessed according to the product’s structure.
Currency: The asset should be denominated in a stable currency that is widely used as a benchmark in financial markets. The currency's stability and acceptance are crucial for accurate risk-free rate determination. In our case, although they are backed by different baskets of assets, most stablecoin are denominated in US dollars.
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Sovereign Control: The process of decentralization is a complex, multidimensional process involving the transfer of responsibilities and resources across different socio-economic dimensions such as political, administrative, and fiscal spheres.
The consensus of blockchain communities depends on a user base’s universal agreement on the deterministic code interpreting the agreed ordering of signed messages. This agreement on code and order is the ultimate authority and the source of the sovereignty of all blockchains. This means that the definition of “right” and “wrong” is determined by two methods: code is law, and use is consent.
Considering these criteria, we can affirm that LSTs backed stablecoin accurately represents the risk-free rate and serves as a reliable benchmark for various financial products and transactions.
Author : @beguin co-writer : @akgemilio