Ethereum: Is Lido doomed to repeat the fate of Three Arrows Capital?

Market research firm Kaiko has published a study on Ethereum’s flagship protocol, Lido Finance (LDO). Study This is a must read for every ETH and LDO investor!

Cautionary tales are valuable reminders of the risks and pitfalls that can await even the most promising projects. Remarkably, Lido Finance has embarked on a massive growth path in recent months, reminiscent of former crypto industry poster child Three Arrows Capital (3AC). Kaiko analyst Riyad Carey writes:

Essentially, 3AC is betting that GBTC – a fundamentally different asset than BTC, with significant friction in entry and exit – will closely track BTC’s price. This saga has been front of mind as I watch STETH (and other liquid staking derivatives) begin to displace ETH in DeFi protocols.

research findings by kaiko

The in-depth research carried out by KAICO provides important insights into the operation of the lido and the potential risks it faces. According to Kaiko’s analysis, “Lido’s success story raises concerns about potential vulnerabilities and risks lurking beneath the surface.” By examining a wealth of data, KAICO highlights liquidity challenges, leverage risks and the potential for a mass liquidation event.

Lido Finance is a platform that allows users to stake Ethereum and receive STETH tokens, which represent the value of the initial deposit and staking rewards. Keiko’s research shows that the STETH token has seen impressive growth over the past year and a half, with the supply increasing fivefold from 1.5 million to 7.5 million, and the number of holders increasing from 40,000 to nearly 220,000.

The analysis by Kaiko also highlights the importance of liquidity in the context of staking derivatives such as stETH. An important aspect emphasized by the research is the Lido DAO’s reliance on Curve’s STETH-ETH pool for liquidity provision.

Data from KAICO shows that from June 2023 onwards, the liquidity incentive for this pool is waning. As a result, liquidity has shrunk and the downtrend is evident. This shift in incentives raises concerns about the stability of the STETH-ETH pool during times of stress or market events, potentially leading to a liquidity crisis.

Another important aspect discovered by Kaiko’s research is the increased leverage associated with stETH usage. Analysis suggests that lending and borrowing protocols have become central to leverage, with SETH gaining popularity as an asset to leverage the strategy.

However, the research highlights fundamental differences between STETH and ETH, as well as concerns about the risks associated with these leveraged positions due to declining on-chain liquidity.

Kaiko found that about a month after adding stETH to Aave V2 it became the most deposited asset, while ETH lending increased from $200mn to $1.6bn in just two months. According to the research firm, the reason is worrying:

This is largely due to the popularity of leveraging STETH manually: depositing STETH into Aawe, borrowing ETH, swapping or staking it for STETH, and repeating as many times as is convenient. It’s a process that begins to look very similar to 3AC’s GBTC trading, where the founders assumed that GBTC would trade closely with BTC.

Implications for the future of Ethereum and Lido

Based on research, the combination of deteriorating liquidity and increasing leverage presents an uncertain situation where a large liquidation event becomes more likely. Caiko says:

Again, this is not a flaw in stETH, but a flaw in how it is being used. In fact, any significant liquidation event that drives the STETH discount could present an incredible opportunity for anyone brave enough to catch the decline.

The data from KAICO’s analysis reveals a drain of liquidity from the STETH-ETH pool and emphasizes the potential risks arising from insufficient on- and off-chain liquidity.

This liquidity crunch could hinder the liquidation of substantial STETH positions, potentially burdening lending and borrowing protocols with significant bad debt.

Kaiko’s findings underline the importance of caution, risk management and proactive measures to address liquidity concerns to safeguard the future sustainability of the lido. Finally, the company has one piece of advice for the Lido DAO:

The DAO is clearly tired of providing such large incentives to the Curve pool, but with those incentives gone (for now) the DAO has to pay a market maker to provide liquidity on a variety of centralized and decentralized exchanges. Should seriously consider doing so.

As of press time, the price of LDO was trading at $1.90, down 10% over the past 24 hours. The outlook for the LDO looks extremely bearish as long as the price continues to move in the downtrend channel established in early March.

Featured Image from iStock, Chart from Tradingview.com