Financial basis

How Ethereum players on Lido Finance are negotiating the merger

Decrypt DeFi is Decrypt’s DeFi email newsletter. Drawing: Grant Kempster

Some of the biggest fortunes in crypto have been made through arbitrage games. Some of them lay in plain sight but too difficult to execute; others were hidden.

Think Arthur Hayes or Sam Bankman-Fried. Arbitrage was exactly how they were able to fund the launch of their respective exchanges. After that, however, the trajectories of the two founders took quite different turns. The former pleaded guilty this year to violating US bank secrecy law, while the latter became the buyer of last resort amid the latest crypto meltdown.

Yet the two have cut their teeth buying crypto low and selling it high elsewhere. Bankman-Fried took advantage of South Korea’s so-called Kimchi bounty, and Hayes made his money from a similar bounty on the Chinese mainland.

Nowadays, another potentially lucrative arbitrage exists. Currently, the value of Lido Staked Ethereum (stETH), a token that previously traded 1:1 to the price of Ethereum, has lost its peg to ETH.

At the time of writing, stETH is worth $1,037 and ETH $1,081, a 4.7% discount on stETH. This discount has been known for a while, so why haven’t any of crypto’s Hayes and Bankman-Fried picked up this neat little trade yet?

Granted, it should be easy to just buy the stETH at a discount, then trade it for regular ETH and pocket the difference, right?

Well, not exactly. This is because of the way Lido Finance, the provider of stETH, works.

How Lido Finance works

Lido is a staking service that allows users to deposit Ethereum, receive stETH in return, and earn a small percentage return for doing so. Lido then takes those repositories and adds them to Ethereum’s Beacon chain, essentially a ghost parallel version of Ethereum’s original proof-of-work version (but which uses proof-of-stake).

Lido has become a market leader for offering this.

Dune Analytics shows that Lido currently controls 31.5% of deposits on Beacon Chain; that is, there are over 4.1 million ETH locked up in Lido smart contracts. That’s a whopping $4.4 billion at today’s prices.

tag string
Depositors of the Ethereum Beacon chain (source: Dune)

Due to the way the platform generates this return (i.e. by betting it on what will eventually become Ethereum 2.0), no redemption mechanism is currently available. Sophisticated arbitrageurs cannot return these stETH deposits for the ETH they deposited in the first place.

From Lido: “While Lido allows you to transfer, trade and use your ‘staked ETH’ before the launch of phase 1.5, you can only trade staked ETH for ETH after transfers are enabled on Ethereum 2.0. “Staked ETH” is minted on a 1:1 basis for each ETH staked through Lido and burned once “Staked ETH” is exchanged for ETH.”

So that’s it for stETH, right? The market is simply expected to ignore this unanchoring as another failed experiment in Challenge?

Not enough. In fact, for some Ethereum bulls, this may even represent another opportunity to bet big on the successful launch of Ethereum 2.0. Remember: “You can only exchange staked ETH for ETH after enabling transfers on Ethereum 2.0.”

So, in the meantime, you could hypothetically start scooping up all that discounted ETH waiting for the time when you can finally redeem it 1:1.

Betting on the merger

It may seem easy, like capturing the Kimchi Premium in its early stages, but it takes a lot of courage.

When you make such a bet, you are assuming that: 1) the long-awaited Ethereum upgrade will indeed take place, 2) Lido will still be there at that time, and 3) the price of ETH will not have not fall at the time of The Merge, gobbling up any potential arbitrage profit.

Today, Ethereum is still in four figures. Tomorrow it could be reduced to three.

Another consideration is that of opportunity cost. By making this bet you are also assuming that there are not yet more lucrative bets to be made elsewhere. You might end up missing the next big thing while waiting to redeem said Ethereum.

Another similar bet you could make is on Grayscale’s Bitcoin Trust, which is currently trading at an even steeper 30% discount to the underlying asset.

In this bet, however, you are essentially betting on the final approval by the Securities and Exchange Commission of a BTC spot ETF. Who knows when that will happen.

As for the Merge event, Ethereum developers are announcing September, for now.

Want to be a crypto expert? Get the best of Decrypt straight to your inbox.

Get the biggest crypto news + weekly digests and more!