How Ethereum Stakers on Lido Finance Trade Merger


Decrypting DeFi is Decrypt’s DeFi email newsletter. Art: Grant Kempster

Some of the biggest fortunes in cryptocurrency have been made through arbitrage games. Some of them lay in sight, but were too difficult to carry out; others were hidden.

Think of Arthur Hayes or Sam Bankman-Fried. Arbitrage was exactly how they were able to finance the launch of their exchanges. However, after that, the paths of the two founders took quite different turns. The former pleaded guilty to violating the US Bank Secrecy Act this year, while the latter emerged as a buyer of last resort amid the latest cryptocurrency crash.

However, both took a cut by buying cryptocurrencies low and selling them high elsewhere. Bankman-Fried profited from South Korea’s so-called Kimchi premium, and Hayes made money from a similar premium in mainland China.

There is another potentially lucrative arbitrage these days. Right now, the value of Lido Staked Ethereum (stETH), a token that previously traded 1:1 to the price of Ethereum, has lost its link to ETH.

At the time of writing, sETH is worth $1,037 and ETH is $1,081, a 4.7% discount to sTETH. This discount has been known for some time, so why haven’t any of the Hayes and Bankman-Fried cryptocurrencies already taken advantage of this neat little trade?

Surely it should be easy to just buy discounted stETH and then redeem it for regular ETH and pocket the difference, right?

Not really. This is because of the way Lido Finance, the stETH provider, works.

How Lido Finance works

Lido is an investment service that allows users to deposit Ethereum, receive stETH in return, and earn a small percentage return for it. Lido then takes those deposits and adds them to Ethereum’s Beacon Chain, essentially a parallel, ghost version of Ethereum’s original proof-of-work version (but using proof-of-stake).

Lido has become the market leader in this offer.

Dune Analytics shows that Lido currently has 31.5% of Beacon Chain deposits; in other words, more than 4.1 million ETH are locked in Lido smart contracts. That’s a whopping $4.4 billion at today’s prices.

Ethereum Beacon Chain Depositories (source: Dune)

Due to the way the platform generates that return (ie, putting it on what will eventually become Ethereum 2.0), there is currently no redemption mechanism available. Smart arbitrageurs cannot refund those stETH deposits for the ETH they first deposited.

From Lido: “While Lido allows you to transfer, trade and use your ‘staked ETH’ before phase 1.5 launches, you can only redeem your Staked ETH for ETH after transfers are enabled on Ethereum 2.0. ‘invested ETH’ are minted on a 1:1 basis for every ETH invested via Lido and burned after the ‘invested ETH’ is redeemed for ETH.”

So that’s it for stETH, right? The market is simply expected to discard this restriction as another failed experiment DeFi?

Not really. In fact, for some Ethereum bulls, it may even represent another opportunity to bet on the successful launch of Ethereum 2.0. Remember: “You can redeem invested ETH for ETH only after transfers are enabled on Ethereum 2.0.”

So in the meantime, you could hypothetically start hoarding all that discounted ETH while you wait for the moment when you can finally redeem it 1:1.

Betting on The Merge

It might sound easy, like filming Kimchi Premium in the early days, but it takes a lot of nerve.

When you make such a bet, you assume: 1) the long-awaited Ethereum upgrade will actually happen, 2) Lido will still exist at that time, and 3) the price of ETH will not fall by the time of the merger, eating up potential arbitrage profits.

Today, Ethereum is still in the four digits. Tomorrow it could be three.

Another consideration is opportunity cost. By placing this bet, you are also assuming that there are no more lucrative bets to be made elsewhere. You could end up missing out on the next big thing while you wait to redeem said Ethereum.

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

In that bet, however, you’re essentially betting that the Securities and Exchange Commission will ultimately approve the BTC spot ETF. Who knows when that will happen.

As for the Merge event, Ethereum developers say it’s September – for now.

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