Risk
Do your own research
Anytime you use leverage, there is risk.
The amount of risk can vary from minimal to crazy-degen, depending on what you are borrowing, how much you are borrowing, and what you are buying with the borrowed funds.
No Risk Example
Suppose I borrow 1 USD and use to buy 1 USD ... which is the same thing as just holding onto it. If the value of USD decreased by 20%, my dollar is worth less. But my debt is denominated in dollars, so it has also decreased by the same amount. The dollar that I have can still be used to pay back 100% of the debt principal.
Low Risk Example
A similar example, this time in crypto. Suppose I borrow 1 DAI and use it to buy 1 USDC. Both are pegged to USD, with reserves backing that value. So again, if USD value decreases by 20%, both my USDC and my DAI debt are likely to decrease in value by the same amount. My 1 USDC can repay my 1 DAI debt principal.
De-pegging Risk
But what if, for some unforeseen reason, the market decides that 1 USDC or 1 DAI is worth something less than 1 USD? Suppose in the previous example, the market price of USDC fell to 0.95 DAI. Now it becomes insufficient to repay my DAI debt.
An extreme example of de-pegging risk was the collapse of the UST "stable" coin on the Terra blockchain, in May 2022. UST was not back by equivalent reserves but instead was back by algorithms and incentive mechanisms to maintain the peg to the USD. Long story short, UST lost its peg, triggering a "bank run" downward spiral until it became worthless. In-depth analyses and opinions can be found elsewhere, but it highlights the fact that mechanism maintaining a peg matters, whether by reserves, incentives, or other means.
stETH Depegging Risk
Lido staked Ether (stETH) is pegged to the price of ETH. For every 1 ETH that gets staked via Lido, 1 stETH is minted. So on this basis, the peg is maintained by 1:1 reserves. However, stETH cannot currently be redeemed for ETH. The reason is that the ETH reserves are locked in the Beacon chain staking contract until the merge (or more accurate, the Ethereum update soon after the merge that will enable withdrawals). As such, the stETH peg is based on the promise that sometime in the future, you will be able to redeem 1 stETH for 1 ETH. In the meantime, rather than redeeming, you can sell your sTETH on the market and exchange it for ETH. There are multiple ETH/stETH liquid pools on Curve, Balancer, etc. to facilitate this, and the Lido DAO provides LDO governance tokens as incentives for providing liquidity to stETH in these pools.
Note that stETH rarely trades for exactly the same price as ETH, usually the stETH price is slightly less. Until recently, stETH traded for between 0.99 and 1.01 ETH, as show in the following chart.
What happened in mid-May 2022? As mentioned above, the collapse of UST happened. And the market crashed. One theory is that if UST can collapse, what about other pegged assets? Speculation aside, the fact is that stETH lost its peg, at least temporarily, and has been trading in the range of 0.975 and 0.985 ETH in recent days (today being May 22, 2022).
Changes in Aave Risk Paramters for stETH
As a result of the de-pegging of stETH in May 2022, Aave governance voted to adjust the rsik parameters for stETH as collateral. Details and rationale can be found in the proposal, but the changes were:
Due to the increased risk, you can now only borrow 69% of the value of your supplied stETH, whereas before you could borrow up to 73%. Perhaps more notable is the new spread between max LTV and the new liquidation threshold of 81%. If you borrowed 69% today the value of your stETH would have to drop significantly before you became at risk of liquidation.
How much would the stETH price need to fall to risk liquidation?
Today (May 22, 2022) the price of stETH in ETH is 0.976 ETH. Suppose you SuperStaked 10 ETH at 69% target LTV. Here is a table with some scenarios that show the changes in LTV at different prices of stETH in ETH terms.
The above table shows that stETH would need to fall to 82.5% of the price of ETH before hitting the liquidation threshold. (For clarity, note that the above chart does not consider the stETH APR nor the interest on the debt, both of which depend on how much time has passed before reaching the stETH price in each scenario). Note that the lowest point during the aftermath of the UST crisis, sTETH briefly traded for 0.95 ETH and has never traded below 0.937 ETH. You can make your own determination about the likelihood of the stETH price dropping to 0.825 ETH but hopefully this chart provides some helpful context.
The Merge
Another risk consideration relates to the Ethereum "merge", when the Ethereum migrates to Proof-of-Stake (PoS). Some predict this will happen in August 2022 and that a subsequent update to enable withdrawals of staked ETH by the end of 2022. But these dates are not guaranteed.
There are two key implications to consider:
When withdrawals are enabled, holders of
stETHwill be able to redeem1 stETHfor1 ETHfrom Lido protocol directly, and will not longer need to rely on liquidity pools and market prices. In theory, de-pegging risk is then reduced.
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