A surge in staked Ethereum (stETH) redemptions has caused it to lose its 1:1 peg with Ethereum.

Lido today warned staked Ethereum, or stETH, holders that the token’s peg to Ethereum has slipped, leaving them at risk of having their collateral liquidated, or sold, to make up the difference.

When Lido, a pooled staking protocol, initially sent its warning on Twitter, the discount was 4.2% and went up to as much as 5% before falling again.

Currently 1 ETH can be exchanged for 1.0248 stETH through the Curve protocol, meaning it’s trading at a 3% discount relative to Ethereum. The stETH price surged as people who had staked it in the Anchor lending protocol, which runs on the all-but-defunct Terra blockchain, rushed to retrieve it on Friday.  

As of this writing, the Terra network has been halted twice in the past day, an attempt by its developers to save the network's native assets from a death spiral caused by Terra's UST stablecoin losing its peg to the dollar.

Terra's collapse has had reverberating effects across the entire crypto market. For instance, while the network was halted, it would have been impossible for Lido users to retrieve their stETH. 

Lido eventually offered advice on how to get stETH off the Terra blockchain, but the damage was done.

Terra should remain live for the weeks to come, nevertheless, it would be prudent to move your assets as soon as practically possible.

— Lido On Terra (@LidoOnTerra) May 13, 2022

As long as stETH is trading at a discount, people can redeem their stETH for more ETH than they initially deposited. That means there wouldn’t be enough ETH in the pool to back everyone’s stETH.

For people who have only staked their Ethereum and received stETH in exchange, the discount doesn’t pose much of a risk. But traders with leveraged positions, meaning they used their stETH as collateral for a loan, could be at risk if the discount grows wide enough to trigger a liquidation of their Ethereum.

“You should urgently de-risk any leveraged positions that have a challenging health factor, for example, by adding extra collateral,” Lido said on Twitter.

If you have a leveraged position (for example through @AaveAave) you might be at risk of liquidation.

You should urgently de-risk any leveraged positions that have a challenging health factor, for example, by adding extra collateral.

— Lido (@LidoFinance) May 13, 2022

When users stake their Ethereum with Lido, they receive staked ETH (stETH) equal to the amount of the initial deposit. That stETH increases in value daily as it earns rewards—currently at an annual percentage rate of 3.6%—creating an incentive for stakers to keep their ETH in the pool.
If the value of their loan increases too much relative to their collateral, a portion of the collateral could be sold to maintain the loan-to-value ratio. That’s what determines how someone can borrow relative to the value of the tokens they’ve put up as collateral.

For example, staking 1 ETH with MakerDAO allows users to borrow funds equal to 0.60 ETH in the form of its DAI stablecoin. That’s why they refer to DAI as an overcollateralized algorithmic stablecoin. 

There’s currently $410 million wrapped stETH, or wstETH, deposited there, according to Lido.

At AAVE, there’s a $2.9 billion pool of deposited stETH. The protocol allows users to borrow ETH, or other tokens, equal to 73% of their stETH collateral. 

So if you deposit 1 stETH, you can borrow 0.73 ETH. But if the value of a loan exceeds 75% the value of their deposit, becoming undercollateralized, it’s in danger of being liquidated.

Some ETH stakers use their stETH tokens as collateral to borrow more ETH from the Aave lending protocol and then repeat the whole process over again. This is known as a recursive investment strategy, an advanced form of  yield farming, that stacks rewards on top of rewards.

The more times a trader does this, the more risk they take on. After all, they’re using borrowed money as collateral to borrow more money. 

If a trader’s initial position starts to unwind through liquidation—which could be triggered by the fact that stETH has become unpegged from ETH—it can cause a cascade of liquidations in the rest of their positions. And the trader is on the hook to pay penalties and gas fees (the cost of transacting on the Ethereum network) for each of those transactions.

— Cobie (@cobie) May 13, 2022

Despite Lido’s warning and offers of advice, crypto traders on Twitter have expressed plenty of frustration over the way the Terra meltdown has reverberated across other blockchains.

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