Authors: (1) Xihan Xiong, Imperial College London, UK; (2) Zhipeng Wang, Imperial College London, UK; (3) Xi Chen, University of Sussex, UK; (4) William Knottenbelt, Imperial College London, UK; (5) Michael Huth, Imperial College London, UK. Authors: Authors: (1) Xihan Xiong, Imperial College London, UK; (2) Zhipeng Wang, Imperial College London, UK; (3) Xi Chen, University of Sussex, UK; (4) William Knottenbelt, Imperial College London, UK; (5) Michael Huth, Imperial College London, UK. Table of Links Abstract and 1. Introduction Abstract and 1. Introduction 2. Related Work 2. Related Work 3 Background 3.1 Blockchain and DeFi 3.1 Blockchain and DeFi 3.2 Ethereum PoS 3.2 Ethereum PoS 3.3 Staking Options 3.3 Staking Options 3.4 LSD 3.4 LSD 3.5 DeFi Lending Protocols 3.5 DeFi Lending Protocols 4 System Model and 4.1 System Participants 4 System Model and 4.1 System Participants 4.2 Leverage Staking with LSDs 4.2 Leverage Staking with LSDs 5 Analytical Study 5 Analytical Study 6 Empirical Study 6 Empirical Study 7 Cascading Liquidation 7 Cascading Liquidation 7.1 stETH Price Deviation and Terra Crash 7.1 stETH Price Deviation and Terra Crash 7.2 Cascading Liquidation and User Behaviors 7.2 Cascading Liquidation and User Behaviors 8 Stress Testing 8.1 Motivation and 8.2 Simulation 8.1 Motivation and 8.2 Simulation 9 Discussion and Future Research Directions 9 Discussion and Future Research Directions 10 Conclusion and References 10 Conclusion and References A. Aave Parameter Configuration A. Aave Parameter Configuration B. Generalized Formalization For Leverage Staking B. Generalized Formalization For Leverage Staking C. Leverage Staking Detection Algorithm C. Leverage Staking Detection Algorithm Abstract In the Proof of Stake (PoS) Ethereum ecosystem, users can stake ETH on Lido to receive stETH, a Liquid Staking Derivative (LSD) that represents staked ETH and accrues staking rewards. LSDs improve the liquidity of staked assets by facilitating their use in secondary markets, such as for collateralized borrowing on Aave or asset exchanges on Curve. The composability of Lido, Aave, and Curve enables an emerging strategy known as leverage staking, where users supply stETH as collateral on Aave to borrow ETH and then acquire more stETH. This can be done directly by initially staking ETH on Lido or indirectly by swapping ETH for stETH on Curve. While this iterative process enhances financial returns, it also introduces potential risks. This paper explores the opportunities and risks of leverage staking. We establish a formal framework for leverage staking with stETH and identify 442 such positions on Ethereum over 963 days. These positions represent a total volume of 537,123 ETH (877m USD). Our data reveal that the majority (81.7%) of leverage staking positions achieved an Annual Percentage Rate (APR) higher than that of conventional staking on Lido. Despite the high returns, we also recognize the risks of leverage staking. From the Terra crash incident, we understand that token devaluation can greatly impact the market. Therefore, we conduct stress tests under extreme conditions, particularly during stETH devaluations, to thoroughly evaluate the associated risks. Our simulations indicate that leverage staking can exacerbate the risk of cascading liquidations by introducing additional selling pressures from liquidation and deleveraging activities. Moreover, this strategy poses broader systemic risks as it undermines the stability of ordinary positions by intensifying their liquidations. 1 Introduction The Ethereum blockchain’s transition from Proof-of-Work (PoW) [1] to Proof-of-Stake (PoS) [2, 3, 4, 5] is a remarkable shift towards a more sustainable consensus mechanism. This change, while crucial for energy efficiency, introduces new challenges in staking ETH. In PoSbased Ethereum, validators must stake ETH to secure the network [6, 7] and earn staking rewards. However, solo staking demands a substantial capital commitment of 32 ETH and technical expertise in maintaining a validator node. Additionally, staked ETH becomes illiquid during the staking period, limiting its usability for other financial activities. To mitigate these challenges, Liquid Staking Derivatives (LSDs), also referred to as Liquid Staking Tokens (LSTs), have emerged as transformative solutions. These derivatives enhance the liquidity of staked assets while preserving their earning potential. Retail users can flexibly stake any amount of ETH on a liquid staking platform (e.g., Lido) to receive the corresponding LSDs. These LSDs are fungible and tradable representations of the staked ETH and its associated rewards. At the time of writing, Lido stands as a leading LSD provider on Ethereum, marked by its top position with a Total Value Locked (TVL) of 40b USD[1]. In the LSD primary market, platforms such as Lido allow users to convert their ETH into stETH, which can then be used in various ways within the Decentralized Finance (DeFi) ecosystem. Specifically, users might choose to simply hold stETH to accrue a staking Annual Percentage Rate (APR) of around 3.6%[2] or utilize stETH in the secondary market for further financial activities. Notably, stETH can serve as collateral on DeFi lending platforms such as Aave to borrow ETH. This allows users to earn rewards on their staked ETH while utilizing stETH as active investment capital[3]. Additionally, stETH can be traded for ETH in the stETH– ETH pool of a Decentralized Exchange (DEX), such as the Curve protocol. The composability between Lido, Aave, and Curve facilitates two novel strategies of leverage staking (see Figure 2 and 3). The first, known as “direct leverage staking”, involves users staking ETH on Lido in the primary market to receive stETH, which is then used as collateral on Aave to borrow ETH, subsequently restaked on Lido. Users can iteratively execute this process to increase financial returns based on their risk profile. The second strategy, “indirect leverage staking”, involves initially swapping ETH for stETH within the Curve pool at secondary market prices, then using the acquired stETH as collateral on Aave to borrow more ETH, which is again swapped for stETH in the Curve pool. This allows users to participate in staking and earn rewards without directly staking their ETH on Lido. Together, these strategies demonstrate the flexibility and depth of the LSD ecosystem, offering varied approaches to increasing returns with leveraged positions. While leverage staking offers high return opportunities, it also presents potential risks. Under adverse market conditions that lead to a substantial decline in stETH prices, leverage staking can act as a catalyst for market instability by increasing the risk of “cascading liquidations”, a phenomenon characterized by successive liquidations that trigger a downward spiral in the stETH price. This paper aims to understand the opportunities and risks of leverage staking. We investigate its mechanisms, evaluate its financial benefits and inherent risks, and assess its broader market impact. We outline our main contributions as follows. Strategy Formalization. We develop a formal framework for leverage staking with stETH that captures both direct and indirect strategies. We conduct an analytical study to derive key metrics such as leverage staking multiplier, Health Factor (HF), and APR for each position. To our knowledge, we are the first to model leverage staking strategy with LSDs. Strategy Formalization. Empirical Measurement. We empirically analyze leverage staking spanning 963 days, from Dec 17, 2020 to Aug 7, 2023. We detect 262 direct leverage staking positions with a total staked amount of 295,243 ETH (482m USD), and 180 indirect leverage staking positions, with a total swapped amount of 241,880 ETH (395m USD). We observe that a majority (81.7%) of leverage staking positions yielded an APR higher than that of conventional staking. Empirical Measurement. User Behavior Analysis. We explore the stETH price deviation in relation to the Terra crash incident. We analyze how users behave when faced with potential liquidations. We discover that users actively deleveraged their leverage staking positions and collectively repaid a substantial debt amounting to 136,069 ETH, further intensifying the stETH selling pressure. User Behavior Analysis. Stress Testing. We perform stress tests on the Lido–Aave–Curve LSD ecosystem to evaluate the impact of leverage staking under extreme conditions where the value of stETH dropped significantly. We find that leverage staking can heighten the risk of cascading liquidations by introducing additional selling pressures into the market. Additionally, we observe that leverage staking contributes to broader systemic risks by exacerbating the liquidation of ordinary positions. Furthermore, our simulations suggest that the deleveraging action taken by leveraged positions can intensify liquidation cascades among system participants. Stress Testing. 2 Related Work We provide an overview of the literature related to PoS staking, LSDs, and DeFi lending. PoS Staking. The economics of PoS staking has been studied by several scholars. For example, Cong et al. [8] developed a continuous-time model to explore the economic impact of staking in token-based digital economies. They found that higher staking rewards lead to increased staking ratios, which in turn predict higher token price appreciation and generate profitable carry trade opportunities with significant Sharpe ratios. Additionally, attention has been given to the security of PoS staking. For instance, Chitra [9] investigated how on-chain lending affects the security of a PoS blockchain. They found that when the yield from lending contracts is higher than the inflation rate from staking, stakers are incentivized to remove their staked tokens and lend them out, thus reducing network security. PoS Staking. LSDs. Tzinas et al. [10] studied the Principal-Agent problem in the liquid staking setting. They discussed the dilemma between the choice of proportional representation and fair punishment and proposed a concrete attack to illustrate their incompatibility. Scharnowski et al. [11] analyzed the liquid staking basis (e.g., the discrepancy) between the prices of LSDs in the primary and secondary market. They observed that the liquid staking basis widens when cryptocurrency volatility increases and liquidity decreases in the secondary market. Cintra et al. [12] utilized the Bayesian Online Changepoint Detection (BOCD) algorithm to identify potential depeg incidents using price data from the curve stETH–ETH pool. This research shows that the proposed approach can assist users in managing potential risks. LSDs. et al. et al. et al. DeFi Lending. Heimbach et al. [13] studied the impact of the Ethereum merge on two DeFi lending platforms, Compound and Aave. They investigated the actions taken by Aave to mitigate the liquidation risk of collateralized stETH positions. Wang et al. [14] formalized a model for under-collateralized DeFi lending platforms and empirically evaluated the risks associated with leveraging, such as impermanent loss, arbitrage, and liquidation. DeFi Lending. et al. et al. This paper is available on arxiv under CC BY 4.0 DEED license. This paper is available on arxiv under CC BY 4.0 DEED license. available on arxiv [1] https://defillama.com/protocol/lido, last accessed on Mar 11, 2024. [2] https://lido.fi/ethereum, last accessed on Mar 11, 2024. [3] https://github.com/lidofinance/aave-asteth-deployment
