Staked Ether (stETH): What It Is and How It Works

What Is Staked Ether (stETH)?

Staked ether (stETH) is a cryptocurrency token that aims to represent an Ethereum token that is "staked" or deposited to support blockchain operations. The token is designed on Lido, a decentralized finance protocol.

Staked ether (stETH) was introduced in 2020 in anticipation of Ethereum's shift to the proof-of-stake consensus mechanism. It is designed to function as a liquidity token, where you can deposit your ETH into a smart contract on the Lido blockchain and receive an equal amount of stETH that can be traded, exchanged, borrowed against, or used for any other liquidity purposes.

Understanding Staked Ether (stETH)

To understand stETH, it's important first to understand the concept of "staking" cryptocurrency tokens. Proof-of-stake is the consensus mechanism used by Ethereum, implemented in September 2022. Ether (ETH) is the native blockchain token for the Ethereum blockchain.

Users that wish to participate in the network by becoming a validator must offer ether as a "stake"—an interest in remaining an honest network participant. The staked cryptocurrency is used as an incentive; it can be taken away if a validator doesn't act in the best interest of the blockchain and other participants.

Owners who stake their cryptocurrency are allowed to participate in transaction validation; they open new blocks and receive rewards in the form of a percentage of the transaction value they work to validate. Because staking effectively removes cryptocurrency from a user's liquid assets, there is a risk that they could lose capital until their ETH is unstaked.

Purpose of stETH

Ether owners wishing to become validators must stake 32 ETH—which is well beyond the holdings of average ether investors—or choose to participate in a validation pool, which still locks up their crypto. Lido Finance allows users to put up any amount of ether as a stake in exchange for an equal amount of stETH.

As a liquidity token, stETH is somewhat similar to derivatives such as futures contracts, where the underlying asset (ETH) is not traded. The stETH tokens allow users to continue trading, lending, or using the capital they have tied up in ETH, even as their tokens are staked.

Uses for stETH

Because it is designed to take the place of staked ether (ETH), stETH has several use cases. Be cautious with any of these uses because they can significantly increase the amount of risk you're taking on:

• Liquidity pools: stETH can be pooled with ETH in a liquidity pool, allowing the user to swap the stETH for ETH when desired. This is called a pool swap and essentially unstakes a user's ETH.
• Lending: Lending platforms such as Aave allow users to wrap (peg another crypto to the value of an underlying one) their stETH and other cryptocurrencies to use as loans to others. Lending in this way is essentially double-wrapping a cryptocurrency—where the value of the lent token depends on the token being wrapped, which depends on the underlying staked token's value.
• Yield Farming: Users that stake their ETH earn interest; those that choose stETH can also use it as another method for earning yield. Token holders can deposit their stETH on a platform such as Harvest and earn yields, which acts as a way to double your yield earnings on one token.
• Derivatives: Alternatives are emerging, with Lido mentioning insurance derivatives and put/call options.

Staked Ether's Decoupling From Ether

In the spring of 2022, stETH became an issue in the cryptocurrency investing community as the cryptocurrency market experienced significant turbulence—many of the leading tokens shed a significant portion of their value. Staked ether (stETH) played a role in the market chaos because its price fell below ETH's, although the two should trade at the same value.

However, following the decoupling in price, stETH still tracked ETH's price, albeit a lower one, until fall 2022, when it returned to within a few dollars of ETH. It's important to note that stETH was not intended to mirror ETH's price—it was designed to be a 1:1 token exchange, not a 1:1 value exchange.

Some analysts have suggested that the stETH/ETH decoupling is different from a stablecoin losing its track. StETH is not a stablecoin, meaning it does not need to trade at a 1:1 value ratio to ETH to function as intended. As a coin designed to address liquidity issues, it has been functioning as designed and offers liquidity to investors who need it.

The Bottom Line

A liquidity token, stETH represents a staked Ethereum token used to support blockchain developments and was introduced when Ethereum shifted from a point-of-work platform to a point-of-stake platform. This token improved liquidity for staked ETH holders.