Staking is the backbone of the Ethereum economy, ensuring the validity of transactions and ownership of digital assets. In compensation for securing the network, validators receive a staking yield composed of ETH issuance and a portion of the network’s transaction fees.

Ethereum staking has grown remarkably: over $100 billion (32 million ETH) is currently deposited into the beacon chain staking contract securing the blockchain.

By having hundreds of billions staked, the cost to attempt an attack on Ethereum is prohibitively expensive, making it one of the most secure blockchains.

On the other hand, as the percentage of staked ETH has increased, the yield paid out to validators has dropped from near 10% initially to just over 3% at the moment. Since 3% is not an attractive yield by most investors’ standards, multiple strategies are built on top of the base staking APY to enhance the return profile.

In this piece, we dive into one of the most interesting of those strategies: ETH leveraged staking. We explore the risks and returns of a leverage staking strategy in DeFi. This is a popular strategy for clients of the ITB Smart Yields platform, where custom smart contracts are deployed to optimize its execution and risk management.

Leverage Staking Strategy Overview

Leverage staking is enabled by liquid staking tokens (LSTs). LSTs like Lido’s stETH create a wrapper around Ethereum validator holdings, allowing these positions to be used across DeFi applications.

Let’s look at an example of how this strategy is executed on top of stETH:

1. The first step is to deposit stETH as collateral into a lending protocol like Aave. That collateral would be passively earning the staking yield, of say 3.5%.
2. Then ETH is borrowed against the stETH collateral, typically at a lower rate such as 2.5%. This part is important, as for this strategy to be profitable, the borrow cost must be below the staking yield.
3. The ETH borrowed is staked (or swapped) for more stETH, which is then redeposited as more collateral.
4. Steps 2 and 3 are repeated until the desired amount of leverage is reached. This can be executed automatically through flash loans for a faster and more cost-efficient approach as we’ll discuss further.

Since the staking yield is higher than the loan cost, every time the borrowed ETH is “looped” back into the strategy for stETH collateral, the strategy’s net APY increases.

Leverage Staking Returns

Projected returns for a leverage staking strategy are directly proportional to the amount of leverage carried out. The higher the leverage, the higher the potential APY — but also the higher the risk.

At the time of writing, Aave users can borrow ETH against stETH up to slightly over 10x leverage. At those levels, this strategy would yield a 12% APY, but would also be very close to its liquidation threshold.

Leverage Staking Risks

There are three main economic risk vectors to consider with a leverage staking strategy:

Liquidation risk — As implied with any strategy involving leverage, this strategy is vulnerable to potential liquidations.

If the value of the collateral drops relative to the amount of debt below the liquidation threshold, a portion of the position is automatically sold off, effectively resulting in losses for the user.

Depeg risk — Related to the liquidation risk, there is the possibility that the value of the LST collateral drops in price.

In the case for stETH, this LST is intended to be pegged 1-to-1 with the price of ETH. Since stETH can be redeemed for ETH at this rate at the protocol level, this creates a potential arbitrage if stETH’s price decreases relative to its ETH peg. However, there have been several instances where stETH has de-pegged over time.

stETH traded at a discount as low as 7% relative to its ETH underlying during June 2022. People executing leverage staking strategies at that time risked getting liquidated due to the price of stETH falling significantly below its peg.

Slippage risk — If swapping large sums of capital with this strategy, people may realize losses resulting from exchange slippage.

Given that stETH can depeg, it is worth considering how much can be swapped without materially impacting its price. Through ITB’s Curve risk radar, you can monitor the most liquid stETH pool to understand the exposure to slippage risk.

At the time of writing, up to 17.3k ETH (~$60M) can be swapped through the stETH/ETH Curve pool with just 0.5% slippage.

While that is certainly a large sum of capital, it is worth noting that the size that would be swapped is also multiplied by the amount of leverage taken out. This means that a $6M position with 10x leverage would effectively be swapping the same as a $30M position with 2x leverage.

Even though stETH can be redeemed for the underlying ETH, it does have to go through the staking exit queue, which can take a few hours (and at worst multiple days). In critical times such as during a depeg, it could therefore be better to swap while being mindful of slippage risk to unwind the position and avoid getting liquidated.

Aside from these three economic risks, it is also worth considering the usual technical risks faced when deploying into any DeFi protocol.

IntoTheBlock’s Risk Management & Execution

As part of the ITB smart yields platform, the ITB leverage staking strategy comes with fully automated deployment and risk management that can be adapted to each client’s profile.

Each strategy is deployed separately for each client, avoiding any co-mingling of funds. The contracts are non-upgradable and non-custodial, assuring the highest security standards.

Our leverage staking strategy consists of two smart contracts (shown as square boxes in the diagram below) and two adjacent risk engines (displayed as rounded boxes).

The position manager smart contract is in charge of receiving, allocating and eventually withdrawing funds into the strategy. The strategy executes a flash loan allowing it to deposit stETH collateral, borrow ETH, mint or swap it for more stETH and redeposit all within one transaction. This simplifies and significantly reduces the cost of this process, which would take dozens of transactions to execute manually depending the desired amount of leverage.

Then, the strategy manager contract serves as the main connector with ITB’s risk engines: the liquidation and slippage monitors.

These risk engines are off-chain models running simulations on a block-by-block basis tracking the strategy’s exposure to economic risks. If the models detect a risk that goes beyond the client’s risk tolerance, it sends a signal to the strategy manager contract and the position would be automatically disassembled and funds sent back to the position manger.

For example, in a stETH depegging scenario and a client has a liquidation threshold at a stETH price of 0.98 ETH, the ITB risk monitors would be able to automatically unwind the position, repaying all the debt at a level such as 0.985 ETH or higher. In doing so, the ITB contracts and engine effectively minimize the strategy’s risks. This does not make the strategy risk-free, but through its state-of-the-art architecture, ITB aims to make deploying capital into DeFi as safe as possible.