Why LST Volatility Undermines the Stable in Stablecoin

LSTs like Lido's stETH and Rocket Pool's rETH are derivatives whose value is pegged to the underlying staked ETH. This peg is maintained by arbitrage, not by a redemption guarantee. In a mass exit or slashing event, the peg can break, causing collateral devaluation.

• Peg relies on market liquidity, not direct redemption.
• ~1-5% daily volatility vs. a target of <0.1% for a stablecoin.
• Depegs are not theoretical (see stETH's ~4% discount in June 2022).

Using volatile LSTs as collateral creates a reflexive feedback loop. A drop in LST price triggers margin calls and liquidations in the stablecoin protocol, forcing the sale of more LSTs into a falling market.

• This mirrors the UST/LUNA death spiral mechanism, but with a different asset.
• Undermines the capital efficiency argument for using LSTs.
• Exposes the entire DeFi stack to systemic risk from a single asset class.

Stablecoins aim to be payment instruments. LSTs are increasingly viewed by regulators (e.g., SEC) as securities. Backing a payment token with a security creates a untenable regulatory liability.

• Creates a single point of regulatory failure for the entire stablecoin.
• Contradicts the money transmitter model sought by entities like Circle (USDC) and Paxos (USDP).
• Invites scrutiny akin to fractional reserve banking without the legal framework.

The only viable model for LST-backed stables is extreme risk mitigation. This means treating LSTs as a risky, yield-bearing asset class and building robust buffers.

• Isolated Vaults (like MakerDAO's) prevent contagion to the core stablecoin.
• High Over-Collateralization Ratios (200%+) to absorb volatility.
• Dynamic Stability Fees that adjust based on LST volatility metrics.

stETH is a claim on future ETH, not a stablecoin. Its price is a function of validator exit queues and market sentiment, not a peg. When Celsius and Three Arrows Capital faced insolvency, they dumped stETH, creating a self-reinforcing depeg spiral.

• Key Flaw: LSTs embed redemption latency and execution risk.
• Systemic Risk: ~$10B in DeFi protocols used stETH as "stable" collateral.

Protocols like Aave and MakerDAO accepted stETH as collateral, relying on high collateral ratios (e.g., 150%+) for safety. This failed because:

• Liquidity Crunch: The primary stETH/ETH pool on Curve experienced ~75% depletion.
• Oracle Risk: Price feeds lagged, creating arbitrage and liquidation cascades.
• Reflexivity: Depeg lowered collateral value, triggering more liquidations, deepening the depeg.

True stability requires isolating the volatile collateral asset from the stablecoin's redeemability. The correct architecture is:

• Direct Yield Source: Use the LST's native yield (e.g., staking rewards) as the revenue stream, not its principal value.
• Hard Redemption Floor: Back the stable asset with a basket of non-correlated, liquid assets (e.g., short-term treasuries, other LSTs).
• Protocols to Watch: This is the design philosophy behind Ethena's USDe (synthetic dollar) and Lybra's eUSD.

The stETH depeg wasn't an isolated event; it was a stress test for LST-based leverage. It revealed that Aave, MakerDAO, and Curve are a tightly coupled system.

• Contagion Vector: A single distressed entity (Celsius) can destabilize the core money lego.
• Design Mandate: Stablecoin protocols must model for black swan liquidity events and asset correlation.
• Future Proofing: This event directly informed the risk frameworks for EigenLayer restaking and LSTFi derivatives.

LSTs are derivatives, not cash. Their value is a function of staking yields, slashing risk, and validator performance, not a peg. A mass validator exit or a consensus-layer exploit can cause the underlying asset (e.g., stETH) to trade at a discount, directly threatening the stablecoin's collateral ratio.

• Key Risk 1: LST price can diverge from its underlying asset (e.g., stETH/ETH depeg).
• Key Risk 2: Cascading liquidations in a depeg event create a death spiral for the stablecoin.

True stability requires collateral whose value is independent of the protocol's own yield mechanics. Look to real-world assets (RWAs) like T-Bills or diversified blue-chip crypto assets (BTC, ETH) held natively, not as yield-bearing derivatives.

• Key Benefit 1: Collateral value is driven by exogenous market demand, not internal staking mechanics.
• Key Benefit 2: Eliminates reflexive risk; a problem in DeFi staking doesn't automatically become a problem for the stablecoin.

If you must use LSTs, architecturally segregate the yield-bearing asset from the stability mechanism. Protocols like Ethena use stETH but hedge the ETH delta with perpetual futures, creating a synthetic dollar. The stablecoin's backing becomes the derivative's delta-neutral position, not the volatile LST itself.

• Key Benefit 1: Transforms volatile collateral into a rate-stable synthetic asset.
• Key Benefit 2: Decouples user yield (from staking) from the stablecoin's peg assurance.

Don't measure health by TVL alone. The critical metric is the collateral correlation matrix during a black swan event. How does your LST collateral behave when the broader staking ecosystem is under stress (e.g., a forced Lido validator withdrawal)? If it's ~1.0, your design is fragile.

• Key Action 1: Model scenarios where staking APR plummets and slashing events occur simultaneously.
• Key Action 2: Require over-collateralization ratios that account for potential depeg depth, not just daily volatility.