Leverage Staking with Liquid Staking Derivatives (LSDs): Opportunities and Risks

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, an iterative process that enhances financial returns while introducing potential risks. This paper establishes a formal framework for leverage staking with stETH and identifies 442 such positions on Ethereum over 963 days. These positions represent a total volume of 537,123 ETH (877m USD). Our data reveal that 81.7% of leverage staking positions achieved an Annual Percentage Rate (APR) higher than conventional staking on Lido. Despite the high returns, we also recognize the potential risks. For example, the Terra crash incident demonstrated that token devaluation can impact the market. Therefore, we conduct stress tests under extreme conditions of significant stETH devaluation to evaluate the associated risks. Our simulations reveal that leverage staking amplifies the risk of cascading liquidations by triggering intensified selling pressure through liquidation and deleveraging processes. Furthermore, this dynamic not only accelerates the decline of stETH prices but also propagates a contagion effect, endangering the stability of both leveraged and ordinary positions.