Welcome to the 2nd part of the deep-dive into osETH! The liquid staking token of StakeWise V3 is set to be deployed in a matter of days as part of the new protocol upgrade, and will bring permissionless access to liquid staking to all Ethereum nodes. Exciting times!
As we prepare for the launch of this game-changing LST, it is time we looked at the mechanisms on which osETH relies to maintain its peg and overcollateralization. We will look into osETH redemptions and liquidations, and explain the process behind each mechanism step-by-step.
Read on to understand the mechanics behind osETH stability and learn why it is one of the most robust LSTs available on Ethereum.
First, let’s start with the basics: osETH is a liquid staking token that makes any stake in the StakeWise Vaults liquid. For stakers in Vaults, osETH is optional — you can mint it once you are ready to take your staked ETH to farms, lending protocols, and DEXs. When you are done, you return it to claim your underlying stake and accumulated rewards. You can also sell it at any time to immediately unstake ETH from the protocol.
As we learned in our previous article about osETH, the new LST can also be bought on the market, which means it has a price. To make sure that the token price is always fair to both buyers and sellers, osETH relies on something we call redemptions.
Redemptions allow buyers of osETH to exchange the token for a certain amount of ETH from the protocol. The amount of ETH received per osETH is determined by the fair exchange rate — a variable that reflects how many staking rewards osETH has earned since its existence. StakeWise continuously calculates the fair exchange rate of osETH so it is always up to date.
Redemptions allow individuals and bots to earn from arbitrage any time they can buy osETH at a discount and redeem at the fair rate. With every purchase and redemption, market participants bring the price of osETH closer to the fair rate. Therefore, redemptions allow osETH to maintain a price close to the fair exchange rate, or in other words, a peg.
osETH redemption mechanics
When a discount emerges to osETH, StakeWise oracles calculate how much osETH must be purchased to eliminate the discount and exit enough validators to support its redemption. In doing so, they use a parameter called the redemption threshold to determine which validators will be exited first.
Redemption threshold is set by the StakeWise DAO and is measured as the value of the user’s minted osETH relative to the value of their stake. It is currently set to 91.5%, which means that if the value of Alice’s minted osETH exceeds 91.5% of their staked ETH value, StakeWise will prioritize her osETH for redemption and exit some validators from her Vault.
If no osETH position exceeds the 91.5% redemption threshold, then the StakeWise DAO can lower the threshold to ensure that redemption requests are being met and the price of osETH in the market reflects the fair exchange rate.
In cases where Vaults have their validators slashed, some of their osETH positions may need to be liquidated, i.e. forcibly closed. Liquidation is a defense mechanism used by StakeWise to protect the overcollateralized nature of osETH.
To understand why liquidations are important, consider the scenario where osETH minted from slashed Vaults continues to circulate in the market. Validators in the slashed Vault stop producing a yield because they were ejected from the network, while osETH continues to accrue yield from the staking rewards earned by the network of Vaults within StakeWise.
At some point, the slashing losses of the Vault and the difference in yields will cause the value of osETH minted from a slashed Vault to exceed the value of ETH staked in it, resulting in an economic loss to StakeWise, and potentially to other osETH holders.
Liquidations protect against this scenario by ensuring that the supply of osETH minted from slashed Vaults is quickly reduced, potentially to zero.
osETH liquidation mechanics
Liquidations of osETH can be performed by anyone by buying osETH on the market and burning it in exchange for the fair value of osETH, plus a liquidation bonus. In effect, liquidations are similar to redemptions, except for two differences:
1) liquidation can be performed only for the osETH positions that exceed the liquidation threshold, and
2) liquidators earn a small bonus amount of ETH when burning osETH, as an incentive to liquidate.
Liquidation threshold is set by the StakeWise DAO and is measured as the value of the user’s minted osETH relative to the value of their stake. It is currently set to 92%, so if the value of the user’s minted osETH exceeds 92% of their stake, their osETH position can be liquidated in exchange for a small ETH bonus paid out from their stake.
Note that the current 8% buffer of illiquid stake is capable of covering the simultaneous slashing of ~2% of validators in the network. Should the slashing conditions in the network deteriorate, the liquidation threshold should be reduced below 92% to ensure a sufficient buffer is maintained.
Redemptions and liquidations are crucial mechanisms for osETH stability. While their logic is intuitive and straightforward, we recommend that stakers become familiar with their mechanics before deploying large positions to avoid surprises down the line.
The easiest way to never experience liquidations or redemptions is to keep osETH health below 91.5%, and while it is our recommendation that stakers keep their positions below that threshold, the StakeWise DAO can always step in and lower it further to restore osETH peg.
Hence, we recommend that stakers stay up to date on the redemption and liquidation thresholds when staking.
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