Apr 7 | 5 min read
icETH provides an enhanced yield on ETH using a leverage liquid staking strategy built on Set Protocol and Aave. This product uses the same battle-tested leverage token infrastructure as the tokens, and it executes a recursive process for maximizing yield.
Within Aave, icETH deposits Lido’s liquid staked Ethereum token—stETH—as collateral and borrows ETH, which is then swapped for more stETH. That stETH is then deposited as additional collateral in Aave, allowing for more ETH to be borrowed and subsequently swapped for additional stETH. This cycle repeats until reaching the target leverage ratio of 3.1x. If the index needs to deleverage, it will execute the same process in reverse: exchange stETH for ETH, reduce debt position in Aave, repeat until reaching the target leverage ratio.
Though the target leverage ratio is 3.1x, the actual ratio can float within a safe range of 3.0x to 3.3x. An automated keeper system constantly monitors the real leverage ratio of the index and will trigger a hard rebalance if the leverage ratio moves outside of the safe range. For example, if the price of stETH were to suddenly de-peg from ETH and render the real leverage ratio to be 3.4x, the index would recenter to the target leverage ratio of 3.1x. The floating leverage ratio also reduces the need for rebalancing and therefore preserves the index’s NAV (Net Asset Value) over time.
In addition to the primary keeper system, there is a secondary safety mechanism in place called ripcord. If the real leverage ratio were to exceed 3.5x and the primary keeper systems were to fail, the ripcord function could be called to aggressively recenter the index back to the target leverage ratio. This function is publicly callable and incentivized with 1 ETH, adding another layer of permissionless defense against liquidation.
For icETH holders, all of this functionality—the collateralized debt position management, the rebalancing, the liquidation protection—is abstracted away and automated by smart contracts. There is no need to actively monitor balances or manually intervene as markets move. Simply hold icETH to capture a premium yield and retain spot exposure to ETH!
There are several specific, idiosyncratic risks to consider for icETH. The first is liquidation risk. As with any use of leverage, there is inherent liquidation risk if the health of the collateralized debt position were to fall below liquidation thresholds. In the case of icETH, the underlying Aave positions would be liquidated if the index’s leverage ratio were to reach 4.0x. The automated keeper system and ripcord function described above minimize liquidation risk by persistently monitoring and adapting the leverage ratio to stay far below liquidation thresholds.
The high correlation between the collateral asset (stETH) and the debt asset (ETH) also significantly lowers liquidation risk. Because their prices move in tandem, there is a more persistent leverage ratio compared to uncorrelated collateral and debt assets like ETH and USDC (the composition of ETH2x-FLI). The inherent price volatility of ETH compared to USDC requires daily rebalancing of ETH2x-FLI to maintain a healthy loan-to-value (LTV) ratio. For icETH, the LTV ratio is more stable and only requires rebalancing every few months. The result is lower liquidation risk and less volatility decay for icETH, enhancing fund safety and preserving NAV.
A second risk to consider is interest rate risk related to the staking rate for stETH and the borrow rate for ETH. Simply stated, incremental yield can only be generated if the stETH staking rate exceeds the ETH borrow rate. These two factors can change favorably and unfavorably. For stETH, the staking rate can fall as more ETH is deposited into the ETH 2.0 staking contract; this would lead to lower yields on icETH. Post-merge, the staking rate for stETH can also increase, which would increase the effective yield on icETH. For ETH, the variable borrow rate within Aave can increase as ETH utilization increases, compressing the yield on icETH as the borrow rate approaches the stETH staking rate. Conversely, if ETH utilization decreases, the yield on icETH will increase. In the event that the borrow rate were to reach parity with the staking rate, icETH can be deleveraged to 1.0x so that the floor yield is simply the staking rate on stETH. Favorably, Aave recently optimized the rate curve for ETH which will allow for better borrowing conditions over time and a higher potential TVL for this holistic strategy.
icETH is subject to similar systemic and idiosyncratic risks as the rest of DeFi—like currency risk, smart contract risk, oracle risk—but liquidation risk and interest rate risk are especially important for token holders to understand.
The return on icETH is variable in the sense that the effective yield can change as staking and borrow rates fluctuate. At time of writing, the yield on icETH versus ETH is ~10.8%, or 2.65x the staking rate earned by simply holding stETH. However, if the borrowing costs within Aave were to double from the current rate of 0.9% to 1.80%, the yield on icETH would fall to ~8.8% (all things held constant). Conversely, if the staking rate on stETH increased to 10% after the merge, the effective yield on icETH would increase to ~20.8% assuming an ETH borrow rate of 5.0% in Aave. In other words, if the spread between the staking rate and the cost to borrow compresses, icETH holders realize less yield; if the spread expands, icETH holders realize more yield.
The yield capture of icETH is based on LIDO stETH, which is multiplied via Borrowing on Aave. stETH is pegged 1:1 to ETH and yield is captured by increasing the stETH token balance in the holder's wallet. When stETH is deposited in an Aave vault, the ratio of stETH to astETH will change as the vault balance of stETH increases; this is the mechanism that captures yield. When astETH is deposited into the icETH contract token, it represents ownership of the astETH and thus the underlying, increasing stETH balance. For icETH holders, this means that the yield will accrue to the token price over time.
Like all yield opportunities in DeFi, returns can be diluted as more capital moves into a given strategy, therefore token holders may experience diminishing returns over time. At time of writing, this holistic leveraged liquid staking strategy can support several hundred million dollars in capacity with current market conditions, and that capacity should increase with Aave’s recent rate curve improvements and after the merge. This icETH dashboard provided by the Index Coop monitors the current and historical yield on icETH and tracks the key metrics outlined above.
Disclaimer: This content is for informational purposes only and should not be construed as legal, tax, investment, financial, or other advice.
Information is for educational and illustrative purposes only. The Index Cooperative is not engaged in the business of the offer, sale or trading of securities and does not provide legal, tax, or investment advice. Cryptocurrencies and other digital assets are speculative and involve a substantial degree of risk, including the risk of complete loss. There can be no assurance that any cryptocurrency, token, coin, or other crypto asset will be viable, liquid, or solvent.No Index Cooperative communication is intended to imply that any digital assets are low-risk or risk-free. The Index Cooperative works hard to provide accurate information on this website, but cannot guarantee all content is correct, complete, or updated.