Ethena’s USDe, a breakthrough or a potential risk ?
Alexis Hebrard
April 23, 2024
Tokenomics
Ethena Labs, a young startup developing a new type of algorithmic stablecoin, raised $20 million from Dragonfly and several major exchanges including Deribit and OKX in June 2023. Six months later, Ethena's token, USDe, reached a market capitalization of over 2.3 billion dollars.
Ethena’s USDe is unique compared to other stablecoins as it is based on a delta-neutral strategy. Ethena Labs claims that:
The mechanism backing **USDe **will enable the first "Internet Bond" that will sit alongside the synthetic dollar, offering a crypto-native, yield-bearing, dollar-denominated savings instrument”
What problems are Ethena trying to solve, how does this new system work? Are their any risks associated? This is what we will see in this article.
Ethena is a protocol that developed a synthetic dollar running on Ethereum, offering a fresh approach to stablecoins in the crypto space. Unlike traditional banking-dependent stablecoins like USDT or USDC, Ethena offers a crypto-native solution, ensuring resilience and independence from external financial systems.
At the core of Ethena's innovation lies its synthetic dollar, USDe, which pioneers a censorship-resistant, scalable, and stable alternative. By employing delta hedging with staked Ethereum as collateral, USDe proposes a decentralized stable asset within the crypto space.
Additionally, Ethena introduces the "Internet Bond", a concept merging Ethereum staking proceeds with funding from perpetual and futures markets to generate a scalable APY for USDe holders, more on that later.
Here is an overview of the protocol:
Crypto needs a decentralized base money asset, and the world has no access to a globally accessible and censorship-resistant savings instrument.
Ethena Labs
But why Ethena feels the urge to develop a decentralized stablecoin?
Ethena Labs believes that the crypto ecosystem needs to move away from relying on traditional infrastructure for stablecoins, to achieve a truly decentralized financial system. It’s becoming evident that for a truly decentralized financial system to thrive on a significant scale, it must adopt a stable asset independent of traditional banking systems. Hence, at the core of this argument is the need for a decentralized stable asset that fulfills both the role of a medium of exchange and core collateral within the crypto ecosystem.
Stablecoins can be considered like the most important instrument in crypto. All major trading pairs are denominated in stablecoin pairs with over 90% of orderbook trades and over 70% of onchain settlements being stablecoin denominated. But the majority of stablecoins used are centralized, which means that crypto is in a way highly dependent on traditional financial institutions.
This is why a stable asset independent from the banking system such as USDe is needed to ensure the resilience and decentralization of the crypto financial ecosystem.
It’s clear that decentralized stablecoins answer to an evident problem, but how does USDe work if it’s not collateralized by real world assets ?
To achieve a decentralized stablecoin, Ethena uses a system called delta-neutral strategy to maintain the peg of its USDe. Alone, this system is not revolutionary as it is widely used in traditional financial markets. However, what makes USDe unique is that it uses staked Ethereum (stETH) as collateral for its delta-neutral system. This means that the stability of USDe is 100% backed by crypto-assets making it fully-decentralized.
Ethena’s delta-neutral system works as follows:
To maintain the peg of USDe, Ethena executes automated and programmatic delta-neutral hedges with respect to the underlying collateral assets, stETH. This involves using stETH to open a perpetual short and long position at the same time. This ensures that USDe’s value remains stable irrespective of market fluctuations.
Let's clarify this concept with a bit more detail. A portfolio that employs a delta-neutral strategy aims to be immune to small price movements in the market. The delta value measures the sensitivity of an option's price to changes in the price of the underlying asset. A delta of 0 indicates that the portfolio's value should not be affected by price fluctuations of the underlying asset.
Here’s a practical example to illustrate:
Imagine you deposit 1 Ether (ETH) as collateral into a portfolio. To implement a delta-neutral strategy, Ethena then takes a position by shorting 1 ETH using a perpetual contract. "Shorting" in this context means betting that the price of ETH will go down. At the same time, your initial deposit of 1 ETH is used as margin, and can be considered as a “long position”. This means the value of the short position is designed to increase or decrease at the same rate as the value of the 1 ETH deposit (long position), with balances automatically the portfolio.
Here’s what happens with the delta-neutral strategy:
This strategy might seem relatively simple but it is resilient to big price fluctuations. For example, lets see what happens if the price of ETH falls by 90%:
To executes these positions Ethena Labs establishes the short perpetual position on a derivatives trading platform. The assets obtained are then directed to a "Off Exchange Settlement" to ensure that the assets are kept on the blockchain and away from exchanges. Meaning, USDe has no reliance upon centralized exchanges.
This system gives Ethena 3 major advantages compared to other stablecoins:
Ethena’s USDe offers another functionality as it also generates yield for its holders. Users are able to receive a portion of the protocol's generated yield by staking their USDe and receiving sUSDe in return.
The yield source is generated from two sustainable sources which are:
However, these two sources don’t offer stable yields they fluctuate with time. As ETH’s APR depends on the networks activity and the funding and basis spread depends on ETH open interest on perpetual futures exchanges. At the time of the writing of this article the APR of Ethena lies around 11.3%, however the graph below shows the historical yields of USDe:
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These yield mechanisms backing USDe will enable the first "Internet Bond", offering a crypto-native, yield-bearing, dollar-denominated savings instrument. The Internet Bond is designed to scale alongside USDe, offering a unique investment opportunity within the crypto space that leverages the inherent yields from staked Ethereum and trading spreads. The real added value of the Internet Bond is clearly highlighted by Ethena:
Whilst US citizens have access to their own $30 trillion treasury market, individuals in the rest of the world do not have permissionless access or an ability to generate a yield on a dollar denominated savings instrument.
Demonstrating that the Internet Bond is a solution to fight financial disparities by offering a dollar denominated savings instrument to billions of people.
Ethena is clearly an innovative and promising protocol, but its system isn’t risk free. Here are the mains risks linked to the protocol.
Funding risks
Given Ethena Labs uses derivatives positions, such as perpetual contracts, to hedge the delta of the digital asset collateral, the protocol is exposed to "Funding Risk".
When you trade these contracts, you either pay or receive a fee called the "funding rate." This rate can be positive or negative. A negative funding rate means Ethena Labs would have to pay money for its trading positions. This situation presents a "Funding Risk" because if the funding rate stays negative for a long time, it could eat into the profits or even lead to losses.
However, to mitigate that risk Ethena created a reserve fund with $35 million (at the time of writing) to step in when the market is experiencing negative funding rates. It's worth noting that such periods are infrequent and typically short-lived.
Reserve fund wallet address: 0x2b5ab59163a6e93b4486f6055d33ca4a115dd4d5
Liquidation and collateral risks
These two risks refer to the uncertainty regarding the value of the asset used as collateral, which is stETH. Because the ETH short positions managed by Ethena are backed by a different asset, stETH, there are liquidation and collateral risks.
These two assets, ETH and stETH are supposed to hold similar values but there are times when their values diverge, a discrepancy referred to as the “spread.” If this spread becomes too important, meaning stETH looses value relative to ETH, it would cause the collateral backing the short position to shrink, potentially leading to its liquidation, causing the collateral to vanish. Meaning the USDe would not be backed anymore, this situation would seriously jeopardize the delta-neutral strategy.
Given the importance of stETH as trading collateral, it’s important to mention that since the Shapella upgrade of the Ethereum network, the stETH/ETH discount has never been more than 0.3%, which is a healthy spread. However, before the Shapella upgrade, the discount reached 8% at its widest. Hence, keeping an eye on the stETH/ETH is important to measure the level of risk of the protocol.
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External platform risks
Ethena Labs uses "Off-Exchange Settlement" providers such as Fireblocks, for the custody of assets. Which creates a reliance on these providers' operational capabilities causing a custodial risk. If these platform were to malfunction, it could affect the operability of the protocol.
Exchange failure risks
As mentionned before, Ethena Labs employs derivative positions to manage its delta strategy, and these positions are traded on centralized exchanges like Binance, Bybit, Bitget, Deribit, and Okx. Therefore, should any of these exchanges experience sudden unavailability, similar to the FTX incident, Ethena would have to manage the fallout. However, to diversify that risk Ethena is utilizing multiple exchanges to de-risk exchange exposure.
Since the UST collapse in May 2022, the crypto ecosystem has become fearful of new stablecoin models. While Ethena's system is not as complicated as UST's algorithm, its novel approach has sparked concerns within the community.
Andre Cronje, a prominent figure in decentralized finance (DeFi), raised concerns about the structures of Ethena Labs' USDe stablecoin in a discussion on X. Noted for his contributions to the DeFi sector, Cronje subtly referred to the protocol, voicing apprehensions particularly about how Ethena Labs handles risk, especially regarding funding rates for perpetual futures contracts.
Cronje noted:
So while things are going great now (because market is positive and shorting funding rates are positive [because everyone is happy being long]), eventually that turns, funding becomes negative, margin/collateral gets liquidated, and you have an unbacked asset.
The counter to that is "law of large numbers", which is pretty much the same as UST's $1bn BTC fund etc. "It works until it doesn't".
Link to the whole thread available here.
However, it's important to view Cronje's concerns with perspective. Evgeny Gaevoy, the founder of Wintermute, a top algorithmic trading firm, countered Cronje’s points by explaining:
If you are long stETH, short ETH perp (and use stETH as collateral for perp position). You cannot be liquidated. Key risks here are custody/execution related. So this is more like FTX than LUNA if you are considering scary outcomes (very oversimplifying here and not fudding the protocol, also Wintermute is an investor)
Link to the whole thread available here.
Wrapping up this discussion, it's true that Ethena faces minimal risk from negative funding rates, a resilience proven even during 2022's harsh market conditions. However, as Evgeny Gaevoy highlighted, the real vulnerability for Ethena lies in its reliance on third-party services like Fireblocks and various exchanges, given the historical precedent of cryptocurrency firms failing.
In summary, Ethena introduces a groundbreaking stablecoin model that is independent from traditional financial institutions, enhancing decentralization within the cryptocurrency ecosystem. Its innovative system combines the decentralization of algorithmic stablecoins with a delta-neutral strategy, a concept with a proven track record in traditional finance to generate a synthetic dollar. This pioneering approach has the potential to significantly advance the decentralization of crypto, especially if the token achieves widespread adoption, spurred by its attractive yields. It's also crucial to acknowledge that while Ethena's stablecoin is independent from financial institutions, it still relies on entities like Fireblocks and exchanges. Positioning it in a middle ground between more decentralized algorithmic stablecoins and centralized stablecoins such as USDT/USDC.
However, as the Terra USD incident has highlighted, decentralization in stablecoins is not without its challenges. Nonetheless, Ethena has implemented measures to address these concerns. As a precaution, it is advisable to monitor the stETH/ETH premium and discount chart closely (available here) to see if liquidation and collateral risks are arising.
