On February 19, Ethen Labs opened its synthetic USD stablecoin deposits to the public, becoming a hot topic of discussion for almost everyone on Crypto Twitter.
With double-digit yields and credits for upcoming airdrops, Ethena’s USDe stablecoin has exploded and has surpassed the $770 million supply to become the sixth-largest USD-pegged stablecoin!
While Ethena’s rise is impressive, the project is not without its critics, who are skeptical of Ethena’s high yields, arguing that it is designed in such a way that it is relatively susceptible to collapse like the Terra/Luna ecosystem.
In this article, we’ll discuss what Ethena is and dissect the risks of the protocol to help you understand if this opportunity is right for you, so you can make an informed decision!
1. What is Ethena?
First of all, both in the crypto market and in traditional financial markets, basis trades have a long history of arbitrage on the pricing difference between spot assets and futures instruments.
The most common way to trade these is to go long on the spot asset and short the corresponding futures, and futures instruments are typically traded at contango (i.e., above the underlying price) due to the need for leverage and the costs attached to holding the spot asset.
The crypto market has also historically operated as a contango trading model, which means that the price of perpetual futures contracts typically exceeds the price of the spot asset, which has led to an environment where the net financing rate is positive, in which the longs pay the shorts for the ability to hold positions.
In this case, one can easily deploy a lucrative delta-neutral basis trade by holding spot crypto assets and hedging the notional value of their positions through perps, allowing users of this strategy to be protected from cryptocurrency price fluctuations while allowing them to reap the benefits of margin payments.
Ethena is essentially an open-ended hedge fund that employs the above strategies to earn yield and tokenize its trading collateral into stablecoins!
Ethena uses liquid staking ETH tokens as collateral to short an equivalent amount of ETH to create a portfolio with a delta of 0, an allocation that ensures that the net value of Ethena’s holdings does not fluctuate with changes in the underlying value of its assets, while at the same time receiving yield from ETH staking and financing payments for its short positions.
There have been multiple protocols that have previously used a similar strategy to Ethena, but previous iterations have struggled to scale due to their reliance on decentralized trading venues. Ethereum circumvents this liquidity cap by utilizing centralized exchanges like Binance.
To protect users’ collateral, Ethena utilizes an over-the-counter settlement (OES) solution, where funds are held by a reputable third-party custodian and only account balances are mapped to CEXs to provide trading margin, ensuring that funds are never deposited on a centralized exchange.
Since staked ETH can be perfectly hedged with short positions of equal notional value, USDe can be minted at a collateralization ratio of 1:1, making Ethena’s capital efficiency comparable to that of USD asset-backed stablecoins such as USDC and USDT, while also avoiding the reliance on sourcing assets from traditional financial markets, where asset issuers are subject to the rules of the physical world.
While Ethena’s current model only uses staked ETH as collateral, the protocol may further use BTC as collateral for larger scaling, but doing so may dilute USDe’s yields, as BTC collateral does not generate staking yields.
2. What’s the worst case scenario for Ethena?
In the crypto world, there is no financial reward without the corresponding risks. Ethena opportunity participants should not expect that there will be other answers.
While lucrative funding rates coupled with staking yields will certainly result in attractive APY APYs, they are not without risk……
In addition to the standard crypto risks expected by DeFi users, Ethena has some atypical risk factors that have raised alarms and caused comparisons to the Terra/Luna algorithm UST stablecoin.
(1) Collateral decoupling risk
Ethena’s main risk is a mix of LST collateral and regular Ether shorts. While this optimization of ETH basis trading helps the protocol maximize its yield sustainability, it increases the risk!
If Ethena’s LST collateral is depegged from ETH, Ethena’s ETH shorts will not be able to capture the volatility, incurring a paper loss to the protocol.
While LST usually trades close to its peg, we have already witnessed multiple de-pegging scenarios for these tokens, such as Lido’s stETH price slashed to nearly 8% during the mid-year 3AC (Three Arrows Capital) black swan liquidation event in 2022!
The April 2023 Shapella upgrade enabled Ethereum staking withdrawals, which made it possible for 3AC liquidation to create the broadest depeg we’ve seen in blue-chip LST, but the fact remains that any future depeg events will put pressure on Ethena’s margin requirements (the amount of funds that must be deployed to exchanges to maintain its hedging exposure and avoid its positions being liquidated).
Once the liquidation threshold is reached, Ethena will be forced to realize a loss.
(2) Financing interest rate risk
While Ethena’s gains may seem staggering from the start, it’s important to note that there have been two previous attempts to scale up synthetic USD stablecoins, both of which have failed due to yield inversions.
To combat negative funding yields, Ethena uses staked ETH as collateral, a strategy that reduces the number of days USDe generates negative yields from 20.5% to 10.8% in a three-year data backtest.
While it is 100% certain that there will be an inversion of the funding rate at a certain point, the natural state of the crypto market is contango, exerting upward pressure on the funding rate and providing a favorable environment for Ethena to trade on the basis.
(3) Counterparty risk
Many people who are not familiar with Ethena’s design believe that deploying user collateral to centralized exchanges is a major risk, but using the aforementioned OES custodial account greatly mitigates this risk.
While unsettled hedged profits against bankrupt exchanges can incur losses, Ethena conducts PnL (profit and loss) settlements at least daily to reduce its capital exposure to the exchange.
If one of Ethena’s exchanges goes bankrupt, the protocol may be forced to use leverage on positions on other exchanges, making its portfolio delta neutral until open positions are settled and the custodians of the affected OES accounts can release the funds.
In addition, if one of the custodians of Ethena’s OES account goes bankrupt, access to funds may be delayed, which necessitates the use of leverage on other accounts to hedge the portfolio.
(4) General encryption risks
As is the case with many early crypto protocols, it’s important to remember that Ethena’s depositors are at risk of the protocol’s team scamming users out of their funds, as ownership of the project’s keys is not currently decentralized.
While the vast majority of crypto projects face a significant risk of hacking in terms of potential vulnerabilities in their smart contracts, Ethena’s use of OES escrow accounts mitigates this risk by eliminating the need to use complex smart contract logic.
3. Summary
In the event that an exchange or custodian goes bankrupt, Ethena has secured their assets and has a contingency plan in place to delta neutral their portfolio in the event that assets are frozen and cannot be traded!
With many exchanges imposing a zero-collateral discount rate on the value of their stETH collateral and offering a 50% margin requirement for accounts up to the size of Ethena, the protocol could result in a loss of up to 65% of its collateral market value at the time of liquidation!
Negative funding rates can lead to a compression of yields and loss of TVL, but negative funding rates themselves do not lead to a depreciation of the dollar. At a maximum annualized financing rate of -100%, Ethena’s notional loss is only 0.091% per 8-hour financing period!
On top of that, Ethena also has an insurance fund that can be used to replenish margin accounts to avoid liquidation, offset long-term negative funding yields, or act as a buyer of last resort for USDe in the open market!
While Ethena can cover a certain amount of losses through an insurance fund, it is important not to forget Murphy’s Law, which reminds us that anything that can go wrong will go wrong, or at the worst possible time.
Imagine a situation where LST starts to decouple.
Centralized exchanges responded by reducing the collateral weight of liquidity-staked ETH tokens, thereby reducing the maximum loss that Ethena could incur on the market value of its collateral before liquidation.
Assuming that the entire market is also selling off during this period, the funding rate will become negative, putting further pressure on Ethena’s collateral and pushing the protocol closer to liquidation, having to realize a loss!
In normal operations, Ethena may not use leverage, but an unexpected insolvency event at the exchange or custodian may temporarily freeze funds, so leverage will need to be used to neutralize portfolio deltas.
Theoretically, a significant discount, combined with a leveraged account and a smaller liquid staking ETH collateral weight, could keep Ethena’s collateral within liquidation.
Now that any crypto person can do basis trading, Ethena can easily swell into billions of dollars under management, meaning that liquidating its massive staked ETH portfolio could further dampen LST market value, exacerbate Ethena’s paper losses, and open the door to the death spiral that ensues!
There is no doubt that the above series of events can only be the result of a black swan catastrophic event, but you must be aware of the potential risks you may face when participating in the crypto world.