Ethena’s USDe is unlikely to have a major collapse, but as the market grows, there may be a situation where USDe returns are close to zero.
Table of Contents:
The Issuance Logic of USDe
Collateral and Liquidation of USDe
Risk Hedging of USDe
Risks and Bottlenecks of USDe
Exchange Risks
Systemic Risks of Lido
Ethena will become a resistance to market growth
Conclusion
Ethena has been a star product recently, attracting significant attention with its launch on Binance and its stablecoin USDe. Even though the market sentiment is currently low, Ethena still has a Total Value Locked (TVL) of around $2.4 billion.
Many people see the model of issuing stablecoins through token collateral and providing high returns and immediately think of Terra’s UST algorithmic stablecoin. From 2021 to 2022, UST attracted nearly tens of billions of dollars in TVL with a 20% annual return rate, but then experienced a collapse along with Terra Luna.
Many readers may have doubts, concerns, or suspicions that Ethena is just another copy of UST and will eventually collapse. However, I want to provide a conclusion here:
Although USDe and UST are both collateralized by mainstream cryptocurrencies and issued at a face value of $1, their operational logics are completely different.
UST operates very simply: the number of UST issued is equal to the value of the collateralized crypto assets. But the key point is that UST is deeply linked to Luna. The higher the demand for UST in the market, the higher the deflationary pressure on Luna, pushing up its price. And the higher the price of Luna, the more UST can be minted.
Therefore, in essence, the operation of UST relies on constantly increasing its virtual market value. With the increase in Luna issuance, an almost infinite amount of UST appeared in the market, leading to the collapse of this tens of billions of dollars fund.
On the other hand, USDe operates in a more complex way.
Firstly, although the collateral for USDe is mainstream cryptocurrencies, it currently does not accept direct deposits of ETH or BTC from ordinary users. It only allows the purchase of USDe through a range of stablecoin assets (USDT, USDC, DAI, etc.), which eliminates the risk of liquidation for ordinary users.
For whitelisted users (usually institutions, exchanges, and whales), they can deposit LST assets, namely stETH, to mint USDe. Therefore, whitelisted users bear the risk of liquidation, but since Ethena performs hedging, they only need to bear the price difference risk between ETH and stETH. Ethena predicts that this price difference risk will be triggered when it reaches 65%, and the largest historical price difference between ETH and stETH was around 8% during the Terra collapse in 2022.
Therefore, under normal operation, this liquidation risk is almost impossible to occur. So, we can rephrase it: Ethena will only be liquidated when there is a systemic risk in Lido’s stETH.
Additionally, since Ethena has a leverage ratio close to spot trading, even if liquidation does occur, it does not mean that Ethena will be completely liquidated and lose all collateral. It will be liquidated gradually based on relevant positions.
It is important to note that Ethena is not a decentralized execution product. It is operated by a centralized asset management team 24/7 and has cooperation agreements with major exchanges. Therefore, Ethena’s official documentation states that when there is a real liquidation risk, the asset management team will manually intervene to reduce the risk.
Furthermore, after completing the collateralization, Ethena does not keep the funds idle but adopts a more counterintuitive centralized asset management approach.
Both stablecoins from ordinary users and LST assets from whitelisted users are split into units with a face value of $1. These units are then used for “holding spot positions in the form of stETH” and “opening ETH short positions on partnering exchanges.” Therefore, the official value equation is derived as follows:
Hence, when Ethereum rises, the unrealized gains from holding spot ETH will offset the unrealized losses from the ETH short position. When Ethereum falls, the unrealized gains from the ETH short position will offset the unrealized losses from holding spot ETH. Ultimately, this achieves the stability of USDe at a face value of $1.
Furthermore, Ethena relies entirely on centralized exchanges for risk hedging. It currently has partnerships with over ten exchanges, including Binance, OKX, Bybit, Bitget, etc. Therefore, Ethena avoids Web3 hacking attacks in terms of fund security and obtains liquidity far beyond decentralized exchanges, as well as lower transaction fees.
The Sources of USDe’s Returns
USDe’s returns come from two sources:
Rewards from staking assets.
Funding rates and basis gained from risk hedging.
The rewards from staking assets are easily understandable, as they come from staking ETH to earn consensus rewards. Currently, Ethena ensures returns by holding stETH, with an annualized interest rate of approximately 3%.
The more noteworthy source is the gains from risk hedging. Basis refers to the well-known concept of futures arbitrage, while funding rates are the fees paid by long and short positions in contract trading based on market dominance.
According to Ethena’s calculations, the returns from futures arbitrage were 18% in 2021, -0.6% in 2022, 7% in 2023, and 18% since 2024. Although the annual returns vary due to market conditions, the long-term average return rate is above 10%.
As for funding rates, they depend on the bullish or bearish market. During the sideways market with Bitcoin above $70,000 last month, Binance’s funding rate reached 0.1%, which directly increased the returns of sUSDe to 30%.
However, there is an important point here. Ethena’s hedging relies on shorting ETH, which means that when the market weakens, Ethena will have to pay shorting fees. Therefore, there may be a period when the returns of sUSDe approach zero during a bearish market.
On a more optimistic note, Ethena also conducted historical backtesting and found that ETH and BTC perpetual futures had negative returns for 19.1% and 16.1% of the days, respectively. The average return rate for ETH was 8.79% and for BTC was 7.63% during the entire period. The most extreme case was in 2022 when Ethereum experienced negative quarterly average returns due to the PoW hard fork arbitrage.
Therefore, from an annual perspective, Ethena’s strategy is indeed profitable in the long run. However, it goes against the nature of the cryptocurrency market, as cryptocurrency players often hold stablecoins to weather the bear market and withdraw them to participate in the bull market. The volatility curve for Ethena’s returns is the opposite – it has high returns during the bull market and low returns during the bear market.
Although Ethena seems to have a well-designed product with various risk controls, there are still potential black swan risks that I believe are not too far-fetched.
Currently, Ethena’s risk hedging strategy relies entirely on centralized exchanges to execute. However, exchanges themselves pose a risk. Issues such as daily crashes or network disconnections can potentially widen spreads, but these can be resolved through compensation or rollbacks. What cannot be resolved are policy-related and systemic risks.
The United States has been imposing stricter regulations on cryptocurrency exchanges. Binance’s CZ was involved in mining pledges, and various exchanges have been sued by the SEC. Moreover, there is a possibility of another FTX-like collapse that could lead to significant losses for Ethena. These are black swan risks.
Lido, as the leader in the Ethereum LST track, has not experienced major security incidents so far. However, once such an incident occurs, it would not only affect Ethena’s collateral but also severely impact the entire Ethereum ecosystem. Let’s not forget the large-scale detachment of stETH that occurred before Ethereum’s PoS upgrade two years ago.
There is a joke in the cryptocurrency industry that playing short contracts is equivalent to shorting one’s own business. Indeed, that’s what Ethena does.
This is the data dashboard from Ethena, showing that the entire market has $8.6 billion of open interest in ETH contracts, and Ethena’s position accounts for 13.52%, which is approximately $1.162 billion. It is also worth noting that 86% of the market’s $8.6 billion contracts include positions from both long and short sides. Even if we roughly split the positions evenly, the short positions would amount to $4.3 billion. However, Ethena only takes short positions in the market, meaning it occupies 27% of the entire ETH short position.
And this is only after a few months since Ethena’s launch and during a period of market downturn. Once the market enters an upward cycle and Ethena’s returns start to rise, more funds will inevitably flow into Ethena, resulting in a larger short position.
As Ethena’s short position increases, the funding rates to be paid during market downturns will also increase. At this point, there may be a marginal effect that leads to returns approaching zero.
In summary, Ethena is indeed a well-designed product, but it is not DeFi, nor is it a side project like UST. If I were to accurately describe it, Ethena is a fund product based on cryptocurrencies.
It incorporates traditional financial risk hedging strategies into the world of cryptocurrencies and captures returns from more volatile market fluctuations. Moreover, due to the permissionless nature of blockchain, anyone can purchase such a fund product without undergoing KYC/AML procedures.
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