Ethena’s Mechanism and Risks

[Recommendation: We have been closely monitoring the market development and competitive landscape of stablecoins for a long time. Since its release, the supply of USDe stablecoin by Ethena has rapidly surged to over $770 million, making it the sixth largest stablecoin pegged to the US dollar. This article aims to provide a quick overview, analyzing its mechanisms and risks.]

Ethena Labs opened its synthetic USD stablecoin deposits to the public on February 19, injecting itself into the minds of almost everyone on Crypto Twitter in the process. By offering double-digit yields and incentives for the upcoming airdrop, the supply of Ethena’s USDe stablecoin rapidly soared to over $770 million, making it the sixth largest USD-pegged stablecoin! Although Ethena’s rise is indeed impressive, the project is not without its critics, who are skeptical of its high yields and believe its design makes it prone to collapse like the Terra/Luna ecosystem.”

Today, we will discuss the role of Ethena and dissect the risks of this protocol to help you make informed decisions about whether this opportunity is suitable for you!

Ethena’s inner mechanisms

Firstly, basic trading has a long history in both the cryptocurrency and traditional financial markets, involving arbitrage opportunities based on pricing differences between spot assets and futures instruments.

Typically, these trades are expressed by longing the spot asset and shorting its futures, as futures instruments often trade at a premium due to demand for leverage and holding costs associated with holding the spot asset.

Historically, cryptocurrency markets have also operated with futures premiums, meaning the price of perpetual futures often exceeds that of spot assets, resulting in a net positive funding rate environment where longs pay funding to shorts.

In this scenario, individuals can hedge their exposure by holding spot crypto assets and shorting an equivalent nominal value in perpetual assets, easily deploying profitable delta-neutral basis trades, thereby allowing users of this strategy to eliminate the risk of cryptocurrency price volatility while enabling them to earn profits from funding payments.

Essentially, Ethena is an open hedge fund that employs the aforementioned strategy to earn profits and tokenizes its trading collateral into stablecoins!

Ethena uses ETH tokens staked as collateral, shorting an equivalent nominal amount of ETH to create a portfolio with a Delta of 0. This configuration ensures that for every $1 change in the underlying value of assets held by Ethena, its net asset value fluctuates by $0, while earning revenue from funding payments on ETH collateral and short positions.

Similar strategies to Ethena have been adopted by multiple protocols in the past, but previous iterations have struggled to scale due to reliance on decentralized trading venues. Ethena mitigates liquidity constraints by leveraging centralized exchanges such as Binance.

To safeguard users’ collateral, Ethena employs an Off-Exchange Settlement (OES) solution, storing funds in reputable third-party custodial institutions, only mirroring account balances into CEXs for margin trading, ensuring funds never reside on centralized exchanges.

As the staked ETH can be perfectly hedged against an equivalent nominal value of short positions, USDe can be minted with a collateral ratio of 1:1, making Ethena’s capital efficiency comparable to USD-backed stablecoins like USDC and USDT while avoiding the need to source assets from traditional financial markets, ensuring compliance with real-world regulations.

Although Ethena’s current model only utilizes staked ETH as collateral, the protocol may consider incorporating BTC as collateral for greater scalability, but doing so may dilute the yield of USDe as BTC collateral does not generate staking rewards.

Ethena’s Risks

In the cryptocurrency realm, economic returns inevitably come with corresponding risks. Participants in the Ethena Opportunity should not expect otherwise.

While attractive APYs are certainly enticing when combined with lucrative funding rates and staking yields, these returns are not without risks…

In addition to the standard cryptocurrency risks expected by DeFi users, Ethena introduces some non-typical risk vectors that have caused concern and prompted comparisons with the Terra/Luna algorithmic stablecoin, UST.

Decoupling Risk

The primary risk with Ethena is the use of LST collateral that matches regular Ethereum shorts. While this optimization of trading against the Ethereum base helps the protocol maximize its revenue-generating capacity, it also increases risk!

If Ethena’s LST collateral decouples from ETH, Ethena’s ETH shorts will fail to capture the volatility, resulting in paper losses for the protocol.

While the trading price of LST typically remains close to its peg, we have seen instances where these tokens can deviate from their peg, such as during the mid-2022 3AC Black Swan liquidation period, where Lido’s stETH saw discounts of nearly 8%!

Shapella enabled Ethereum staking withdrawals in April 2023, potentially creating the most widespread decoupling we’ve seen from blue-chip LST during the 3AC liquidation, but the fact remains that any future decoupling events will still pressure Ethena’s collateral requirements (the amount it must deploy to exchanges to keep its hedge open and avoid position liquidation).

If the liquidation threshold is reached, Ethena will be forced to incur losses.

Funding Rate Risk

While Ethena’s yields have been remarkable from the outset, it’s worth noting that two protocols previously attempted to scale synthetic USD stablecoins but failed due to inverted yield curves.

Source: https://tinyurl.com/ykhg7u87

To counteract the negative returns brought about by funding, Ethena utilizes staked ETH as collateral. This strategy, as demonstrated in a retrospective test conducted three years ago, reduced the number of days USDe experienced negative returns from 20.5% to 10.8%.

While it’s virtually certain that funding rates will eventually turn negative, the natural state of the cryptocurrency market is in contango, which exerts upward pressure on funding rates and provides a conducive environment for Ethena’s basis trading.

Counterparty Risk

Many individuals unfamiliar with Ethena’s design perceive deploying user collateral to centralized exchanges as a major risk. However, this risk has been greatly mitigated by employing the aforementioned OES custodial accounts.

Although unrealized profits from hedging on bankrupt exchanges could lead to losses, Ethena settles profits and losses daily at a minimum, reducing the capital risk for the exchanges.

If one of Ethena’s exchanges were to go bankrupt, the protocol might be compelled to leverage positions on other venues to offset the Delta of its portfolio until unsettled positions are resolved, and the trustees of the affected OES accounts can release the funds.

Additionally, if one of the trustees of Ethena’s OES accounts were to go bankrupt, access to funds might be delayed, necessitating the use of leverage on other accounts to hedge the portfolio.

General Cryptocurrency Risks

As with many early-stage crypto protocols, it’s important to remember that Ethena’s depositors face the risk of the protocol team potentially misappropriating user funds, as ownership of the project’s keys has not yet been decentralized.

While most crypto projects face significant exploit risks associated with potential vulnerabilities in their smart contracts, Ethena’s use of OES custodial accounts eliminates the need for complex smart contract logic, thereby mitigating this risk.

Summary

Ethena has safeguarded its assets from the impact of exchange or custodian bankruptcies and has developed contingency plans to offset incremental portfolio exposure in situations where assets are frozen and cannot be traded!

Since many exchanges value stETH collateral at 0% and offer 50% maintenance margin requirements for accounts of Ethena’s scale, the protocol could incur market value losses of up to 65% on its collateral before approaching liquidation!

Negative funding rates might lead to yield compression and potential TVL losses, but they themselves wouldn’t cause a USDe implosion; with a maximum annualized funding rate of -100%, Ethena’s nominal losses amount to just 0.091% per 8-hour funding cycle!

Most importantly, Ethena also possesses an insurance fund that can be used to top up margin accounts to avoid liquidation, offset prolonged negative funding rates, or act as a buyer in the open market for USDe!

While Ethena can absorb some degree of loss with its insurance fund, it’s crucial to remember Murphy’s Law, which reminds us that anything that can go wrong will go wrong, and at the worst possible time.

Consider a scenario where LST starts decoupling. Measures taken by centralized exchanges to address this involve reducing the collateral weight of staked ETH tokens, thereby minimizing the maximum market value loss on Ethena’s collateral before liquidation.

Suppose the entire market experiences a sell-off during this period, driving funding rates into negative territory, further pressuring Ethena’s collateral and pushing the protocol closer to liquidation and acknowledgment of losses!

While Ethena may not typically employ leverage in its normal operations, unexpected bankruptcies of exchanges or custodians might temporarily freeze funds, necessitating the use of leverage to offset incremental portfolio exposure.

In theory, steep discounts along with leveraged accounts and reduced collateral weight of staked ETH could place Ethena’s collateral within the liquidation range.

Now, anyone in cryptocurrency can engage in basis trading, and assets managed by Ethena could easily swell into the billions of dollars, meaning that potential liquidation of its heavily staked ETH portfolio could further suppress the market value of LST, exacerbating Ethena’s paper losses and opening the floodgates for a death spiral to follow!

Undoubtedly, the aforementioned series of events would only result from catastrophic black swan events, but it’s essential to remember all potential risks you face when engaging in cryptocurrency.

Like any project on the cutting edge of cryptocurrency, Ethena carries its risks, but for those who seize the opportunity early, participation could bring immense benefits.

Whether you’re looking to earn double-digit APYs offered by sUSDe or to farm shards to maximize your potential Ethena airdrop allocation, there’s no better way to start your journey than by DYOR first!

Statement:

1. This article is reprinted from [marsbit], the original title is “Ethena’s mechanics and risks”, the copyright belongs to the original author [Jack Inabinet], if you have any objection to the reprint, please contact Gate Learn Team , the team will handle it as soon as possible according to relevant procedures.

2. Disclaimer: The views and opinions expressed in this article represent only the author’s personal views and do not constitute any investment advice.

3. Other language versions of the article are translated by the Gate Learn team, not mentioned in Gate.io, the translated article may not be reproduced, distributed or plagiarized.