In-depth Analysis of the Success Factors and Death Spiral Risks of Ethena

In the past few days, the market has been ignited by Ethena. This is a stablecoin protocol that can provide an annualized return of over 30%. Many articles have already introduced the core mechanism of Ethena, so I won’t go into detail here. Simply put, Ethena.fi tokenizes arbitrage trades of ETH’s “Delta Neutral” through issuing stablecoins representing the value of Delta Neutral position in Delta. Their stablecoin USDe also earns arbitrage profits - hence they claim it is a form of internet bond providing internet-native returns. However, this scenario inevitably reminds us of the last crypto cycle’s turning point from bull to bear triggered by the issuance of algorithmic stablecoin UST by Terra, which quickly attracted deposits with a 20% annualized return subsidized by its ecosystem-native lending protocol Anchor Protocol for UST lenders, only to collapse rapidly after being subjected to a run. Learning from this lesson, the explosion of USDe (the stablecoin issued by Ethena) has also sparked widespread discussion in the crypto community, with skepticism from DeFi opinion leader Andre Cronje attracting considerable attention. Therefore, the author hopes to delve deeper into the reasons for Ethena’s explosion and the risks inherent in its mechanism.

The Success of Ethena as a CeFi Product: Savior of the Centralized Exchange Perpetual Contract Market

The key to Ethena’s success lies in its potential to become the savior of the perpetual contract market on centralized cryptocurrency exchanges. First, let’s analyze the problems faced by the current mainstream centralized cryptocurrency exchanges in their perpetual contract markets, namely the lack of short positions. We know that futures serve two main purposes: speculation and hedging. Due to the overwhelmingly optimistic sentiment of most speculators in the current market environment, the number of long positions in the futures market significantly outweighs the number of short positions. This imbalance results in a situation where the funding rate in the perpetual contract market becomes higher for long positions, increasing the cost of capital for long positions and dampening market vitality. For centralized cryptocurrency exchanges, the perpetual contract market is the most active trading area and one of the core sources of revenue through transaction fees. However, high funding costs also reduce the exchange’s profitability. Therefore, finding short positions in the perpetual contract market during a bull market becomes crucial for exchanges to increase revenue and competitiveness.

In this context, it may be necessary to supplement some basic knowledge, namely the principles of perpetual contracts and the role and charging method of funding rates. Perpetual contracts are a special type of futures contract. We know that traditional futures contracts usually involve delivery, which involves the transfer of equivalent assets and settlement, increasing the operating costs of exchanges. Additionally, for long-term traders, nearing the expiration date involves actions such as transferring positions, and the fluctuation of the mark price is usually greater nearing the expiration date. This is because, with the transition of positions, the market liquidity of the old underlying asset gradually deteriorates, introducing many hidden trading costs. To reduce these costs, perpetual contracts are designed. Unlike traditional contracts, perpetual contracts lack a delivery mechanism, hence no expiration date, and users can choose to hold positions indefinitely. The key to this feature lies in ensuring that the perpetual contract price is correlated with the price of the underlying asset. In futures contracts with delivery mechanisms, correlation comes from delivery, as the delivery mechanism transfers physical assets (or equivalent assets) according to the contract’s price and quantity. Therefore, theoretically, the price of futures contracts will converge with the spot price at delivery. However, perpetual contracts lack a delivery mechanism, so additional designs are incorporated to ensure correlation, one of which is the funding rate.

We know that prices are determined by supply and demand. When supply exceeds demand, prices rise. This is also true in the perpetual contract market. When there are more long positions than short positions, the price of perpetual contracts will be higher than the spot price. This price difference is usually called the basis. When the basis is too high, there needs to be a mechanism that can counteract it, and this is where the funding rate comes in. In this design, when a positive basis occurs, indicating that there are more long positions than short positions, long positions need to pay fees to short positions, and the rate is proportional to the basis (not considering the funding rate composed of fixed rates and premiums). This means that the greater the deviation, the higher the cost for long positions, which suppresses the motivation for going long, thus bringing the market back to equilibrium.

Conversely, the same applies. Under such a design, perpetual contracts become correlated with spot prices.

Returning to the initial analysis, we know that in the current extremely optimistic market, the funding rate for long positions is very high, which suppresses the motivation for going long and also suppresses market vitality, reducing the profitability of exchanges. Usually, to alleviate this situation, centralized exchanges need to introduce third-party market makers or become counterparties themselves (as can be seen in the aftermath of the FTX incident), to bring the funding rate back to a competitive level. However, this also introduces additional risks and costs. To hedge these costs, market makers need to hedge the risk of short positions in the perpetual contract market by going long in the spot market. This is the essence of the Ethena mechanism. However, due to the large market size at this time, exceeding the capital limit of individual market makers, or in other words, introducing high single-point risks for market makers or exchanges. To spread this risk, or to raise more funds to stabilize the basis and make their perpetual contract market funding rate more competitive, centralized exchanges need more interesting solutions to raise funds from the market. And now is the perfect time for the arrival of Ethena!

We know that the core of Ethena lies in accepting cryptocurrencies as collateral, such as BTC, ETH, stETH, etc., and shorting their corresponding perpetual contracts on centralized exchanges, achieving Delta risk neutrality, and earning native returns on collateral and perpetual contract market funding rates. The stablecoin USDe it issues is essentially similar to a warrant share of an open-ended market maker fund for Delta-neutral cryptocurrency futures arbitrage. Holding shares is equivalent to obtaining the right to dividends from the fund. Users can easily enter this high-threshold track and earn substantial profits through this product, while centralized exchanges also gain broader short liquidity, reduce funding rates, and enhance their competitiveness.

There are two phenomena that support this view. First, this mechanism is not unique to Ethena. UXD in the Solana ecosystem actually uses this mechanism to issue its stablecoin assets. However, its impact did not meet expectations because it collapsed before accessing centralized exchange liquidity, and it was greatly affected by the collapse of FTX in addition to the low-interest rate environment for perpetual contracts caused by the reversal of the entire crypto cycle. Second, if we carefully observe Ethena’s investors, centralized exchanges account for a large proportion, which also proves their interest in this mechanism. However, while excited, we cannot ignore the risks it entails!

Negative Funding Rates Are Just One of the Possible Triggers for a Run, the Basis Is the Key to the Death Spiral.

We know that for stablecoin protocols, tolerance to runs is crucial. In most discussions about Ethena’s risks, we’ve already clarified the damage inflicted on the collateral value of USDe by the negative interest rate environment in the cryptocurrency futures contract market. However, this damage is usually temporary. Backtesting across cycles has shown that negative interest rate environments typically do not last long and are not easy to occur. This has been extensively proven in Chaos Labs’ audit report on its economic model publicly released by Ethena. Moreover, the damage caused by negative rates to collateral value is gradual, as contract rates are usually collected every 8 hours. According to backtesting results, even with the most extreme -100% rate estimate, this implies that the maximum loss of concept in any 8-hour period is 0.091%. Over the past 3 years, negative rates have occurred only three times, with an average duration of 3-5 weeks. The recovery period from negative rates in April 2022 lasted about three weeks, with an average level of -3.3%. June 2022 also lasted about three weeks, with an average level of -4.8%. Including the extreme funds from September 11th to 15th, this period lasted for 5 weeks, averaging -17.9%. Considering that rates are positive at other times, this means Ethena has ample opportunities to save for a rainy day and accumulate a certain Reserve Fund to cope with negative rates, thereby reducing the erosion of collateral value and avoiding situations where the collateral ratio falls below 100%. Therefore, I believe the risk of negative rates is not as significant as imagined or can be greatly mitigated through some mechanisms. It can be said that this is just one of the possible triggers for a run. Of course, if we question the statistical significance, this is not within the scope of this discussion.

However, this does not mean that Ethena will have a smooth sailing. After reading some official or third-party analysis results, I believe we have all overlooked a fatal factor, and that is the basis. This is precisely the key vulnerability for Ethena when dealing with runs, or the key to the death spiral. Looking back at two very typical runs on stablecoins in the cryptocurrency market, the collapse of UST and the run on USDC caused by the bankruptcy of Silicon Valley Bank in March 2023, it can be observed that in the current era of internet technology, panic spreads very rapidly, leading to very quick runs. Typically, when panic sets in, a large number of redemptions will occur within a few hours or days. This requires stablecoin mechanisms to face the challenge of tolerance to runs. Therefore, most stablecoin protocols will choose to allocate highly liquid assets as collateral, rather than blindly pursue high returns, such as short-term US Treasury bonds, etc. During a run, the protocol can cope by selling collateral to obtain liquidity. However, considering that Ethena’s collateral consists of a combination of cryptocurrencies with price volatility risk and their futures contracts, this poses a significant challenge to the liquidity of both markets. When Ethena’s issuance reaches a certain scale, encountering large-scale redemptions, whether the market has sufficient liquidity to unwind this futures-arbitrage combination to obtain liquidity to meet redemption demands becomes its main risk.

Of course, liquidity issues with collateral are a problem faced by all stablecoin protocols. However, Ethena’s mechanism design will introduce additional negative feedback mechanisms to the system, which means it is more susceptible to the risk of a death spiral. The so-called death spiral refers to when a run occurs, constrained by a certain factor, it will amplify the effect of panic, triggering a larger-scale run. The key to this lies in the basis. The basis refers to the price difference between futures contracts and spot prices. Ethena’s collateral design is essentially a strategy of shorting the basis in a futures-arbitrage, holding spot, and shorting equivalent futures contracts. When the basis expands positively, meaning the price increase of the spot will be lower than the price increase of the futures contract, or the price decrease of the spot will be higher than the price decrease of the futures, this investment portfolio will face the risk of unrealized losses. However, when a run occurs and users sell USDe massively in a short period, this will lead to a significant price decoupling in the secondary market of USDe. To stabilize this decoupling, arbitrageurs need to actively close the open short contracts in the collateral and sell the spot collateral to obtain liquidity to buy back USDe from the secondary market, reducing the market circulation of USDe to restore the price. However, with the closing operation, unrealized losses turn into actual losses, resulting in permanent loss of collateral value. USDe may be in a state of insufficient collateralization. At the same time, the closing operation will further expand the basis, because closing short futures contracts will push up their futures prices, while selling spot will suppress spot prices, further amplifying the basis. The expansion of the basis will make Ethena encounter greater unrealized losses, which will accelerate user panic, leading to a larger-scale run until it reaches an irreversible outcome.

This death spiral is not an exaggeration. Although backtesting data suggests that the basis exhibits mean-reverting characteristics in most cases, and after a period of development, the market will eventually reach a state of equilibrium. However, this is not suitable as a counterargument to the above argument, because users have a very low tolerance for price fluctuations in stablecoins. For an arbitrage strategy, users may tolerate a certain degree of drawdown risk. However, for stablecoins whose core functions are the storage of value and medium of exchange, users’ tolerance is extremely low. Even for interest-bearing stablecoins whose core selling point is revenue, during the project’s promotion process, they inevitably attract a large number of users who do not understand complex mechanisms and participate based on literal understanding. (This is also one of the core accusations faced by DoKwon, the founder of UST, namely fraudulent promotion.) These users are the core user group that triggers runs and suffer the most severe losses. The risk cannot be underestimated.

Of course, when there is sufficient liquidity in the futures market for shorts and in the spot market for longs, this negative feedback will be mitigated to some extent. However, considering the current scale of Ethena’s issuance and the high subsidy accompanying its ability to attract deposits, we must be vigilant about this risk. After all, with Anchor offering a 20% savings subsidy, the issuance of UST skyrocketed from 2.8 billion to 18 billion in just five months. During this time, the growth of the entire cryptocurrency futures market is certainly unable to keep pace with such an increase. Therefore, there is reason to believe that the open interest in Ethena’s contracts will soon skyrocket to an exaggerated proportion. Imagine when more than 50% of the short positions in the market are held by Ethena, closing these positions will face extremely high friction costs because there will be no shorts in the market capable of absorbing such a scale of closing positions in the short term. This will make the amplification effect of the basis even more pronounced, and the death spiral will become more intense.

I hope that the above discussion, it can help everyone to have a clearer understanding of the risks of Ethena, maintain a respectful attitude towards risks, and not be blinded by high returns.

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