Discussing the possibility that Ethena will surpass Tether to become the largest stablecoin

*Forwarded Original Title: Arthur Hayes：为什么Ethena将超越Tether成为最大的稳定币

Summary:

Hokkaido welcomes sunny days, but nights are bitterly cold, known as the “dust on the Earth’s crust.” The author proposes creating synthetic-backed Ethena, a legal stablecoin, using Ether to create synthetic dollars with yields of up to 50%, potentially surpassing Tether. The Federal Reserve hopes to destroy Tether, making Ethena the best choice. The article analyzes the Fed’s motives, introduces Ethena’s construction, pegging to the dollar, and risk factors. Ethena’s valuation model is also provided. Tether carries risks that could disrupt global bond markets. Ethena allows for the minting of stablecoin USDe by depositing assets, with pledging yielding high returns. Ethena may become the kingdom of the crypto domain, valued at billions of dollars.

The dust on the crust returns to Hokkaido, Japan as expected. During the day, the sun shines brightly, creating a pleasant warmth, but at night, it becomes bitterly cold. This weather pattern contributes to the unfortunate snow conditions known as “dust on the crust.” Beneath the seemingly pristine surface lies ice and brittle snow. It’s something to be wary of.

With the accelerating transition from winter to spring, I find myself revisiting an article I published a year ago titled “Dust on the Crust.” In this piece, I proposed the creation of a synthetic-backed fiat stablecoin, one not reliant on the traditional banking system of TradFi. My idea involved merging long crypto hedges with short perpetual swap positions to create a synthetic fiat currency unit. I named it the Nakaddollar, envisioning its creation through Bitcoin and shorting the XBTUSD “perp” swap. In concluding the article, I pledged to support a credible team to the best of my ability to turn this idea into reality.

The changes over the past year have been tremendous. Guy is the founder of Ethena. Prior to his involvement in the Ethena project, Guy worked at a hedge fund with assets under management of $60 billion, focusing on special situations in credit, private equity, and real estate. He became enamored with DeFi tokens during the DeFi summer of 2020 and never looked back. After reading “Dust on the Crust,” he was inspired to launch his own synthetic dollar. But like all great entrepreneurs, he sought to improve upon my initial idea. Instead of using Bitcoin, he opted to create a synthetic dollar stablecoin using Ethereum. At least, that was the initial plan. Guy chose Ethereum because the network provides native yield. To provide security and process transactions, Ethereum network validators are rewarded with a small amount of ETH directly from the protocol for each block. This is what I referred to as Ethereum staking yield. Additionally, since Ether is now a deflationary currency, there is a fundamental reason why ETH/USD forward, futures, and currency swap trades consistently trade at a premium to spot. Holders of short option swaps can capture this premium. Combining physically staked ETH with short ETH/USD swap positions, Guy created a high-yield synthetic dollar. As of this week, the current annual yield for Staked Ethena USD (sUSDe) is approximately >50%.

Without an executable team, a great idea is nothing. Guy named his synthetic dollar Ethena and assembled a rock star team to swiftly and securely launch the protocol. Maelstrom joined as a founding advisor in May 2023, and in exchange, we received governance tokens. I’ve worked with many high-quality teams in the past, and the people behind Ethena spare no effort. Twelve months later, just three weeks after the stablecoin USDe launched, the issuance approached nearly one billion units (TVL at $1 billion; 1 USDe = 1 USD).

Let me take off my knee pads so I can honestly discuss the future of Ethena and stablecoins. I believe Ethena can surpass Tether to become the largest stablecoin. This prophecy will take many years to fulfill. However, I want to explain why Tether is both the best and worst business in the crypto space. It’s the best because it’s probably the most profitable financial intermediary for both TradFi and crypto industry employees. It’s the worst because Tether’s existence is to appease its less wealthy TradFi banking partners. The envy of banks and the problems Tether brings to the guardians of the “Pax Americana’’ financial system may immediately lead to Tether’s demise.

To those who have been misled by Tether FUDsters, let me clarify. Tether isn’t involved in financial fraud, nor has it misled anyone about its reserves. I hold deep respect for the individuals behind Tether’s creation and operation. However, if I may be candid, Ethena is poised to disrupt Tether.

This article will be divided into two parts. First, I will explain why the Federal Reserve (Fed), the U.S. Department of the Treasury, and politically connected large U.S. banks want to dismantle Tether. Second, I will delve into Ethena. I will briefly outline how Ethena was built, how it maintains its peg to the U.S. dollar, and its risk factors. Finally, I will provide a valuation model for Ethena’s governance token.

After reading this article, you will understand why I believe Ethena is the best choice for providing synthetic dollars based on public blockchains in the crypto ecosystem.

Note: Fiat-backed stablecoins are issued by entities holding fiat currency coins in bank accounts, such as Tether, Circle, First Digital (ahem… Binance), and others. Synthetically-backed fiat stablecoins are issued by entities holding cryptocurrency coins hedged with short-term derivatives (i.e., Ethena).

Jealousy

Tether (symbol: USDT) stands as the largest stablecoin by circulating supply. Each USDT token is pegged to the value of 1 USD. These tokens can be transferred across various public blockchains, like Ethereum. To uphold this peg, Tether maintains a reserve of 1 USD in a bank account for each USDT token in circulation.

Without a USD bank account, Tether cannot fulfill its functions of creating USDT, holding the USD backing for USDT, and redeeming USDT.

Creation: Without a bank account, there’s no way to create USDT because traders have nowhere to send their dollars.

USD Custody: Without a bank account, there’s nowhere to hold the dollars backing the USDT.

USDT Redemption: Without a bank account, there’s no way to redeem USDT because there’s no bank account to send dollars to the redeeming party.

Having a bank account is not sufficient to ensure success because not all banks are equal. While there are thousands of banks worldwide that can accept deposits in dollars, only certain banks have a primary account with the Federal Reserve. Any bank wishing to fulfill its obligations as a dollar correspondent bank by clearing dollars through the Federal Reserve must hold a primary account. The Federal Reserve has complete discretion over which banks it grants primary accounts to.

I’ll quickly explain how correspondent banking works.

There are three banks: A, B, and C. Banks A and B are located in two non-US jurisdictions. Bank C is a US bank with a primary account. Banks A and B wish to transfer US dollars within the legal financial system. They each apply to use Bank C as their correspondent bank. Bank C evaluates the banks’ customer bases and approves them.

Bank A needs to transfer $1000 to Bank B. The fund flow is $1000 transferred from Bank A’s account at Bank C to Bank B’s account at Bank C.

Let’s slightly modify the example and add Bank D, which is also a US bank with a primary account. Bank A uses Bank C as its correspondent bank, while Bank B uses Bank D as its correspondent bank. Now, if Bank A wants to transfer $1000 to Bank B, the fund flow is as follows: Bank C transfers $1000 from its account at the Federal Reserve to Bank D’s account at the Federal Reserve. Bank D then credits $1000 to Bank B’s account.

Typically, banks outside the United States use correspondent banks to wire US dollars globally. This is because once US dollars move between jurisdictions, they must be cleared directly through the Federal Reserve.

Since 2013, I’ve been involved in the cryptocurrency industry. Typically, the banks used by cryptocurrency exchanges for fiat deposits and withdrawals are not registered banks in the United States. This means they rely on a US bank with a primary account to process fiat transactions. These smaller non-US banks are eager to onboard deposits from cryptocurrency companies because they can charge hefty fees without incurring any costs for deposits. Globally, banks often urgently need cheap USD funding as the dollar is a global reserve currency. However, these smaller foreign banks must interact with their correspondent banks to handle USD deposits and withdrawals outside their jurisdiction. While correspondent banks tolerate fiat flows related to crypto businesses, sometimes, for various reasons, certain crypto clients are asked to leave by their smaller banks, often at the behest of the correspondent bank. If smaller banks fail to comply, they risk losing their correspondent banking relationships and, consequently, their ability to transact USD internationally. For a bank to lose its ability to transact in USD is akin to being rendered defunct. Therefore, when correspondent banks make requests, smaller banks invariably relent and part ways with crypto clients.

This underscores the indispensability of correspondent banks when analyzing the strength of Tether’s banking partners.

Tether Bank Partners:

Britannia Bank & Trust

Cantor Fitzgerald

Capital Union

Ansbacher

Deltec Bank and Trust

Among the five banks listed, only Cantor Fitzgerald is registered in the United States. However, none of these five banks have a primary account with the Federal Reserve. Cantor Fitzgerald is a primary dealer that assists the Federal Reserve in conducting open market operations, such as buying and selling bonds. Tether’s ability to transfer and hold dollars depends entirely on the whims of unpredictable correspondent banks. Considering the scale of Tether’s US Treasury portfolio, I believe their collaboration with Cantor is crucial for continued access to the US market.

If the CEOs of these banks haven’t negotiated equity stakes in Tether in exchange for providing banking services, then they are fools. When I later present the income metrics of each Tether employee, you’ll understand why.

This explains why Tether’s banking partners are not optimal. Next, I want to explain why the Federal Reserve dislikes Tether’s business model and why fundamentally, it has little to do with cryptocurrency but more with how the USD money markets operate.

Full-reserve banking

When viewed through the lens of traditional finance (TradFi), Tether operates as a fully-reserved bank, also known as narrow banking. A fully-reserved bank only accepts deposits and does not engage in lending. Its sole service is facilitating transfers back and forth. Since depositors face no risk, it pays minimal, if any, interest on deposits. If all depositors simultaneously demand their funds back, the bank can immediately meet this demand. Hence the name - fully reserved. In contrast, fractional reserve banks have loan portfolios that exceed their deposit base. If all depositors simultaneously demand their money back from a fractional reserve bank, it will collapse. Fractional reserve banks pay interest to attract deposits, but depositors face risk.

Tether essentially operates as a fully reserved USD bank, offering USD transaction services powered by public blockchains. That’s its core function: no lending, no complexities.

The Federal Reserve’s dislike of fully reserved banks stems not from their customer base, but from how these banks manage their deposits. To grasp why the Federal Reserve holds this view, it’s essential to delve into the mechanics and repercussions of quantitative easing (QE).

Banks collapsed during the 2008 financial crisis because they didn’t have enough reserves to cover losses from bad mortgage loans. Reserves are funds banks hold at the Federal Reserve. The Federal Reserve monitors the ratio of bank reserves to outstanding loans. Since 2008, the Federal Reserve has ensured banks never run short of reserves by implementing quantitative easing.

Quantitative easing refers to the process whereby the Federal Reserve buys bonds from banks and lends reserves held by the Federal Reserve to banks. The Federal Reserve has implemented quantitative easing measures worth trillions of dollars, expanding bank reserve balances. Hooray!

Quantitative easing doesn’t lead to rampant inflation like the pandemic stimulus measures did because bank reserves stay with the Federal Reserve. The pandemic stimulus was handed directly to the public, allowing them to spend as they wished. If banks were to lend out these reserves, inflation would spike immediately post-2008, as the money would be in the hands of businesses and individuals.

The existence of small banks hinges on lending; if they don’t lend, they don’t make money. Therefore, all else being equal, fractional reserve banks are more inclined to lend their reserves to paying customers rather than keeping them with the Federal Reserve. The Fed faced a dilemma: how to ensure the banking system had near-infinite reserves without causing inflation? Their solution was to essentially “bribe” the banking sector rather than lending.

Bribing the banks involves the Federal Reserve paying interest on excess reserves held by the banking system. To calculate the scale of the bribe, multiply the total reserves held by the Federal Reserve by the interest on excess reserves (IORB). The IORB must hover between the lower and upper bounds of the federal funds rate. Read my article “Kites or Boards“ to understand why.

Loans carry risks. Borrowers default. Banks prefer earning risk-free interest income from the Federal Reserve rather than lending to the private sector, avoiding potential losses. Therefore, as quantitative easing progresses, the outstanding loans in the banking system have not grown at the same pace as the assets on the Federal Reserve’s balance sheet. However, success doesn’t come cheap. When the federal funds rate is between 0% and 0.25%, the cost of bribing is not high. But now, with the federal funds rate between 5.25% and 5.50%, bribing through IORB costs the Federal Reserve billions of dollars annually.

The Federal Reserve maintains “high” policy rates to curb inflation; however, due to the high cost of IORB, the Federal Reserve becomes unprofitable. The US Treasury, and ultimately the American public, are directly funding the bribing of banks through the IORB program. When the Federal Reserve earns profits, it sends this money to the US Treasury. When the Federal Reserve incurs losses, the US Treasury borrows money and transfers it to the Federal Reserve to offset its losses.

Quantitative easing addressed the issue of insufficient bank reserves. Now, the Federal Reserve aims to curb inflation by reducing bank reserves, entering into a process known as quantitative tightening (QT).

Quantitative tightening (QT) involves the Federal Reserve selling bonds to the banking system while maintaining reserves. Unlike quantitative easing (QE), which increases bank reserves, QT reduces them. As bank reserves decrease, the cost of IORB bribes also diminishes. Naturally, the Fed wouldn’t be pleased if it had to pay high rates due to IORB while bank reserves were rising.

The fully-reserved banking model contradicts the Federal Reserve’s established objectives. Fully-reserved banks do not extend loans, meaning 100% of deposits are held as reserves with the Fed. If the Fed were to start issuing full-reserve banking licenses to banks engaged in similar activities as Tether, it would exacerbate the Fed’s losses.

Tether is not a U.S.-chartered bank, so it cannot directly deposit funds with the Federal Reserve and earn IORB. However, Tether can park cash in money market funds, which can participate in the Reverse Repurchase Program (RRP). Similar to IORB, the Fed must pay interest rates within the federal funds rate corridor to accurately steer short-term rates. Treasury bills are zero-coupon bonds with maturities of less than one year, yielding slightly more than the deposit reserve rate. Therefore, while not a bank, Tether’s deposits are invested in instruments that require interest payments from the Fed and the U.S. Treasury. Tether has invested nearly $81 billion in money market funds and Treasury bills. Tether is arbitraging the Fed because it pays 0% interest on USDT balances but earns returns close to the federal funds rate’s upper limit. This is Tether’s Net Interest Margin (NIM). As you can imagine, Tether is delighted by the Fed’s rate hikes, as the NIM surged from essentially 0% to nearly 6% in less than 18 months (March 2022 to September 2023).

Tether is not the only stablecoin issuer arbitraging the Federal Reserve. Circle (USDC) and all other stablecoins that accept dollars and issue tokens are doing the same. If banks were to abandon Tether for some reason, the Fed would be powerless. In fact, the members of the Federal Reserve Board would have a bigger cheese to nibble on during Tiffany Fong’s non-spousal visit than Sam Bankman-Fried’s chubby cheese.

As for that bad girl Yellen, does her Treasury have any opinions on Tether?

Tether is too big

U.S. Treasury Secretary Janet Yellen needs a well-functioning U.S. Treasury market. This allows her to borrow the necessary funds to cover the government’s annual trillions of dollars in deficits. Since 2008, the size of the U.S. Treasury market has expanded rapidly alongside the fiscal deficit. The larger it grows, the more fragile it becomes.

The chart from the U.S. Government Securities Liquidity Index clearly illustrates the decline in liquidity in the U.S. Treasury market since the onset of the COVID-19 pandemic (higher numbers indicating poorer liquidity conditions). Just a small amount of selling can disrupt the market. By market disruption, I mean a rapid drop in bond prices or an increase in yields.

Tether is currently one of the top 22 holders of U.S. Treasuries. If Tether were to quickly reduce its holdings for any reason, it could potentially create turmoil in the global bond market. When I say global, I mean that all sovereign debt instruments are priced, to some extent, shape, or form, off the U.S. Treasury curve.

If Tether’s banking partners exit Tether, Yellen may intervene in the following ways:

1. She may stipulate to give Tether a reasonable amount of time to ensure customer identity so it won’t be forced to sell assets to meet rapid redemption demands.

2. She may freeze Tether’s assets to prevent it from selling anything until the market can absorb Tether’s assets.

However, Yellen is unlikely to assist Tether in finding another long-term banking partner. The growth of Tether and similar stablecoins servicing the crypto market poses risks to the U.S. Treasury market.

If Tether decides to purchase long-term bonds instead of the short-term ones in high demand, Yellen might stand behind them. But why would Tether take on such term risk for less profit? This may be due to the yield curve inversion (long-term rates lower than short-term rates).

The most powerful financial institutions under Pax Americana would prefer Tether not to exist. These issues have nothing to do with crypto itself.

Tether is too rich

Maelstrom’s brilliant analysts have created the following speculative balance sheet and income statement for Tether. They combined Tether’s public disclosures with their own judgments to create this.

The table below lists the eight “Too Big to Fail” (TBTF) banks operating within the “Pax Americana” economic and political system, along with their net profits for the fiscal year 2023.

Cantor Fitzgerald is not a bank but a primary dealer and trading firm. There are only 23 primary dealer banks. Therefore, in the Total Deposits column, Cantor’s figure represents the value of assets on its balance sheet. I obtained Cantor’s estimated net income and total workforce from Zippia.

Tether’s employees earn $62 million each. No other bank on the list comes close. Tether’s profitability is another example of how cryptocurrencies are reshaping the largest wealth transfers in human history.

Why don’t these TBTF banks offer a stablecoin pegged to fiat currency? The income of each Tether employee exceeds that of all these banks, but without these banks and similar ones, Tether would not exist.

Perhaps one of these banks could purchase Tether instead of demanding Tether to become bankified. But why would they do that? It’s certainly not due to technology. With the transparency of public blockchains, the code to deploy smart contracts for Tether clones is readily available on the internet.

If I were the CEO of a US bank, I would immediately detach Tether from the bank and offer a competing product. The first US bank to offer a stablecoin would quickly dominate the market. As a user, holding tokens from JPMorgan Chase carries lower risk than Tether. The former is a liability of a “too big to fail” bank, while the latter is essentially a liability of the entire empire. The latter is the responsibility of a privately-owned company scorned by the entire US banking system and its regulatory authorities.

I don’t believe that US banks are conspiring to overthrow Tether, but that may not be important. Tether’s existence entirely depends on its access to the US banking system, making it a key player in the cryptocurrency industry. Why would the US banking system allow Tether to make more profit in a few trading days than Jamie Dimon? Well…

As the crypto bull market progresses, any stocks related to crypto business lines are likely to rise. With market panic over bad commercial real estate loans, the stock price of a US bank is declining, prompting the bank to potentially enter the crypto stablecoin market to boost valuation. This could be all the motivation US banks need to directly compete with Tether, Circle, and others in the end.

If Circle’s IPO progresses smoothly, it is expected to face challenges from the banking system. Stablecoin companies like Circle and Tether should trade at prices lower than their earnings because they lack competitive moats. The fact that Circle can go public through an IPO is a comedy in itself.

It’s not that there aren’t higher mountains…

I just explained why destroying Tether by the US banking system is easier than defeating Caroline Ellison in the Olympic math competition. But as part of the crypto ecosystem, why should we create a different type of stablecoin pegged to fiat currency?

Thanks to Tether, we know that the crypto capital market needs a stablecoin pegged to fiat currency. The problem is that banking services are poor because there’s no competition to make them better. With Tether, anyone with an internet connection can use dollars for payments around the clock.

There are two main problems with Tether:

1. Users don’t receive any share of Tether’s NIM.

2. Tether could be shut down overnight by the US banking system, even if it operates entirely by the book.

Fairly speaking, users of any currency typically do not share in the seigniorage income. Holding physical cash in US dollars doesn’t entitle you to profit from the Federal Reserve, but you certainly bear the losses. Therefore, holders of USDT should not expect to receive any share of Tether’s NIM. However, one group of users who should be compensated are cryptocurrency exchanges.

Tether’s primary use case is as a financing currency for cryptocurrency trading. It also offers a nearly instant way to transfer fiat currency between trading platforms. Exchanges, as venues for cryptocurrency trading, give Tether its utility, but they haven’t received any rewards. There are no Tether governance tokens available for purchase, providing holders with claims to NIM. Unless exchanges somehow obtained equity in Tether early on, there’s no way to share in Tether’s success. This isn’t a sob story about why Tether should fund exchanges. Instead, it prompts exchanges to support stablecoin issuers that pass most of the NIM to holders and offer exchanges the opportunity to buy governance tokens at cheap valuations in the early stages of issuer development.

This approach is quite simple: to surpass Tether, most of the NIM must be paid to stablecoin holders, and governance tokens should be sold to exchanges at a low price. This is your way of attacking fiat-backed stablecoins.

Ethena has followed this script entirely. USDe holders can directly stake on Ethena and receive most of the NIM. Major exchanges have invested in Ethena in its early financing. Ethena counts Binance Labs, Bybit via Mirana, OKX Ventures, Deribit, Gemini, and Kraken as exchange partner investors.

In terms of market share represented by these exchanges, they cover around 90% of ETH’s open interest across major exchanges.

How does it work?

Ethena is a synthetically-backed fiat-pegged cryptocurrency.

ETH = Ethereum

stETH = Lido Staking ETH Derivatives

ETH = stETH

ETH = stETH = $10,000

ETH/USD perpetual swap contract value = 1 USD worth of ETH or stETH = 1 / USD value of ETH or stETH pegged exchange rate

USDe is a stablecoin issued by Ethena, designed to be pegged 1:1 with the US dollar. Ethena has enlisted various authorized participants (APs). APs can mint and burn USDe at a 1:1 ratio.

Minting:

Currently, it accepts stETH from Lido, Mantle mETH, Binance WBETH, and ETH. Then, Ethereum is automatically sold for perpetual contracts of ETH/USD to lock in the USD value of that ETH or ETH LSD. The protocol then generates an equivalent amount of USD matched with the USD value of the short hedge.

example:

1.AP deposits 1 stETH, worth $10,000.

2.Ethena sells 10,000 ETH/USD / perpetual swap contract = 10,000 USD / 1 USD contract value.

1. AP received 10,000 USDe because Ethena sold a 10,000 ETH/USD perpetual swap contract.

Burning:

To burn USDe, APs will deposit USDe into Ethena. Then, Ethena will automatically cover a portion of its ETH/USD perpetual contract short position, unlocking a certain amount of USD value. Subsequently, the protocol will burn the USDe and return a certain amount of ETH or ETH LSD based on the total unlocked USD value minus execution fees.

For example:

1.AP deposit is US$10,000.

1. Ethena repurchases 10,000 ETH/USD / perpetual swap contract = 10,000 USD / 1 USD contract value

3.AP receives 1 stETH = 10,000 * $1 / $10,000 stETH/USD minus execution fee

To understand why initially USDe should trade at a slightly higher price than the dollar on stablecoin trading platforms like Curve, I will explain why users would want to hold USDe.

The yield of USDe

The yield of USDe, when combined with the yield from ETH staking and funds from ETH/USD perpetual contracts, offers a significantly high synthetic dollar yield. To earn this yield, USDe holders can directly stake it on the Ethena application. It takes less than a minute to start earning returns.

This is because as of the time of this article’s publication, the yield on sUSDe is around 30%, which is quite high. Users who have been holding stablecoins with much lower yields will likely switch to sUSDe. This creates buying pressure and drives up the price of USDe in the Curve pool. When USDe trades at a sufficiently high premium, Authorized Participants (APs) intervene and arbitrage from it.

As you can see, the yield on sUSDe (with collateralized US dollar bonds) is significantly higher than that of sDAI (with collateralized US dollar bonds) and US Treasury bonds. Source: Ethena

Imagine this: 1 USDe = 2 USDT. If AP can create 1 USDe with 1 USDT worth of ETH or stETH, they can earn a risk-free profit of 1 dollar. The process goes as follows:

1. Wire transfer USD to the exchange.

2. Sell 1 USD for ETH or stETH.

3. Deposit ETH or stETH into the Ethena app to receive 1 USDe.

4. Deposit USDe on Curve and sell it for 2 USDT.

5. Sell 2 USDT on the exchange for 2 USD and withdraw the USD to a bank account.

If users believe Ethena is secure and the earnings are legitimate, then in this hypothetical scenario, the circulation of USDT would decrease while the circulation of USDe would increase.

The Yield of Terra USD (UST)

Many in the cryptocurrency industry believe that Ethena will fail similarly to UST. UST is a stablecoin affiliated with the Terra/Luna ecosystem. Anchor is a decentralized money market protocol within the Terra ecosystem that offers a 20% annual yield for those who collateralize UST. People can deposit UST, and Anchor lends out the deposits to borrowers.

UST is backed by Luna, and Bitcoin is purchased by selling Luna. Luna is the governance token of the ecosystem. The foundation owns most of the Luna. Because Luna’s price is high, the foundation sells Luna for UST to pay the high UST interest rates. The interest rates are not paid in physical dollars, but rather you earn more UST tokens. While UST is pegged 1:1 to the dollar, the market believes that if there is more UST held, there will be more dollars held as well.

As the total value of UST locked in Anchor grows, so does its UST interest expense. The foundation continues to sell Luna to subsidize Anchor’s UST rewards, which has become unsustainable. This income is only because the market believes Luna should be worth billions of dollars.

When the price of Luna begins to decline, the death spiral of algorithmic stablecoins begins. Due to the way Luna is minted and burned to maintain a 1:1 peg with the dollar, it becomes increasingly challenging to sustain the peg as the value of Luna drops. Once the pegged exchange rate is violently broken, all the interest accumulated on Anchor becomes worthless.

The Yield of Ethena

The way USDe generates income is completely different from UST. Ethena holds two types of assets that generate income.

Staking ETH:

ETH is staked using liquidity staking derivatives like Lido (stETH). stETH earns staking rewards in ETH. The ETH is deposited in Lido, which operates validator nodes capitalized with deposited ETH and distributes the ETH rewards earned on the Ethereum network to stETH holders.

Perpetual contract:

Perpetual swap contracts are continuous short-term futures contracts. Most perpetual contracts reset their funding rate every 8 hours. The funding rate is based on the premium or discount of the perpetual contract relative to the spot price. If the perpetual contract traded at a premium of 1% relative to the spot price in the past 8 hours, the funding rate for the next period will be +1%. If the funding rate is positive, long positions pay short positions; if it is negative, it is the other way around.

Ethena holds short positions in perpetual swap contracts to hedge the dollar value of its collateralized ETH holdings. Therefore, if the funding rate is positive, Ethena earns interest income. If it is negative, it pays interest. Obviously, as USDe holders, we want to be sure that Ethena earns interest rather than paying it. The question then arises: why should the ETH/USD trade at a premium on the forward basis?

Ethereum is presently considered a deflationary asset, in contrast to the dollar, which is viewed as inflationary. If Ethereum is expected to decrease in value over time while the dollar is anticipated to appreciate, then the ETH/USD pair should trade at a higher rate in the future. This suggests that the trading price of leveraged forward derivatives, such as options swaps, should exceed the current spot price. Consequently, funding rates are likely to remain largely positive, indicating that Ethena would receive interest. This assertion is supported by available data.

What would cause Ethereum to transition from a deflationary currency to an inflationary one? If the usage of the Ethereum network sharply declines, then the amount of ETH gas burned per block would decrease significantly. In such a scenario, the block rewards of Ethereum would exceed the consumption of ETH gas.

What would cause the US dollar to transition from an inflationary currency to a deflationary one? US politicians should not spend as much money to get re-elected. The Federal Reserve must shrink its balance sheet to zero. This would lead to a significant contraction in the circulation of the US dollar credit currency.

I believe both scenarios are unlikely to occur; therefore, there is reason to expect that for the foreseeable future, the funding rates for most periods will be positive.

USDe is not UST.

The combination of ETH staking yield and positive perpetual swap funding is the reason for generating yield for USDe. The yield is not based on the value of Ethena governance tokens. USDe and UST generate yield in completely different ways.

Ethena’s Risk

Wrap it up!

Ethena is exposed to counterparty risk. It is not decentralized and has no intention of becoming decentralized. Ethena holds short perpetual contract positions on centralized derivative exchanges (CEX). If, for any reason, the CEX fails to pay the profits from perpetual contract positions or return the deposited collateral, Ethena will incur capital losses. Ethena attempts to mitigate direct counterparty risk by entrusting funds to third-party custodians, such as:

Tether faces counterparty risk from traditional financial banks. Ethena’s counterparty risk comes from derivative CEXs and cryptocurrency custodians.

CEXs are investors in Ethena and have a vested interest in ensuring their derivatives are properly paid out and not compromised by hackers. Derivative CEXs are some of the most profitable crypto companies, and they want to keep it that way. It’s not good business to harm your customers. As Ethena grows and the number of outstanding derivative contracts increases, so does the fee revenue for CEXs. All incentives are aligned. CEXs want Ethena to succeed.

Tether’s product contributes to the functioning of the crypto capital markets. Cryptocurrencies exist within decentralized TradFi banks. TradFi banks hope cryptocurrencies fail. Fundamentally, Tether’s banking operations accelerate the demise of TradFi. The incentives are not aligned. TradFi banks don’t want Tether to succeed, and neither do their regulators.

Ethena is for us, by us, aka FUBU.

Tether is for us, by them, aka FUBAR.

LSD smart contracts and risk-cutting

Ethena holds ETH LSD. It faces smart contract risk. For example, there could be issues with Lido that render stETH worthless. Additionally, there is slashing risk. Slashing occurs when Ethereum network validators violate certain rules. As a penalty, validators’ held ETH capital decreases, resulting in slashing.

Negative funds

As I mentioned before, the funding rate for perpetual swaps may remain negative for a long period of time. The funding rate could drop to negative values, causing Ethena’s asset net value to fall below the issued US dollars. Then, the US dollar will break the pegged exchange rate when it goes down. Similarly, as I mentioned before, the funding rate for perpetual swaps may remain negative for a long period of time. The funding rate could be so low that the asset net value of Ethena falls below the amount of US dollars issued. Then, USDe will break the pegged exchange rate when it goes down.

Ethena’s smart contract risks

Just like Tether, Ethena operates smart contracts on a public blockchain. Errors in the code could exist, leading to unexpected behavior and ultimately causing losses for USDe holders. Typically, hackers may attempt to mint large amounts of stablecoins for free and then trade them for another cryptocurrency on platforms like Uniswap or Curve. As the supply of stablecoins increases without a corresponding increase in the assets backing the stablecoins, it leads to the peg breaking.

However, Ethereum smart contracts are relatively simple, with most of the complexity lying in off-chain engineering. The on-chain minting/redeeming contracts consist of only about 600 lines of code, and only approved participants can interact with the most sensitive contracts on-chain. This helps mitigate the risk and prevents malicious unknown counterparties from interacting with them.

Limits to growth

The circulating supply of USDe can only be as large as the total open interest of ETH futures and perpetual swap contracts on exchanges. The circulating supply of physically-backed fiat stablecoins is approximately $130 billion. The total open interest of ETH contracts traded on exchanges where Ethena operates is around $8.5 billion, and globally it is approximately $12 billion. Additionally, there are $31 billion worth of BTC contracts open, which Ethena can utilize once it decides to accept BTC as collateral. With approximately $43 billion worth of BTC and ETH open interest contracts, it is not feasible for Ethena to claim the top position given the current market conditions. Although Ethena starts with ETH, adding BTC and SOL to their system is relatively straightforward—it’s just a matter of prioritization.

While the above is true, remember I said Ethena would be crowned king many years later. Although the above is true, remember what I said about Ethena being crowned king many years from now. With the growth of cryptocurrencies as an asset class, the total open interest will experience exponential growth. Some believe that cryptocurrencies as an asset class will reach $10 trillion in this cycle. At this level, considering that Ethereum is the second-largest cryptocurrency by market capitalization, it is not unreasonable to think that the open interest in Ethereum could exceed $1 trillion.

Ethena will grow along with the growth of cryptocurrencies.

Insurance fund

The existence of insurance funds is to mitigate the economic losses caused by some of the risks mentioned above. If the funding rate turns negative or the synthetic USD exchange rate decouples from the USD, these funds will act as bidders for USD bonds in the public market. The fund consists of stablecoins (USDT and USDC), stETH, and USDe/USD LP positions. Currently, the funding for this insurance fund comes from several rounds of financing by Ethena Labs and a portion of the income generated by USDe. In the future, as the circulation supply of USD increases, these funds will yield long-term returns. As of writing this article, the insurance fund stands at $16 million.

Both USDT and USDe are not riskless. However, the risks are different. Tether and Ethena may ultimately fail, but for different reasons.

Token

As people begin to believe that the yield of USDe is not illusory, the circulating supply of USDe will increase. The next step is to own a part of the kingdom. This is where the upcoming Ethena governance token comes into play.

Evaluation on Ethena

Like any currency issuer, the fate of Ethena depends on the seigniorage tax. This is the difference between the cost of creating money and the real goods that money can buy. I would like to propose a simple model based on these seigniorage tax revenues to evaluate Ethena. For those who may be considering purchasing Ethena governance tokens in the coming months, you should at least attempt to build a model to assess the protocol.

Any issued USDe can be staked to earn ETH staking and perpetual funding rewards. As of now, Ethena distributes the income generated from assets supporting sUSDe, while the income generated from assets supporting uncollateralized USDe is sent to the insurance fund. Following this split activity, the income will enter the protocol. I estimate that in the long term, 80% of the protocol-generated income will accumulate to staked USDe (sUSDe), while 20% of the generated income will belong to the Ethena protocol.

Ethena protocol annual income = Total yield rate (1 - 80% (1 - sUSDe supply / USDe supply))

If 100% of USDe is staked, meaning sUSDe supply = USDe supply:

Ethena protocol annual income = Total yield * 20%

Total yield rate = USDe supply * (ETH staking yield rate + ETH perpetual funding)

The Ethereum staking yield rate and ETH perpetual funding are variable rates. Recent history can guide us towards potential future outcomes.

ETH staking yield — I assume 4% annual yield

ETH perpetual swap funding — I assume 20% PA.

Staking Percent — Currently, only 28% of USDe is staked. I expect this number to rise over time. I assume there will be 50% stake going forward.

The key part of this model is the ratio of fully diluted valuation (FDV) to the income multiple. This is always a guessing game, but I will propose some future paths based on comparable DeFi stablecoin projects.

Using these multiples as a guide, I created the following potential Ethena FDV.

The horizontal axis represents the supply in billions of dollars, while the vertical axis represents the FDV/Rev multiple.

Ondo is the newest and hottest kid on the stablecoin block. The company has a cash inflow of around $6 billion, with revenue of only $9 million, resulting in a P/E ratio of 630x. Ouch! Can Ethena’s valuation reach similar heights?

This week, Ethena’s assets of $820 million generated a yield of 67%. Based on a supply ratio of sUSDe to USDe at 50%, Ethena’s annualized income is estimated to be around $300 million. If we apply a valuation similar to Ondo’s, the company’s external value would reach $1.89 trillion. Does this mean Ethena’s FDV will approach $200 billion upon launch? No. But it does mean that the market will pay a hefty premium for Ethena’s future income.

Yachtzee!!

This story

If you don’t remember anything else from this article, remember this:

Ethena is for us, by us, aka FUBU.

Tether is for us, by them, aka FUBAR.

Whether to go long or short on USDe, or ultimately the Ethena governance token, is your decision. I hope this article clarifies Ethena’s mission and why it’s crucial for the success of crypto.

With that said, I bid you farewell as I must focus on not hurting my thighs while tearing through this tough snow.

Disclaimer：

1. This article is reprinted from [marsbit]. Forward the Original Title‘Arthur Hayes：为什么Ethena将超越Tether成为最大的稳定币’. All copyrights belong to the original author [*Arthur Hayes]. If there are objections to this reprint, please contact the Gate Learn team, and they will handle it promptly.
2. Liability Disclaimer: The views and opinions expressed in this article are solely those of the author and do not constitute any investment advice.
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