Original author: ROUTE 2 FI

Original compilation: Deep Chao TechFlow

Ethena is a synthetic dollars protocol built on Ethereum that will provide a crypto-native solution for currencies that do not rely on traditional banking system infrastructure, while providing a globally accessible USD-denominated savings instrument— — Internet Bond.

Ethena’s synthetic U.S. dollar, USDe, will provide the first censorship-resistant, scalable, and stable crypto-native currency solution enabled by delta hedging of collateralized Ethereum.

USDe will be fully transparently supported on-chain and freely composable in DeFi.

USDe’s pegged stability is ensured by hedging the collateral held by the protocol using delta-hedging derivatives positions, as well as through minting and redemption arbitrage mechanisms.

“Internet Bonds” will combine proceeds from staking Ethereum with funding and basis spreads from perpetual and futures markets.

Ethena was built to solve the biggest, most obvious immediate need in crypto. DeFi attempts to create a parallel financial system, however, stablecoins are the most important financial instrument and are completely dependent on and subject to traditional banking infrastructure.

Why are stablecoins so important?

Stablecoins are the single most important tool in the crypto space.

All major spot and futures market trading pairs are denominated in stablecoin pairs, with over 90% of order book transactions and over 70% of on-chain settlements denominated in stablecoins. Stablecoins have settled over $12 trillion on-chain this year, making up 2 of the 5 largest assets in the space, accounting for over 40% of TVL in DeFi, and are by far the most widely used in decentralized currency markets assets.

Centralized stablecoins, such as USDC or USDT, offer stability and capital efficiency, but they introduce:

• Unhedged custody risk exists for bond collateral held in regulated bank accounts that are vulnerable to scrutiny

• Dependence on existing banking infrastructure and changing regulations in specific countries

• This is an “unrewarded risk” for users as the issuer internalizes the benefits while exporting the risk of decoupling to users

Historically, decentralized stablecoins have encountered issues with scalability, mechanism design, and lack of embedded benefits.

• “Overcollateralized stablecoins” have historically had problems with scalability, as their growth is inevitably tied to the growth in demand for leverage on the Ethereum chain. Recently, some stablecoins have improved scalability by introducing treasuries, but at the expense of censorship resistance

• “Algorithmic stablecoins” face challenges related to their mechanism designs, which are found to be inherently fragile and unstable. We don’t think these designs are sustainably scalable

• “Delta-neutral synthetic dollars” struggle to scale due to heavy reliance on decentralized exchanges that lack sufficient liquidity

Therefore, USDe has the following advantages:

• Scalability is achieved by leveraging derivatives, which allows USDe to scale with capital efficiency. Since pledged ETH can be perfectly hedged by an equivalent short position, synthetic USD only requires 1:1 collateral

• Providing stability by executing hedging on transferred assets immediately upon issuance, ensuring the synthetic USD value behind USDe under all market conditions

• Resist censorship by decoupling backing assets from the banking system and storing trustless backing assets in decentralized liquidity venues outside of on-chain, transparent, 24/7 auditable, programmatic custodial account solutions

How does Ethena Labs work?

• Users deposit approximately $100 in stETH and automatically receive approximately $100 in USDe after deducting any execution costs for executing the hedge.

• Ethena Labs opens a short perpetual position on a derivatives exchange roughly equal to the dollar value

• The assets received are transferred to an over-the-counter settlement provider. Support assets to be kept on-chain and on off-exchange servers to minimize counterparty risk

• Ethena Labs delegates the backing assets to a derivatives exchange but never transfers custody to a derivatives exchange, holding a permanent hedged short position on margin.

Ethena Labs generates two sustainable revenue streams from deposited assets.

Revenue returned to qualified users comes from:

• Stake Ethereum to receive consensus and execution layer rewards (3.5% APR)

• Financing and basis spreads from delta-hedged derivative positions (5-20% APR)

Earnings from staking Ethereum are floating in nature and are denominated in ETH. Financing and basis spread returns can be floating or fixed.

Historically, funding and basis spreads have generated positive returns due to the supply and demand mismatch of cryptocurrency leverage and the presence of positive baseline funding.

If the funding rate continues to be negative for an extended period of time, such that the proceeds from staking Ethereum cannot cover the funding and basis spread costs, the Ethena Insurance Fund will bear the cost.

Click here, you can find historical returns.

Once users exchange USDe for sUSDe, they can begin accruing protocol earnings without any further actions or fees.

The amount of sUSDe a user receives depends on how much USDe was deposited and when. Ethena’s sUSDe uses the same “Token Vault” mechanism as Rocketpool’s rETH or Binance’s WBETH.

The protocol will not rehypothecate, lend or otherwise use deposited USDe for any purpose. There is no need for any such action, as the mechanics behind USDe itself create protocol benefits.

If the protocol suffers a loss due to financing or other reasons, Ethenas insurance fund will bear the cost, not the staking contract.

• When a user mints USDe, Ethena Labs opens a short position

• When a user redeems USDe, Ethena Labs will close the position

• Ethena Labs realizes unrealized PL by closing/opening positions on exchanges

If the value of USDe on external markets is lower than the value of Ethena Labs, users can:

• Buy 1 USDe from Curve using USDC at a discount of 0.95

• Exchange USDe for USDC at a price greater than 1.00 on the Curve pool

• Buy ETH on Curve using USDC

• to gain profit

What are the risks?

financing risk

“Financing risk” relates to the likelihood of continued negative financing rates. Ethena is able to earn income from funds, but may also be required to pay funds (equal to lower protocol income).

The Ethena Insurance Fund exists and will step in when funding rates for LST assets (e.g. stETH) and short perpetual positions become negative. This ensures that the collateral backing USDe is not affected. Ethena will not pass on any negative returns to users who exchange USDe for sUSDe.

Combining annualized stETH returns and funding rate values, only 10.8% of days saw negative returns. This number is positive compared to the roughly 20.5% of days that yield a negative funding rate when not incorporating stETH earnings.

If you remember Anchor Protocol’s Yield Reserve, the Ethena Insurance Fund will work in a similar way, supporting yields on “negative” days.

liquidation risk

Ethena uses staked Ethereum spot assets as collateral for hedging derivatives positions. Ethena uses staked Ethereum assets, such as Lido’s stETH, as collateral for short ETHUSD and ETHUSDT perpetual positions on CeFi exchanges. Therefore, the asset used by Ethena, stETH, is not the same as the underlying asset ETH of the derivative position.

The spread between ETH and stETH would have to widen to 65%, which has never happened historically, with the maximum being 8% (before Shapella and when Luna unanchored in May 2022), before Ethena’s positions would begin to gradually liquidate , and Ethena will suffer a realization loss.

The stability of the $USDe peg is automatically achieved through programmatic delta-neutral hedging with the underlying collateral asset.

To mitigate “liquidation risk” resulting from the above risk scenarios:

• If either risk scenario occurs, Ethena will systematically commission additional collateral to improve the margin position of our hedging positions

• Ethena has the ability to temporarily rotate delegated staking between exchanges to support specific situations

• Ethena can quickly deploy insurance funds to support hedging positions on the exchange

• In the event of an extreme situation, such as a critical smart contract vulnerability for staked Ethereum assets, Ethena will take immediate action to protect the collateral value. This includes closing hedging derivatives to avoid the risk of liquidation and exchanging the affected asset for another asset.

Custody risk

Given that Ethena Labs relies on OTC settlement provider solutions to custody protocol-backed assets, there is a dependence on its operational capabilities. Ethena has the ability to deposit, withdraw, and delegate to exchanges. The unavailability or degradation of any of these capabilities will hinder the availability of trading workflows and minting/redeeming USDe functionality.

Exchange failure risk

Ethena Labs uses derivatives positions to offset the delta of digital asset collateral. These derivatives positions are traded on CeFi exchanges such as Binance, Bybit, Bitget, Deribit, and Okx. Therefore, if an exchange suddenly becomes unavailable, such as FTX, Ethena will need to bear the consequences. This is exchange failure risk.

Collateral risk

“Collateralization risk” here refers to the difference between the collateral asset of USDe (stETH) and the underlying asset of the perpetual futures position (ETH).

Currently, all protocols that rely on stETH (and any ETH LST) accept this liquidity risk profile. This means that if a user needs to trade on external markets immediately, the amount of stETH that can be unstaking through Lido may be delayed, or the user may have to accept a slight loss.

Approved users of Ethena can redeem USDe for stETH (or any ETH LST) at any time on demand, or request alternative assets, and take advantage of Ethena’s ability to access multiple liquidity pools.

Due to the discovery of critical smart contract vulnerabilities in LST, there may be a loss of confidence in the integrity of LST. In this case, users may try to unstake or exchange LST for alternative collateral as soon as possible. This could lead to long exit validator queues for protocols like Lido, and liquidity drying up on DeFi and CeFi exchanges.

discuss

This is a rather technical discussion. Now, lets see why this product is interesting.

• 27.6% annualized return on stablecoins

• Profit comes from placing LSD $ETH as collateral for a 1x ETH short position

• LSD $ETH yield + short $ETH funding rate = $sUSDe yield

• Upcoming airdrop (called Ethena Shards), 3-month event, or stopping when $USDe supply reaches $1 billion

• Providing Liquidity Providers (LP) + Locking LP Tokens = 2 0x Shards/Day

• Buy and hold $USDe = 5 x shards/day

• Staking and holding $sUSDe = 1 x shard/day

• TVL is growing rapidly: $300 million TVL to date

• All stablecoin pool caps are currently full (expect they will raise the cap, just my gut feeling)

• Smart contracts have lower risk but higher centralization risk (funding on exchanges) and perform best in bull markets when people leverage (dont expect positive funding rates when everyone wants to short ETH)

Taking it a step further, you’ll soon be able to use your sUSDe in DeFi, see an example from Seraphim, Head of Growth at Ethena Labs below:

Still, what people struggle to understand is why we need funding rates.

The funding rate is set to ensure that the funding mechanism aligns the futures market price with the index spot price: whenever the demand for long $ETH is too large, the $ETH perpetual price is greater than the $ETH spot price, so CEX needs some way to Discourage people from going long further.

Therefore, the funding rate is a way to maintain a dynamic balance between the futures market price and the index spot price. Since the overall market is biased towards the long side, i.e. there are more longs than shorts, if you are short $ETH, you are able to take advantage of those who are long $ETH to offset excessive demand and move the $ETH perpetual price back more closely to $ETH spot price.

Global asset management firm AllianceBernstein predicts that the market value of stablecoins will reach $3 trillion by 2028. If we look at the market today, the stablecoin market cap is currently $138 billion and peaked at $187 billion. That’s a potential growth of 2000%!

Additionally, Ethena has moved from including@binance, @CryptoHayes, @Bybit_Official, @mirana, @lightspeedvp, @FTI_USReceived $14 million in investment from the world’s top investors. Notably, angel investors include@dcfgod, @cobieand@blknoiz 06 

Ethena has a really nice dashboard that you can monitor here, and at least it provides some psychological comfort in terms of risk.

Disadvantages of Ethena

Simply put, its just a basis trade. When yields reverse, you start losing money, and the larger the stablecoin, the more money you lose. Currently, those who are long $ETH pay profits to those who are short. This situation can last for a long time, especially in a bull market. But at some point, yields will reverse and people will short ETH and get paid for it. Suddenly, Ethena had to bear the cost. They have an insurance fund to temporarily fix the problem. But with the yield on sUSDe declining, I suspect people may want to withdraw. That being said, this is not a death spiral. Its just that people may want to look for gains elsewhere.

Using stETH as collateral provides a higher margin of safety than negative interest rates. This means that Ethena only cares about days when the ETH funding rate is more negative than stETH yields. However, stETH’s liquidity is very important for pegging. USDe cannot scale to $100 billion without ample stETH liquidity.

Okay, in the case where this happens:

• User redemption

• Insurance funds can be used for coverage. According to Ethena, USDe can survive on $20 million per $1 billion, withstanding almost all pessimistic forecasts for funding rates (Chaos Labs says $33 million per $1 billion is needed).

• The biggest risk for this project may not be liquidation, but who would be willing to lock their money in a yieldless token when you have credible alternatives (I say credible just to point out things like Lindy stablecoins like USDT or USDC, I’m not saying these are better, but because they have been around for a while, most people default to them being more trustworthy).

• Counterparty risk on CEX and smart contracts is probably one of the biggest issues. according to@tbr 90 The long-term risk is that negative interest rates inevitably drain insurance funds and then force a slow decoupling.

As Cobie points out, people can do this trade themselves.

For example, go short ETHUSDT and receive funds every 8 hours, go long stETH or mETH (for higher temporary gains). There is no 7-day staking queue, you choose your own risk. You need to rebalance yourself.

@leptokurtic_(Founder of Ethena) agreed, but noted that “Ethena Labs was not created to save you the hassle of executing cash and arbitrage trades. What’s exciting is being able to tokenize this asset and make it available through DeFi and CeFi It’s extremely liquid, which then allows new interesting use cases to be built on top of it. It’s the Lego stitching together of different currencies.”

Anyway, I love this project. Something new is always interesting. I could see perpetual dexes implementing their stablecoins and DeFi protocols wanting to use it as currency LEGO, like what happened with EigenLayer and the recollateral narrative.

People may remember that I used to be a big fan of the Anchor Protocol, and Ethena felt like a healthier way to do things. Personally I wouldnt use this protocol much as I think there are greater opportunities in a bull market rather than chasing 20% ​​annual returns. However, we will chase the airdrop.

Another thing I dont like is that it takes 7 days to redeem from staking and 21 days to redeem from LP. If unstaking could be done immediately, I would consider using it during periods when I need a break from the market, but 7 days is a long time to wait in crypto.

Having said that, they may implement sUSDe in a few DeFi protocols so you can earn while trading/liquidity staking etc. I will try more when these solutions are in place.

Overall, a positive opinion of the product, even though the article may seem a bit negative overall.

Click here, see all the FUD directed at Ethena.