Ethena's USDe: The next stablecoin to fail

Introduction

In the evolving DeFi space, new projects like Ethena are changing the traditional notions of stablecoins and investment returns. Ethena, built on the Ethereum blockchain, has introduced its own stablecoin, USDe, which uniquely leverages both Ethereum and Bitcoin as collateral through delta-hedging. This mechanism aims to stabilize a market known for its volatility by not relying on conventional fiat-collateralized reserves but instead using a sophisticated risk management strategy. This article delves into how Ethena operates, the sources of its yield, and the potential risks that could threaten its viability.

What is Ethena

Ethena is a synthetic dollar protocol designed to provide crypto investors with dollar-denominated savings through what the team refers to as the "Internet Bond." The core of Ethena's offering is its primary synthetic asset, USDe, which aims to maintain a 1-to-1 price parity with the US dollar. This stability is achieved by delta-hedging the staked Ethereum used as collateral.

The protocol offers between 17.5% and 35% yield on its Internet Bond, which is generated through a couple of methods. First, by delta hedging derivatives positions against the Ethereum held, it helps stabilize USDe's value close to the dollar. Additionally, the bond aggregates yields from staked Ethereum and profits from the funding and basis spread in perpetual and futures markets.

Regarding the ENA token, its exact role within the Ethena ecosystem isn't fully defined at the moment. However, it is likely to be used primarily for governance purposes, similar to other tokens in the crypto market. Potential uses could include allowing holders to vote on decisions related to the extent of USDe staking rewards, the ratio of futures and options contracts used for hedging, and other governance matters. This would enable token holders to actively participate in shaping the protocol's financial and operational strategies.

Where does the yield come from

Ethena operates a stablecoin platform that derives its yields primarily from two sources: staked Ethereum (stETH) and delta hedging on its Ethereum futures. A portion of Ethena's funds is allocated to staking Ethereum, specifically in the form of stETH, which currently offers a yield of approximately 3.4%. Staking involves locking up the cryptocurrency to support the operation and security of the blockchain network, which, in return, rewards the stakers.

The delta hedging trading strategy is another significant source of yield for Ethena. It is a common arbitrage strategy in the cryptocurrency markets that becomes particularly useful during periods of market inefficiency. In this strategy, Ethena buys Ethereum at the current market price while simultaneously selling Ethereum futures contracts. If the futures price is higher than the spot price, it creates an opportunity for yield. The position is typically held until the futures contract expires, at which point the Ethereum is delivered to the holder of the future at the pre-agreed price. This strategy is 'delta neutral', meaning that fluctuations in the market price of Ethereum do not affect the outcome of the arbitrage; the profit instead arises from the price differential between the spot and futures prices.

Ethena utilizes both traditional futures, which have a set expiry date and require delivery of the underlying asset, and perpetual futures, which do not expire and use a funding rate mechanism to keep the futures price aligned with the spot price. The funding rate, a fee paid periodically, varies based on the balance of long and short positions in the market. For instance, the current funding rate for Kraken ETH Perpetual futures could yield up to 32.2% annually, although such rates are highly volatile and subject to rapid changes.

The execution of Ethena's strategy is managed by a company based in Rome, which has received Virtual Asset Service Provider approval from the Italian regulator. The platform uses reputable crypto asset custodians like Copper.co to manage its holdings. Users can purchase Ethena's stablecoin, USDe, using other USD-denominated stablecoins either directly from Ethena or through exchanges such as Curve.fi.

To tap into the yields, users lock their USDe into sUSDe for a minimum of seven days. Behind the scenes, Ethena uses the stablecoin deposits to purchase and stake ETH for yields and to take short positions in both perpetual and traditional futures on major exchanges, including Binance, OKX, Deribit, and Kraken. The yields generated from these activities are then distributed among all stakers.

How can Ethena fail

Ethena's profitability is largely driven by a delta-hedging trade strategy, which capitalizes on the price discrepancies between futures and spot market prices. When futures prices are higher than the spot prices—a condition known as contango—this spread can be profitably locked in. However, this strategy faces significant risks in a market condition called backwardation, where futures prices are lower than spot prices. In such scenarios, prevalent in bear markets with negative funding rates, Ethena's automated trading algorithms may struggle to adapt, potentially leading to losses.

Navigating a complex regulatory landscape adds another layer of risk for Ethena. Its business model, which involves issuing its stablecoin USDe against deposits and promising returns through its trading strategies, could be construed by regulatory bodies as a collective investment scheme. This interpretation would necessitate Ethena obtaining the appropriate fund management licenses in each jurisdiction where it operates, complicating its compliance efforts. Additionally, given its centralized operations, it falls under stringent EU and Italian financial regulations.

In worst-case scenarios, such as a severe market downturn or a regulatory crackdown, Ethena could face the risk of insolvency. Such circumstances might compel the platform to liquidate its holdings at a loss, potentially decimating the value for token holders. The ensuing legal and regulatory challenges could rapidly deplete Ethena's financial reserves, leading to further financial distress.

Thus, while Ethena's innovative strategies may offer high yield potentials, they come intertwined with a complex set of risks. Investors considering Ethena's offerings need to thoroughly understand these risks. A careful assessment of market conditions, regulatory compliance, and potential financial vulnerabilities is crucial to gauge the sustainability and safety of investing in such a platform.

Conclusion

Ethena represents a bold attempt to integrate the principles of DeFi with the need for stablecoins and reliable investment returns. By employing strategies like staked Ethereum and delta-hedging trades on Ethereum futures, Ethena offers potential high yields and contributes to the DeFi ecosystem's broader stability. However, the innovative nature of Ethena does not shield it from the inherent risks of the market and regulatory landscape. From market conditions like backwardation that could undermine its trading strategies to stringent regulatory challenges across various jurisdictions, Ethena's path is filled with potential pitfalls that could impact its sustainability and the security of investor assets.

As Ethena navigates these complex waters, potential investors and users must diligently assess the interplay of market dynamics, regulatory status, and operational strategies. The allure of high returns should be weighed carefully against the risks of significant disruptions and regulatory interventions. In conclusion, while Ethena offers a novel approach to stablecoin utility and yield generation, its the definition of a high-risk, high-reward project in the DeFi sector.