The annualized rate of USDe issued by Ethena is as high as 27%, an in-depth analysis of the risks behind it

Compiled by: LlamaC

We have been paying attention to the development and competitive landscape of the stablecoin market. The supply of Ethena’s USDe stablecoin has grown sharply to more than $770 million since its release. , becoming the sixth largest stablecoin pegged to the US dollar. This article aims to briefly introduce its mechanisms and potential risks.

Ethena Labs opened deposit services for its synthetic U.S. dollar stablecoin to the public on February 19, a move that nearly stole the spotlight on cryptocurrency social media platforms.

Ethena’s USDe stablecoin supply is offering double-digit yields and points on the upcoming airdrop, allowing it to quickly grow to over $770 million, becoming the sixth-largest USD-pegged stablecoin !

While Ethena's rise has been impressive, some critics are skeptical of the project. They expressed doubts about Ethena's high yields and believed its design could lead to a collapse of the Terra/Luna ecosystem. While the project has been a success, this skepticism also points to some concerns about its future stability. These objections remind people to be cautious in their enthusiasm for emerging projects, rationally evaluate their potential risks, and focus on the long term. Today, we will delve into the features of the Ethena protocol and evaluate its potential risks to help You make an informed choice to determine if this opportunity fits your needs!

The inner workings of Ethena

Basis trading has a long history in both cryptocurrencies and traditional financial markets. This type of trading involves taking advantage of price differences between spot assets and futures instruments for arbitrage operations.

Typically, investors would trade by going long on a spot asset and simultaneously shorting the related futures contract. This trading strategy is mainly because investors usually need to use leverage to increase returns, and holding spot assets may incur certain holding costs. For these reasons, futures contracts often trade at a premium, that is, at a higher price than the actual price of the underlying asset.

Historically, cryptocurrency markets have also operated in contango, meaning that the price of perpetual futures typically exceeds the price of spot assets, resulting in a net positive funding rate environment in which bulls Pay shorts the ability to cover their positions.

In this case, one can easily deploy a lucrative delta neutral basis trade by holding spot crypto assets and hedging the notional value of their holdings with perpetual assets, thus making this Users of the strategy are able to eliminate the risk of cryptocurrency price fluctuations while enabling them to earn income from funding disbursements.

Ethena is essentially an open-ended hedge fund that uses the above strategy to earn income and tokenizes its trading collateral into stablecoins!

Ethena uses liquid pledged ETH tokens as collateral and shorts an equivalent nominal amount of ETH to create a Delta 0 portfolio. This configuration ensures that every $1 change in the underlying value of Ethena's holdings , the net value of its holdings will fluctuate by $0, while earning income from ETH pledges and fund payments for short positions.

Multiple protocols have previously adopted a similar strategy to Ethena, but previous iterations have struggled to scale due to their reliance on decentralized trading venues. Ethena circumvents liquidity caps by leveraging centralized exchanges like Binance.

In order to protect users' collateral, Ethena utilizes over-the-counter settlement (OES) solutions to store funds in reputable third-party custodians, and only mirrors account balances to CEX to provide trading margin. Ensure funds are never deposited into centralized exchanges.

Because staked ETH can be perfectly hedged by short positions of equal notional value, USDe can be minted at a 1:1 collateralization ratio, making Ethena as capital efficient as USD asset-backed stablecoins such as USDC and USDT Quite, while risk aversion requires sourcing assets from traditional financial markets, subjecting their issuers to physical space regulations.

While Ethena’s current model only uses staked ETH as collateral, the protocol may consider BTC as collateral to achieve greater scale, but doing so may dilute USDe’s returns as BTC collateral does not generate staking returns.

Risks of Ethena

In the field of cryptocurrency, financial rewards inevitably come with corresponding risks. Ethena Opportunity participants should not expect to find otherwise.

While the combination of generous financing rates and staking yields will certainly result in attractive APYs, these returns are not without risks...

In addition to what DeFi users have come to expect Beyond standard cryptocurrency risks, Ethena brings with it some atypical risk vectors that have caused panic and prompted comparisons to the Terra/Luna algorithmic UST stablecoin.

Collateral Decoupling Risk

The main risk with Ethena is using LST collateral that matches the normal Ethena space header. While this optimization of ETH’s underlying transactions helps the protocol maximize its revenue-generating capabilities, it also increases risk!

If Ethena’s LST collateral were decoupled from ETH, Ethena’s ETH shorts would be unable to capture the volatility, leaving the protocol with a paper loss.

While LST typically trades close to its peg, we have seen multiple instances where these tokens can come off the peg, such as during the mid-2022 3AC Black Swan liquidation when Lido’s stETH discount reached nearly 8%!

Shapella enabled Ethereum staking withdrawals in April 2023, making the 3AC liquidation perhaps the most widespread decoupling we’ve seen from blue-chip LST, but the fact Still, any future decoupling events will put pressure on Ethena's margin requirements (the amount of funds it must deploy to the exchange to keep its hedges open to avoid position liquidation).

If the liquidation threshold is reached, Ethena will be forced to lose money.

Funding Rate Risk

Although Ethena’s rate of return seemed impressive from the start, it’s worth noting that two previous protocols have attempted to scale synthetic USD stablecoins, But all failed due to yield inversion.

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In order to cope with the negative returns brought by financing, Ethena uses pledged ETH as collateral. This strategy produced negative returns on USDe in a backtest three years ago. The number of days decreased from 20.5% to 10.8%.

While it is 100% certain that funding rates will turn negative at some point, the natural state of the cryptocurrency market is contango, which puts upward pressure on funding rates and provides an advantage for basis trading with Ethena environment of.

Counterparty Risk

Many people unfamiliar with Ethena’s design believe that deploying user collateral to centralized exchanges is a major risk, but by using the OES escrow account described above, this risk is eliminated has been greatly relieved.

While hedging unsettled profits from bankrupt exchanges may result in losses, Ethena at least settles profits and losses on a daily basis to reduce the exchange's capital risk.

If one of Ethena's exchanges goes bankrupt, the protocol may be forced to use leverage on positions at other venues to offset the delta of its portfolio until open positions are settled and the affected OES accounts The custodian can release the funds.

Additionally, if one of the custodians of Ethena’s OES accounts becomes insolvent, access to funds may be delayed, requiring the use of leverage on other accounts to hedge the portfolio.

General Cryptocurrency Risks

As is the case with many early crypto protocols, it is important to remember that depositors of Ethena face the risk that the protocol team may embezzle its users’ funds, as the Ownership of project keys is not yet decentralized.

While the vast majority of crypto projects face substantial exploitation risks related to potential vulnerabilities in their smart contracts, Ethena mitigates this risk by using OES escrow accounts, eliminating the need to use complex smart contract logic.

Summary

Ethena has protected their assets from exchange or custodian insolvency and has contingency plans in place to offset their assets in the event that they are frozen and unable to trade. Portfolio increment!

With many exchanges applying 0% discount to the value of stETH collateral and providing 50% maintenance margin requirements for Ethena-sized accounts, the protocol may cause a market for its collateral to close before liquidation The value loss is as high as 65%!

Negative funding rates may lead to yield compression and may lead to TVL losses, but they will not themselves lead to the implosion of USDe; the maximum annualized funding rate is -100%, and Ethena’s nominal loss is only every 8 hours 0.091% of the financing cycle!

On top of that, Ethena also has an insurance fund that can be used to replenish margin accounts to avoid liquidations, offset long-term negative funding yields, or act as an open buyers market for USDe!

While Ethena can absorb a certain amount of losses with an insurance fund, it's important to remember Murphy's Law, which reminds us that anything that can go wrong will go wrong, and at the worst time.

Imagine a situation where LST starts to decouple.

Centralized exchanges responded by reducing the collateral weight of liquid pledged ETH tokens, thereby reducing the maximum loss in market value that collateral Ethena could incur before liquidation.

Assuming the entire market also sells off during this period, funding rates will become negative, putting further pressure on Ethena’s collateral and pushing the protocol closer to liquidation and having to admit losses!

Ethena may not use leverage in the normal course of operations, but an unexpected bankruptcy of an exchange or custodian may temporarily freeze funds, requiring the use of leverage to offset portfolio increments.

Theoretically, a steep discount combined with a reduction in the collateral weight of leveraged accounts and liquid pledged ETH could bring Ethena's collateral within liquidation range.

Now that anyone in crypto can basis trade, Ethena’s assets under management could easily swell into the billions, meaning the liquidation of its massive ETH-collateralized portfolio could further dampen LST market value, thereby exacerbating Ethena's paper losses and opening the floodgates to death. The spiral ensues!

There is no doubt that the above series of events can only be the result of a catastrophic black swan event, but it is important to remember all the potential risks you face when participating in cryptocurrencies.

Like any project on the cryptocurrency front, Ethena has its risks, but for those who seize the opportunity early, participation can have huge benefits.

Whether you want to earn the double-digit APY that sUSDe offers, or you want to farm shards to maximize your potential Ethena airdrop allocation. There’s no better way to start your journey than after DYOR!

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