USDe may not be the next UST, but it implies unique risks.

Original | Odaily Planet Daily (@OdailyChina)

Author|Azuma(@azuma_eth)

With the rapid decline of the encryption market yesterday, the discussion on the risks of Ethena and its Stable Coin USDe was once again brought to the forefront.

Dune data shows that as of the publication, the supply of USDe has decreased from over 3.6 billion at its peak to about 3.1 billion, with a daily reduction of about 95 million. The reason for the circulation reduction of USDe is essentially the narrowing of the funding rateArbitrage space in the downward trend, even temporarily turning negative, and investors choose to reduce position out of risk aversion and adjustment of Arbitrage strategies.

In the context of the market’s partial panic, some users are also concerned that USDe may have difficulty handling large-scale redemption pressures, and some users even begin to compare USDe with UST, worrying that the former may experience a death spiral similar to the latter.

In our view, while USDe has its own risks, it is unfair to compare it with UST, as the differences in their design mechanisms determine that they are two completely different systems, and their response logic under pressure is also completely different. Even in the most extreme environment, USDe may only experience irreversible systemic trauma after several detectable extreme conditions occur (explained in detail below).

Ethena: funding rate Arbitrage protocol

For users who are not familiar with Ethena, you can read “An Analysis of Ethena Labs: Valued at 3 Billion USD, the Stable Coin Disruptor in Arthur Hayes’ Eyes” before reading this article.

In short, Ethena is essentially a funding rate Arbitrage protocol, where USDe is a new stablecoin collateralized by an equal amount of Spot long positions (currently only supporting ETH and BTC) and futures short positions.

The largest tag of USDe is “Delta Neutral”. The so-called Delta is an indicator used in finance to measure the impact of changes in the price of underlying assets on the portfolio. Considering the nature of USDe’s products, since the collateral assets of this stablecoin consist of an equal amount of Spot long positions and futures short positions, the Delta value of Spot Holdings is “1”, and the Delta value of the futures short positions exposure is “-1”, the Delta value after hedging is “0”, achieving “Delta Neutral”.

Compared to traditional Stable Coin projects, USDe stands out for its more imaginative potential for returns.

• One is the stable income from Spot longs stake. Ethena supports staking Spot ETH through Liquidity stake derivative protocols such as Lido, earning an annualized return of 3% - 5%.
• The second is the unstable income from the futures shorts funding rate. Users who are familiar with contracts understand the concept of funding rate. Although funding rate is an unstable factor, for short positions, the majority of the time, funding rate is positive in the long term, which means that overall income will be positive.

The combination of two sources of income has enabled Ethena to achieve a considerable rate of return (the latest protocol yield published on the Ethena official website is 8.83%, and the yield of sUSDe is 12.61%). In normal circumstances, it can sustainably outperform national debt-based products denominated in sDAI, making USDe the most attractive Stable Coin product in the current market.

• Odaily Note: The yield data provided on the Ethena website often has a latency of several days, and the latest data has not yet been updated.

The fundamental difference between USDe and UST

The story of UST has been over for too long, and old players may have forgotten its design model.

In Terra’s economic model, the stability of UST price is regulated by the Arbitrage system and protocol mechanisms. Market participants can mint UST by burning equivalent LUNA, and vice versa, they can burn UST to exchange for equivalent LUNA.

For example, if the demand for UST exceeds the supply (assuming a price of $1.01), arbitrageurs have the opportunity to on-chain destroy LUNA and mint UST, then take the price difference as profit on the open market; conversely, if the supply of UST exceeds the demand (assuming a price of $0.98), arbitrageurs can purchase 1 UST for less than $1, then destroy and mint $1 worth of LUNA for profit.

The design model of UST has two fundamental problems. Firstly, UST itself does not have sufficient value support and is entirely maintained based on Algorithm; secondly, in the extreme market situation where both UST and LUNA are falling, its built-in balance mechanism will lose its regulatory ability, and may even become a double-edged sword of the backlash system - the Arbitrage program will accelerate the decline of LUNA, thereby exacerbating panic.

This is also the fundamental difference between USDe and UST.

• USDe essentially still has sufficient “Spot+Futures” Positionsupport, and Guy Young, the founder of Ethena, also mentioned yesterday that the collateralization ratio of USDe has always remained above 101%, while UST made a commitment to anchor 1 US dollar without sufficient collateralization.
• In addition, the operation of UST must rely on LUNA, and the volatility of the latter’s token price will affect the system itself; whereas the operation of USDe is not tied to ENA, even if ENA goes to zero, it will not directly cause the system to collapse.

In light of such fundamental differences, USDe and UST have different response strategies when facing large-scale redemptions. When faced with the failure of the stabilization mechanism, UST had to seek external funding assistance such as Jump, while USDe only needs to ensure the smooth redemption of collateral assets, which involves the Close Position of futures and the sale of Spot (including already staked Spot). This part also carries independent risks, which will be discussed in more detail in the next section.

Four Layers of Risk for USDe

Columbia Business School professor and Zero Knowledge Consulting’s founder and managing partner Austin Campbell has written a detailed analysis of the potential risks of USDe, and we believe this is the best risk analysis of USDe in the current market.

Austin analyzed the four potential risks of USDe in the article.

• The first is the security risk at the stake level, namely whether the security and sustainability of the stake can be guaranteed. As mentioned earlier, Ethena will stake Spot ETH to earn stake income. However, if the stake protocol itself is attacked, it may cause a loophole in Ethena’s own collateral assets.
• The second is the security risk of the futures contract opening platform. Like stake protocol, both DEX and CEX are exposed to Hacker attack risk, which may also result in the loss of collateral assets.
• The third is the risk of contract availability. With the expansion of Ethena, the liquidity required for it is constantly increasing. Sometimes there may not be enough liquidity in the trading platform to short, in extreme cases, there may not be enough liquidity to close the position, or even the platform may disconnect the network (for example, at 312, assuming one side of the spot has been sold, and the other side of the futures cannot be closed)… This may cause the Arbitrage mechanism of Ethena to fail, and the protocol may face losses.
• Fourth, funding rate risk, which is also the current situation facing USDe. Although the funding rate for short positions is mostly positive, there is also a possibility of turning negative. If the comprehensive yield after weighted stake income is negative, it will inevitably cause outflow of protocol.

Since the market downturn, the funding rates of both BTC and ETH have temporarily turned negative, leading to losses for the Ethena protocol during these periods. As of the time of writing, the funding rates of BTC and ETH remain negative, so the protocol’s losses continue.

Market Outlook Prediction

In short, it is expected that the funding rate may continue to remain at a low level (including negative values) due to market panic in the coming period. This also means that USDe is likely to continue facing outflows, which in a sense is also a self-repair of the protocol.

However, from the design model of Ethena, the period of negative fee rate transactions was predictable, in other words, the current situation is a rare but inevitable state in the normal operation of Ethena. According to past historical patterns, the duration of positive fee rate periods is often longer, which also makes Ethena’s overall revenue expectations objective. However, at the turning point of the bear market, no one knows whether the historical patterns will still work.

We are more inclined to believe that, even if the downward trend continues, as long as the market does not experience too extreme a situation, Ethena will have enough time to process redemptions. The most pessimistic result here is that the circulation of USDe will be significantly reduced, but the operation of the protocol itself will still be effective.

Relatively speaking, the more dangerous thing is still the extreme market situation - mainly the third point of risk mentioned earlier, because the probability of the first two risks is relatively low - that is, the problem of contract liquidity of the trading platform itself, which will cause the malfunction of Ethena’s operation logic and irreversible damage to the protocol.