There are many risks with USDe, but it will not be the next UST.

Original | Odaily Planet Daily (@OdailyChina)

Author|Azuma(@azuma_eth)

With the rapid decline of the encryption market yesterday, the risk discussion about Ethena and its stablecoin USDe has once again come to the fore.

According to Dune data, as of the time of writing, the supply of USDe has been reduced from over 3.6 billion at its peak to about 3.1 billion, with a supply reduction of about 95 million yesterday. The reason for the reduction in USDe circulation is essentially the narrowing of funding rate and Arbitrage space under the downward trend, even temporarily turning into negative values. Investors have chosen to reduce their positions due to risk aversion and adjustment of Arbitrage strategies.

In the prevailing panic market sentiment, some users are concerned that USDe may not be able to withstand large-scale redemption pressure. Some users even compare USDe with UST, worrying that the former may experience a death spiral similar to the latter.

In our view, USDe certainly has its own risks, but it is not fair 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 circumstances, USDe will only experience irreversible systemic trauma after several detectable extreme conditions occur (as will be explained below).

Ethena: funding rate Arbitrage protocol

For users who are not very 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 essence, Ethena is actually a funding rateArbitrageprotocol. 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 label of USDe is “Delta Neutral”. Delta, in finance, is an indicator used to measure the impact of changes in the price of underlying assets on portfolio variations. Considering the nature of USDe’s product, the collateral assets of this stablecoin are composed 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 futures short positions is “-1”. After hedging, the Delta value becomes “0”, achieving “Delta Neutral”.

Compared to traditional Stable Coin projects, the biggest feature of USDe is its more imaginative yield space.

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

The combination of two yields has achieved a substantial return for Ethena (The latest protocol yield disclosed on the Ethena official website is 8.83%, and the yield of sUSDe is 12.61%). Under normal circumstances, it can sustainably outperform government bond-like yield 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 official website often has a latency of several days, and the latest data has not been updated yet.

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 UST price stabilization system is regulated through the Arbitrage system and protocol mechanisms. Market participants can mint UST by destroying an equivalent amount of LUNA, and conversely, they can destroy UST to exchange for an equivalent amount of LUNA.

For example, if there is more demand than supply for UST (assuming the price is $1.01), arbitrageurs have the opportunity to mint UST by on-chain burning LUNA, and then take the price difference as profit in the open market; conversely, if the supply of UST exceeds the demand (assuming the price is $0.98), arbitrageurs can buy 1 UST for less than $1, then burn and mint $1 worth of LUNA for profit.

There are two fundamental problems with the design model of UST. Firstly, UST itself does not have sufficient value support and is entirely based on algorithm maintenance. Secondly, in extreme market conditions where both UST and LUNA are falling, its built-in balance mechanism will lose its regulatory capacity and even become a double-edged sword for the backlash system - the Arbitrage program will accelerate the decline of LUNA and further exacerbate panic.

This is also the fundamental difference between USDe and UST.

• **USDe still has sufficient “Spot+ Futures” Positionsupport in essence, Ethena founder Guy Young also mentioned yesterday that USDe’s collateralization ratio has always remained above 101%, while UST has made a short commitment to peg $1 without sufficient collateral. **
• In addition, the operation of UST must rely on LUNA, whose price volatility will have an impact on the system itself; while the operation of USDe is not directly tied to ENA, even if ENA goes to zero, it will not directly cause the system to collapse.

In this essential difference, USDe and UST also have different response plans when facing large-scale redemptions. When UST faced the failure of the balance mechanism, it could only seek external funding assistance such as Jump, while USDe only needs to ensure the smooth redemption of the collateral assets - involving the Close Position of futures and the sale of Spot (including staked Spot), which also carries independent risks, as will be explained in the next section.

Four Layers of Risk for USDe

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

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

• First, there is the security risk at the stake level, that is, whether the security and sustainability of the stake can be guaranteed. As mentioned earlier, Ethena will stake Spot ETH to earn stake rewards, but if the stake protocol itself is attacked, it may result in a shortfall of Ethena protocol’s staked assets.
• The second is the security risk of the futures contract opening platform. Like stake protocol, both DEX and CEX are at risk of Hacker attacks, which may also lead to the loss of staked assets.
• Three is the availability risk of the contract. As the scale of Ethena expands, the required Liquidity is constantly increasing. Sometimes there may not be enough Liquidity in the trading platform to Short, and in extreme cases, there may not even be enough Liquidity to Close Position. The platform may even pull the network cable (for example, at 312, assuming that 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, thereby causing the protocol to face losses.
• The fourth is the risk of funding rate, which is also the current situation faced by USDe. Although the funding rate of 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, which has led to losses for the Ethena protocol during these periods. As of the time of writing, the funding rates of BTC and ETH are still negative, so the protocol losses continue.

Market Outlook

In summary, 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, which also implies that USDe is likely to continue to face outflows - outflows, to a certain extent, are also a self-repair of the protocol.

However, from the design model of Ethena, the time period of negative fees is predictable. In other words, the current situation is a relatively rare but inevitable state in the normal operation of Ethena. According to historical patterns, the duration of positive fee periods tends to be longer, which still makes the overall profit expectation of Ethena objective. However, at the turning point of a bear market, nobody knows whether historical patterns still work.

We tend 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 handle redemptions. The most pessimistic outcome here is that the circulation of USDe will be greatly reduced, but the operation of the protocol itself will still be effective.

Relatively speaking, the more dangerous one 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.