Editor's note: On February 16, Ethena Labs, the developer of the Ethereum-based stablecoin USDe, completed a strategic round of financing of $14 million at a valuation of $300 million. Dragonfly, Brevan Howard Digital and Maelstrom, the family office of BitMEX founder Arthur Hayes, jointly led the investment, and PayPal Ventures, Franklin Templeton, Avon Ventures, Binance Labs, Deribit, Gemini and Kraken participated in the investment. It is reported that USDe is an Ethereum-based stablecoin, guaranteed by derivatives, and its biggest label 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 changes in investment portfolios, with a value range of "-1 to 1". The definition of "Delta neutrality" is that if an investment portfolio consists of related financial products and its value is not affected by small price changes in the underlying assets, such an investment portfolio has the nature of "Delta neutrality". Related reading: " With $14 million in financing, is it possible for Ethena Labs to reshuffle the stablecoin market? " To create USDe, Ethena allows users to use USD, ETH, or liquid pledge tokens as collateral. Crypto researcher ROUTE 2 FI analyzed Ethena Labs' synthetic dollar protocol, exploring its working principles, advantages, risks, and comparisons with other similar protocols. BlockBeats translated the original text as follows:

There are two DeFi protocols that really excite me this year: EigenLayer and Ethena Labs.

I’ve already covered EigenLayer in detail, this time I want to take a look at Ethena Labs and their crazy 27% APY.

Ethena is a synthetic dollar protocol built on Ethereum that aims to provide a crypto-native solution for currencies that do not rely on traditional banking system infrastructure and provide a globally accessible dollar-denominated savings tool - "Internet Bonds".

Ethena’s synthetic USD, USDe, will provide the first censorship-resistant, scalable, and stable crypto-native currency solution by delta-hedging staked Ethereum.

USDe will be fully collateralized transparently on-chain and can be freely combined in DeFi.

USDe’s anchor stability is ensured by delta-hedging derivative positions on collateral held by the protocol and by minting and redemption arbitrage mechanisms. “Internet Bonds” will combine returns from staked Ethereum with funding and basis returns from perpetual and futures markets.

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

Why are stablecoins so important?

Stablecoins are the most important tool in cryptocurrency.

In all major centralized and decentralized trading venues, whether in the spot or futures markets, the main trading pairs are denominated in stablecoins, and more than 90% of order book transactions and more than 70% of on-chain settlements are denominated in stablecoins.

Stablecoins have settled over $12 trillion on-chain, constitute two of the top five assets within the space, account for over 40% of the total value locked (TVL) in DeFi, and are by far the most widely used asset in the decentralized money market.

Centralized stablecoins, such as USDC or USDT, provide stability and capital efficiency, but also introduce some problems:

Pledges of bonds in regulated bank accounts introduce custody risk that cannot be hedged and is susceptible to scrutiny.

· Critical reliance on existing banking infrastructure and country-specific evolving regulations.

Users face a “risk-free return” situation because the issuer internalizes the benefits and transfers the decoupling risk to the users.

Decentralized stablecoins have historically experienced a number of issues related to scalability, mechanism design, and the lack of built-in returns.

"Ultra-collateralized stablecoins" have historically had problems scaling, as their growth is inevitably tied to the growth of leverage demand on Ethereum. Recently, some stablecoins have chosen to absorb treasuries in order to improve scalability, at the expense of censorship resistance.

"Algorithmic stablecoins" face challenges in their mechanism design and are found to be inherently fragile and unstable. We believe that these designs do not have sustainable scalability.

Previous “zero-risk synthetic dollars” were difficult to scale due to their critical reliance on decentralized trading venues that lacked sufficient liquidity.

Therefore, USDe offers the following benefits:

· Scalability with capital efficiency is achieved by leveraging derivatives, which allows USDe to scale with capital efficiency. Since the staked ETH assets can be perfectly hedged by an equal short position, synthetic USD only requires 1:1 "collateralization".

Provides stability through hedging operations executed immediately after issuance, which ensures that the synthetic dollar value of USDe is backed in all market conditions.

Censorship resistance is achieved by decoupling the backing assets from the banking system and storing the trustless backing assets in an on-chain transparent, 24/7 auditable programmatic custody account solution outside of decentralized liquidity venues.

How does it work?

A user deposits approximately $100 in stETH and instantly receives approximately $100 in USDe, minus any costs of executing the hedge.

Ethena Labs opens a corresponding short perpetual position for approximately the same USD value on a derivatives exchange. The received assets are transferred to an OTC settlement provider. The backing assets are retained on-chain and on OTC servers to minimize counterparty risk.

Ethena Labs delegates, but never transfers, backing assets to derivatives exchanges for use as collateral for short-term perpetual hedging positions. Ethena Labs generates two sustainable revenue streams from deposited assets.

The income returned to qualified users comes from:

· Stake Ethereum to receive consensus and execution rewards (3.5% annualized rate of return)

· Funds from hedging derivative positions and basis spreads. (5-20% annualized yield)

The return on staking Ethereum is floating and denominated in ETH. The return on funding and basis spreads can be floating or fixed. Funding and basis spreads have historically generated positive returns due to the mismatch between leveraged demand and supply in cryptocurrencies and the presence of positive baseline funding.

If the funding rate is deeply negative for a long period of time, such that the return on staked ETH cannot cover the funding and basis spread costs, the Ethena Insurance Fund will cover the costs. Historical returns can be viewed here.

Once a user stakes their USDe for sUSDe, they begin to automatically earn the protocol yield without any further action or cost. The amount of sUSDe a user receives depends on the amount of USDe deposited and when it was deposited. Ethena's sUSDe uses a "token vault" mechanism, the same as Rocketpool's rETH or Binance's WBETH.

The protocol will not re-stake, lend, or otherwise utilize deposited USDe for any purpose. Since the backing mechanism of USDe itself generates protocol yield, there is no need for any such operation. If the protocol suffers a loss due to funding or other reasons, Ethena's insurance fund will bear the cost, not the staking contract.

When users mint USDe, Ethena Labs opens a short position on the exchange.

When users redeem USDe, Ethena Labs closes short positions on exchanges.

Ethena Labs closes/opens positions on exchanges to realize unrealized P&L.

If the value of USDe in the external market is lower than the value provided by Ethena Labs, users can:

· Use USDC to buy 1 USDe at Curve at a price of 0.95.

Redeem 1 USDe from Ethena Labs at 1.00 and get ETH.

Sell ​​the acquired ETH for USDC on Curve.

Profit.

If the value of USDe in the external market is higher than the value provided by Ethena Labs, users can:

Mint USDe using ETH from Ethena Labs.

Sell ​​USDe for USDC in the Curve pool at > 1.00.

Buy ETH using USDC on Curve.

Profit.

What are the risks?

Funding cost risk

“Funding cost risk” involves the potential risk of continued negative interest rates. Ethena can earn income from funding, but it may also need to pay funding (equal to lower protocol returns).

The Ethena guarantee fund exists and will intervene when the yield on combined LST assets (such as stETH) and the funding rate for short-term unlimited positions is negative. This ensures that the collateral backing USDe is not affected. Ethena will not pass on any "negative yield" to users who pledge their USDe as sUSDe.

Combining the annualized stETH yield and funding rate values, only 10.8% of days have a total negative yield. This is a positive comparison compared to the approximately 20.5% of days that have a negative funding rate when stETH yield is not considered.

If you remember Anchor Protocol’s yield reserve, the Ethena Guarantee Fund will operate in a similar manner, supporting yields on “negative” days.

Liquidation Risk

Ethena uses collateralized Ethereum spot assets that are collateralized on short-term derivatives positions. Ethena uses collateralized Ethereum assets, such as Lido's stETH, to collateralize short-term ETHUSD and ETHUSDT perpetual positions on CeFi exchanges. Therefore, the collateral asset used by Ethena is stETH, which is different from the underlying asset ETH of the derivatives position.

The spread between ETH and stETH must widen to 65%, which has never happened in history, with the historical maximum being 8% (before Shapella and before the Luna depeg in May 2022), before Ethena's positions will begin to be gradually liquidated and Ethena will suffer realized losses. USDe's peg stability is automated through programmatically based delay-neutral hedging with the underlying collateral asset. See @CryptoHayes's "Dust on Crust".

In order to mitigate the “liquidation risk” caused by the above risk scenarios:

Ethena will systematically delegate additional collateral to improve the margin profile of our hedged positions in case any risk scenarios materialize.

In the event of any risk scenario, Ethena is able to temporarily cycle delegated collateral between exchanges to provide support in specific situations.

Ethena can leverage our insurance fund and deploy quickly on exchanges to support hedge positions.

In the event of an extreme situation, such as a critical flaw in an Ethereum smart contract, Ethena will immediately take steps to mitigate the risk, with the sole motivation of protecting the value of the collateral. This includes closing hedge derivative positions to avoid liquidation risk becoming the focus, and trading the affected assets into other assets.

Custody Risk

Since Ethena Labs relies on the solutions of "Off-Exchange Settlement" providers to custody the assets supporting the protocol, it is dependent on their operational capabilities. Ethena's capabilities include depositing and withdrawing assets on exchanges and conducting entrusted transactions. If any of these capabilities are unavailable or compromised, it will hinder the trading process and the availability of USDe's issuance and redemption functions.

Risk of Exchange Failure

Ethena Labs uses derivatives positions to offset the risk 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 deal with the consequences. This is the "exchange failure risk".

Collateral Risk

In this case, “collateral risk” refers to the fact that the collateral asset of USDe (stETH) is different from the underlying asset of the perpetual futures position (ETH).

Currently, all protocols that rely on stETH (and any ETH LST) are subject to this liquidity risk profile. This means that the amount of stETH that can be unstaked may be subject to delays, or users may have to accept a slight discount if it needs to be traded immediately in external markets.

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

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

discuss

OK, that was a fairly technical introduction. Now let’s look at why this product is interesting.

27.6% annual interest rate

Profits come from using LSD ETH as collateral for a 1x ETH short position

LSD ETH income + short ETH financing rate = sUSDe income

An upcoming airdrop (called Ethena Shards) will last for 3 months or until USDe supply reaches $1 billion

Provide LPs + lock LP tokens = 20 times Shards per day

Buy and hold USDe = 5 times Shards per day

· Stake and hold sUSDe = 1x Shards per day

TVL is growing pretty fast right now: $300 million to date

All stability pool capacities are currently full (expect them to remove the cap, this is just my hunch)

Lower smart contract risk, but higher centralization risk (funds are on centralized exchanges), works best in bull markets (when people are borrowing leverage) (don’t expect funding rates to be positive when everyone wants to short ETH)

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

One thing that is hard for people to understand is why we need financing rates.

The funding rate is set up to ensure that the funding mechanism keeps the futures market price consistent with the index spot price: whenever there is too much demand for long-term ETH, the ETH perpetual price > ETH spot price, so CEX needs some way to reduce people's motivation to continue to increase their positions.

Therefore, the funding rate is a way to maintain a dynamic balance between the futures market price and the index spot price. Since the entire market is biased towards bullishness, i.e. longs > shorts, if you short ETH, you will receive the profits earned by those who are long ETH to offset the overwhelming demand that pushes the ETH perpetual price closer to the ETH spot price.

AllianceBernstein, a global asset management company with $725 billion in assets under management, predicts that the market value of stablecoins will reach $3 trillion by 2028. If we look at the market today, the market value of stablecoins is currently $138 billion, with a peak of $187 billion. This means that there is a potential growth space of up to 2,000%.

In addition, Ethena has received $140 million in investment from top global investors, including @binance, @CryptoHayes, @Bybit_Official, @mirana, @lightspeedvp, @FTI_US, etc. Notably, angel investors include @dcfgod, @cobie, and @blknoiz06.

Ethena has a really nice dashboard that you can monitor here, which gives at least some peace of mind in terms of risk.

Disadvantages of Ethena

In simple terms, it's just a basis trade. When the yield curve inverts, you start losing money, and the larger the stablecoin, the more money you lose. Right now people who are long ETH pay people who are short ETH. This situation may continue for a long time, especially in a bull market. But at some point, the yield curve will invert and people will short ETH and make a profit. At this time, Ethena will suddenly have to bear this cost. They have their insurance fund to temporarily solve this problem. But as the yield on sUSDe decreases, I suspect people may want to withdraw their funds. That being said, it's not a fatal spiral. It's just that people may want to look for yield elsewhere.

Using stETH as collateral provides a margin of safety against negative interest rates. This means that Ethena only cares about those days when ETH funding is more negative than stETH yields. However, stETH liquidity is very important for anchoring. Without sufficient stETH liquidity, USDe cannot scale to $100 billion.

Assume the following happens:

User redemption

Insurance funds can be used for coverage. According to Ethena, every $1 billion of USDe can survive almost all pessimistic funding rate forecasts (Chaos Labs says $33 million per $1 billion).

The biggest risk to this project is probably not explosive growth, but that more people will consider locking their funds in non-yielding tokens instead of choosing “trusted” alternatives (I’m just pointing out Lindy stablecoins like USDT or USDC, not saying these are better, but since they’ve been around for a while, most people trust them more).

· Counterparty risk from CEXs and smart contracts is probably one of the biggest issues. According to @tbr90, the long-term risk is a slow drain as negative rates eventually deplete the insurance fund, which then forces a slow unlock.

As Cobie points out, people can make this kind of trade themselves.

For example, short ETHUSDT and get funding every 8 hours, while going long stETH or mETH (to get higher temporary yields). There is no 7-day staking queue, and the risk is your choice, but you must rebalance yourself.

Ethena founder @leptokurtic_ agreed, but noted: “Ethena Labs is not about saving you the hassle of executing cash transactions. What’s exciting is being able to tokenize this asset, make it extremely liquid through DeFi and CeFi, and then allow novel use cases to be built on top of this, snapping together different money legos.”

Regardless, I like this project. It brings something new and interesting to the table. I can see perpetual swap DEXs implementing their stablecoins and DeFi protocols looking to use it as a currency lego, similar to what happened with EigenLayer and the re-collateralization narrative.

People may remember that I was a big fan of Anchor Protocol, and Ethena seems to be a healthier way to do things. Personally, I think chasing a 20% annual yield in a bull market is not much better than pursuing bigger opportunities, so I may not use the protocol often, but I will participate in airdrops.

Another thing I don’t like is that it takes 7 days to redeem from staking and 21 days to redeem from LPs. If I could unstake instantly, I would consider using it when I need to stay away from the market for a while, but 7 days is a long time to wait in crypto.

That being said, they may implement sUSDe in several DeFi protocols so that you can get yield on trading or mining etc. I will try to use it more when these solutions are implemented.

Overall, positive attitude towards the product, even if this rant may seem a bit negative.