Introduction

Ethena aims to create a scalable, crypto-native currency that advances the financial system. Ethena’s synthetic dollar, USDe, hedges against Ethereum collateral, providing a stablecoin for the crypto market and creating a fully transparent, censorship-resistant, and permissionless system through its synthetic dollar USDe and “Internet bonds.” This system not only enhances the stability and scalability of cryptocurrencies but also reduces reliance on traditional banks, fostering the independence and healthy development of the DeFi ecosystem.

The Stablecoin Market

Stablecoins are the backbone of the crypto world, seen as digital assets suitable for global markets. Their significant market influence makes them a crucial tool in the crypto field. Stablecoins play vital roles in the spot and futures markets of trading platforms, with over 90% of order transactions and more than 70% of on-chain settlements conducted in stablecoins. As of 2023, the on-chain settlement amount of stablecoins has exceeded $12 trillion, representing more than 40% of the total TVL in DeFi. Alliance Bernstein predicts that by 2028, the stablecoin market could reach $2.8 trillion, indicating huge growth potential. The popularity of stablecoins in both centralized and decentralized platforms highlights their indispensable role in the crypto ecosystem.

For a truly decentralized financial system to operate at scale, transaction funds and core financing collateral must rely on stable assets that do not depend on traditional banking infrastructure. However, centralized exchanges need reliable and transparent stablecoins for their order books, while DeFi faces risks due to its reliance on USDC, which has centralized control. Reducing the dependence of crypto infrastructure on traditional banking is one of the industry’s most critical challenges today.

The Stablecoin Trilemma

Stablecoins come in three main types: over-collateralized, fiat-backed, and algorithmic. Each type addresses part of the stablecoin trilemma (decentralization, stability, and scalability) but always sacrifices one aspect, an unavoidable issue for stablecoins.

Fiat-backed stablecoins (e.g., USDC, USDT)

• Stability: Maintained by authorized participants (e.g., market makers) through minting and arbitrage mechanisms, pegged to the dollar to ensure stability.
• Scalability: Highly scalable and capital efficient due to the 1:1 collateral structure.
• Decentralization: Highly centralized, with holders facing counterparty risk (e.g., bank solvency, asset freezes) and censorship risk.

Over-collateralized stablecoins (e.g., DAI)

• Stability: Anyone can mint or redeem DAI by providing collateral, and utilizing arbitrage mechanisms to maintain stability.
• Scalability: Limited scalability, primarily serving leverage needs. Compared to other DeFi products like Aave, it has weaker scalability.
• Decentralization: Relatively decentralized but partially relies on centralized stablecoins and government bonds as collateral.

Algorithmic stablecoins

• Scalability: Highly capital efficient and scalable, no need for external collateral minting, and distributes rewards to participants when demand exceeds supply.
• Decentralization: Relies on crypto-native collateral, maintaining decentralization.
• Stability: Poor stability performance, as it is supported only by endogenous collateral, prone to systemic risk, and may ultimately collapse into a “death spiral.” All attempts at algorithmic stablecoins to date have faced similar failures.

USDe

• Stability: USDe is fully backed by delta-neutral positions, balanced by staking ETH and shorting ETH in perpetual contracts. Authorized participants can exchange USDe for the underlying collateral, ensuring stability. While this design is innovative, it does come with some risks.
• Scalability: USDe performs excellently in scalability for two reasons. First, like fiat-backed stablecoins, Ethena can mint its collateral at a 1:1 ratio. However, unlike fiat-backed stablecoins, Ethena can generate returns for its holders. Specifically, USDe can be staked into sUSDe to earn protocol yields, which combine stETH yields and funding rates.

Comparison with Traditional Stablecoins

Comparing Ethena’s cryptocurrency with traditional stablecoins shows some significant differences that highlight Ethena’s innovative approach. Here is a detailed look at these differences.

Centralization vs. Decentralization

Traditional stablecoins (like USDC and USDT) are usually controlled by centralized institutions with low transparency regarding their reserves, raising concerns about their reliability. In contrast, Ethena’s cryptocurrency (USDe) operates in a decentralized framework, aiming for high capital efficiency and stability without central control, making it a strong competitor in the stablecoin market.

Yield Opportunities

Traditional stablecoins (like Tether) usually do not offer returns to holders, limiting their use beyond being a medium of exchange. Ethena’s cryptocurrency (USDe) is designed as a decentralized, yield-generating asset, providing users with the potential for returns, and enhancing its appeal as an investment tool.

Stability and Scalability

Traditional stablecoins (like Terra’s UST) often face increased risks in maintaining their peg, which can undermine user trust and the token’s utility. Ethena’s cryptocurrency (USDe) focuses on stability and capital efficiency, offering a scalable and stable solution to these common problems.

Risk and Reward

Traditional stablecoins usually transfer all risks to users while keeping all rewards for themselves, creating a one-sided benefit structure. Ethena aims to balance risk by providing a decentralized platform and distributing rewards more fairly among users.

In summary, Ethena’s USDe offers a strong alternative to traditional stablecoins by addressing key issues such as centralization, yield opportunities, stability, and scalability. Its innovative approach could redefine what users expect from stablecoins, making it an important player in the DeFi space.

Risk and Risk Control

Ethena clearly explains the risks associated with USDe, the data backtesting they have done, and their risk management plans.

Capital Risk

Ethena hedges its digital asset collateral using derivative positions like perpetual contracts. A prolonged negative funding rate could lower Ethena’s returns. While Ethena earns returns from funding, it sometimes needs to pay funding as well. Although this poses a direct risk to protocol yields, data shows that negative yields typically do not last long and eventually return to a positive average. In the past three years, ETH funding rates have ranged from 6% to 8%, and using LST collateral (like stETH) can provide annual returns of 3%-5%, adding an extra layer of safety against negative funding.

Source: Ethena documentation

Risk Control Strategy: Ethena has a reserve fund to step in when LST (like stETH) assets and short perpetual positions have negative funding rates, protecting USDe’s stability. Additionally, Ethena ensures that any “negative yields” are not passed on to sUSDe users.

Liquidation Risk

Ethena uses spot ETH and BTC as collateral for short derivative positions and staked Ethereum assets as additional collateral. When the value of the collateral falls below the maintenance margin required by the exchange, user positions are gradually liquidated. Although liquidation poses a risk, Ethena uses stETH and other products as collateral, which increases in value when prices rise, reducing the risk of forced liquidation.

Risk Control Strategy: Ethena systematically adds extra collateral to improve the margin of hedged positions. Furthermore, Ethena can rotate collateral between exchanges and quickly deploy reserve funds to support hedged positions. In extreme cases (such as a significant drop in the value of staked Ethereum assets), Ethena will take quick action to protect asset value.

Custody Risk

Ethena’s funds are held by third-party custodians, which is a compromise in the current market environment. The operational capabilities of these custodians are crucial; if they encounter issues with deposits, withdrawals, or exchanges, it could affect the protocol’s efficiency and the minting and redemption of USDe.

Risk Control Strategy: Ethena uses “Off-Exchange Settlement” custody, where funds do not actually enter the exchange but are jointly managed by Ethena, the custodian, and the exchange. This mechanism eliminates the risk of a single point of failure at centralized exchanges, ensuring fund safety.

CEX Risk

Ethena uses derivative positions to offset incremental protocol support assets, and these positions are traded on multiple centralized exchanges (CeFi). If these exchanges suddenly become unavailable, Ethena faces risks. Additionally, there is counterparty risk for Ethena’s short trades on these exchanges.

Risk Control Strategy: Ethena manages and controls collateral assets through over-the-counter (OTC) service providers, reducing potential losses if a single exchange encounters issues. If an exchange fails, Ethena will transfer collateral to other exchanges and hedge unliquidated positions. Additionally, Ethena continuously integrates new liquidity sources to mitigate exchange risk.

LST Asset Risk

Since Ethena uses stETH and other LST to secure delta-hedged derivative positions, the integrity and confidence in these assets are crucial. Ethena must ensure that the price difference between these assets is minimal to avoid decoupling risks.

Risk Control Strategy: Ethena uses staked Ethereum assets (like stETH) as a margin for ETHUSD and ETHUSDT perpetual positions on centralized exchanges. Since the Shanghai upgrade, the price difference between stETH and ETH has never exceeded 0.3%, reducing the likelihood of this risk.

Summary

Ethena aims to minimize the risks associated with USDe by implementing clear risk management measures and maintaining transparent operations. These efforts not only safeguard investors’ interests but also build market trust and confidence in Ethena’s stablecoin. Beyond the risks outlined by Ethena, there are additional risks such as contract risks and operational risks.

Conclusion

Stablecoins have always been crucial in the cryptocurrency sector, holding a significant place in the market. The market continually seeks ways to achieve stable and sustainable returns through stablecoins. Ethena’s unique design has met this challenge. Its innovative approach offers a new choice for the stablecoin market, potentially influencing the future of the DeFi ecosystem profoundly.