Ethena finance came across my desk yesterday - it seems to have taken CT by storm. When I landed on their website (ethena.fi), I was greeted with the possibility of 27% yield on a stablecoin and a cap table analogous to that of an NBA all star game. So, here I am - trying to decipher ponzinomics from real yield.

As an industry, when we hear about high yields on stablecoins, we’re predisposed to having an allergic reaction - given our encounter with Anchor & TerraLUNA. And I’ll be the first to admit, when I opened the Ethena landing page, I immediately thought, “oh shit, here we go again”. So, out of curiosity, I decided to dive in to the mechanism design and was pleasantly surprised by the lack of blatant ponzinomics.

Basics of the Mechanism Design:

In all fairness, it’s elegantly simplistic. The TL;DR is the following:

Ethena.fi tokenises a ‘delta neutral’ carry trade on ETH by issuing a stablecoin which represents the value of the delta neutral position. Their stablecoin, USDe, also collects the carry yield - hence their claim, an internet bond providing internet native yield.

Let’s get slightly into the weeds, the process works as follows:

1. Deposit stETH into the protocol, mint the equivalent amount of USDe against it
2. The stETH is sent to a custodian (i.e., Fireblocks or Copper), the value of the stETH is communicated to various CEXs
3. The protocol shorts ETH perpetual futures contracts, on various CEXs, against the collateral - effectively neutralising the delta of the deposited collateral.
4. The net result is a book that is long stETH and short ETH perp.
5. The delta neutral position is the collateral behind the USDe.

The ‘internet native yield’ is generated by adding the staking yield to the basis yield, this yield is then passed back to the holder of USDe. To be specific:

• The deposited asset, stETH, is yield bearing (it has positive carry) and,
• The hedge, short ETH perp, is yield bearing (it collects funding, on average)
• If all goes to plan, the book earns positive yield on both legs of this trade - that is to say: stETH yield + basis yield > 0.

Generally speaking, ETH is a good asset to use as the underlying due to it’s network effects and the possibility of yield on both legs of the trade. As we have seen, over and over again, the fastest way to bootstrap a network is to offer yield - participants of all types will do anything for yield. USDe is one of the few stables passing yield back to users, while the biggest names in the space (USDT & USDC) keep all the yield for themselves - I’m all for a yield bearing stablecoin. Furthermore, the seperation of the custody, execution and client is a positive step in the pursuit of risk mitigation - given the saga that was FTX, minimising counterparty risk is always a value add.

This an elegantly simple design, however, the astute market participant will point out that there are a myriad of assumptions that are required to hold in order for this mechanism design to work.

Assumptions and Risks:

Before we begin with this section, it’s prudent to note that the team at Ethena has made the risks abundantly clear and has not tried to obfuscate them - for this, I commend them.

My issue with projects of this nature is that in order to function, they need a large amount of assumptions to hold. The idea of conditional probability comes to mind - as the number of assumptions tends toward infinity, the conditional probability of all assumptions holding tends toward zero. Offering an APY that is 20% above the risk free rate means that you’re getting an additional 20% worth of yield as payment for taking on these risks. If we look at USDe as a tokenised claim on the cash flows of delta neutral position, we can begin to call a spade, ‘a spade’ and understand when the trade breaks down.

Position Risk:

This an an all encompassing label for the risks associated with hedging the book and the assumptions around the sources of yield.

1. Long stETH - they make the assumption that if the yield on the hedge were to go negative, the stETH yield will cover these losses. If this is not the case, then the collateral decays at a rate of basis yield - stETH yield. While this holds in theory - stETH yield is a fraction of the basis yield, these two cannot be thought of as opposite ends of a libra scale.
2. Short ETH - there are assumptions that this position, on average, pays. There is evidence that this is the case, however negative funding is no anomaly - this makes the hedge leg an expense as opposed to an income. I’ve yet to see a compelling backtest or theoretical framework explaing how Ethena flows will impact funding rates.
3. My general concern here is that as adoption of USDe increases, the demand to be long stETH and short ETH perp increases - this means that their source of yield is getting crushed from both sides. Just doesn’t sound like a good set up.

I have seen many graphs such as the one below, they highlighting that the carry trade has a positive yield 89% of the time. Generally speaking, the data seems to be in their favour.

• Funding tends to be positive, the longest streak of positive days was 110 while the longest streak of negative days was 13.
• On a quarter by quarter basis, Q3 ‘22 was the only quarter in the last couple years where the stETH + basis yield was negative. This included the period in which everyone had the ETH pow fork trade on.
• Exchanges tend to have a baseline funding rate - this mens that funding reverts to +10% APY when the market aren’t frothy.

The assumption is that if the combined yield is negative, users will withdraw their funds and the supply of USDe will shrink. Once enough short ETH perp positions have been unwound, the position will be profitable again. Moreover, they have an insurance fund that sits alongside the protocol - this fund is there to subside the yield when it’s negative. The fund will be seeded with VC capital + clip some yield on positive days. However, if the yield on the book is negative and the insurance fund has been emptied - participants need to redeem USDe or USDe begins to become undercollateralised. It’s worth noting that in this situation, participants need to redeem - there is little the protocol can do to fix this, it’s out of their hands.

Source: Velo Data

Above is the APY of being short ETH perp over the last 3 years - if we eyeball it, it’s not entirely clear that being short the contract in perpetuity is a great idea.

Generic Risks:

The following is a brief overview of some of the generic risks.

1. Liquidation risk - Ethena is using a derivative of spot ETH to collateralise a secondary short ETH perp position, stETH and ETH aren’t 100% fungible. This can be though of as a ‘dirty hedge’ - stETH and ETH trade at parity 99% of the time, but there is no mechanical link between the two. Should the exchange rate of stETH/ETH drop drastically, the short leg of the hedge is liable to be liquidated. More information of the specific mechanics of liquidation can be found here

Source: Ethena Labs

1. Custodial risk - Ethena relies upon “Off-Exchange Settlement” provider solutions to custody protocol backing assets, there is a dependence upon their operational ability. Loosely, this can be broken down into Accessibility and Availability risk, Performance of Operational Duties risk, Custodian counterparty risk.
2. Exchange failure risk - Ethena uses CEXs to hedge the long stETH position, should an exchange go down, the book would not be fully hedged and the uPnL will be lost.
3. Collateral risk - Ethena uses stETH as collateral, in the event of a loss of confidence in LidoDAO, the consequences could be wide and varying. For example, Lido could suffer from a slashing event, or a smart contract venerability, or any manner of ‘highly profitable trading strategy’.

Ethena Labs Risk Assessment

Concluding thoughts

I think this is a very interesting project - as far as a honest solution to the decentralised dollar problem, Ethena is a sector leader. They have come up with a brilliant mechanism to pass ‘crypto native yield’ to the user while keeping the stablecoin reasonably decentralised.

Let’s call a spade, ‘a spade’.

Ethena.fi collateralises stETH and shorts the ETH perp against it - it’s a classic cash and carry trade with the additional benefit of the long leg offering positive carry. They tokenise the ‘delta neutral’ book by issuing USDe against it, this USDe has rights to the cash flows generated by the ‘delta neutral’ position. This protocol is closer to a structured product that it is a vanilla stablecoin.

Most have spent enough time in the space to see through the marketing language, it’s an important skill to have. If we think about Ethena + USDe as a tokenised cash and carry trade, we can be more honest about the risks and assumptions. And, in all honesty, 27% APY for tokenising umpteen risks is probably reasonable compensation.

The core issue I see with this protocol is the assumptions around the persistence of yield - they rely on the short leg paying out bigly, and this is far from a guarantee. I don’t find the use of historical data and extrapolation convincing as Ethena itself introduces a material shift in the landscape - I think their impact, if successful, will be hard to reason about, a priori. The reality is that they introduce a massive demand to be long stETH and short ETH prep, which will compress the returns of that trade ~ their adoption means that their sources of yield get squeezed from both sides. There is no such thing as a free lunch.

Moreover, let’s say that their adoption is massive, but this compresses their yield down to 10% - is that sufficient compensation for all the risks mentioned above? What about at the risk free rate of 5%? Intuitively, there is a point where their success becomes their downfall and they cannot compensate holders of USDe for the risks they are taking. Neutralising the delta on the book and clipping the yield will be manageable in most states of the world - however when vol eventually picks up and systemic risk increases, this is not an easy position to maintain. Moreover, they cannot just take the position off, they are required to manage and maintain delta neutrality in all future states of the word.

Ponzinomics or Real Yield - our position is that this is real yield, however risky that yield may be.

This is an ambitious project, they should be commended on their idea and honesty about the risks facing holders. The risks are plentiful and holder get compensation to bear these risks. It will be an interesting project to follow and we wish them success.

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