Original title: What potential risks will the fully collateralized semi-centralized stablecoin USDe bring?

1. Definition of USDe: a fully collateralized semi-centralized stablecoin

Stablecoins can be classified in many ways, such as:

(1) Full collateral and non-full collateral;

(2) Centralized custody and decentralized custody;

(3) On-chain issuance and centralized institution issuance;

(4) Permissioned and permissionless;

There will also be some overlap and changes. For example, in the past we believed that the supply and circulation of algorithmic stablecoins such as AMPL and UST were completely regulated by algorithms. According to this definition, most stablecoins are non-fully collateralized stablecoins, but there are exceptions, such as Lumiterra’s LUAUSD. Although its minting and burning prices are algorithmically regulated, the protocol vault provides no less than LUAUSD’s anchor value as collateral. LUAUSD both attributes of algorithmic and full collateral.

Another example is DAI. When DAI’s collateral is 100% of on-chain assets, DAI is a decentralized managed stablecoin. However, after the introduction of RWA, some of the collateral is controlled by real entities, and DAI becomes a stablecoin managed by both central and decentralized custody institutions.

Based on this, we can peel off overly complex classifications and abstract them into three core indicators: whether there is sufficient collateral, whether it is issued without permission, and whether it is de-custodial. In comparison, USDe and other common stablecoins have some differences in these three attributes. If we believe that [decentralization] needs to meet both the conditions of [permissionless issuance] and [de-custodial], then USDe does not meet the requirements, so classifying it as a [fully collateralized semi-centralized stablecoin] is suitable.

2. Collateral value analysis

The first question is whether USDe has sufficient collateral. Obviously, yes. As stated in the project documentation, USDe is collateralized by a synthetic asset of the crypto asset and the corresponding short futures position as collateral.

l Synthetic asset value = spot value + short futures position value

l In the initial state, spot value = X, futures position value = 0, assuming the basis is Y

l Collateral value = X + 0

l Assume that after a certain period, the spot price increases by “a” US dollar, and the futures position value increases by “b” US dollars (“a” and “b” can be negative). Position value = X + a -b = X + (a-b), and the basis becomes Y + ΔY, where ΔY = (a-b)

It can be seen that if ΔY remains unchanged, then the intrinsic value of the position will not change. If ΔY is a positive number, then the intrinsic value of the position will increase, and vice versa. In addition, for delivery contracts, the basis is generally negative in the initial state, and will gradually become 0 by the delivery date (regardless of transaction friction), which means that ΔY must be a positive number, so if at synthesis, the basis is Y, the value of the synthetic position on the delivery date will be higher than the initial position.

The asset portfolio of holding spot and shorting futures is also called “spot arbitrage”. This arbitrage structure itself is risk-free (but there are external risks). According to current data, constructing this kind of investment portfolio can earn about 18% low-risk annualized returns.

Let’s go back to Ethena. I didn’t find an accurate definition on the official website about whether to use delivery contracts or perpetual contracts (considering the depth of transactions, the probability of perpetual contracts is relatively high), but the on-chain address of the collateral and CEX distribution were announced.

In the short term, there will be some differences between the two methods. The delivery contract will provide a more “stable and predictable” rate of return, and the return to maturity will always be positive. The perpetual contract is a product with fluctuating interest rates, and the daily interest rate may also be negative under certain circumstances. But from experience, the historical arbitrage return of the perpetual contract will be slightly higher than that of the delivery contract, and both are positive:

1) Delta-neutral futures airdrops are essentially lending funds. Lending funds cannot maintain 0 interest rates or negative interest rates for a long time, and this kind of position stacks USDT risks and centralized exchange risks, so the required rate of return is > the risk-free return of US dollars.

2) For perpetual contracts, its users need to bear variable maturity yields and pay additional risk premiums.

Based on this, it is completely wrong to worry about “USDe” being insolvent or to compare USDe to UST. According to the collateral risk assessment framework introduced at the beginning of the article, USDe’s current core/narrow collateral coefficient is 101.62%. After taking ENA’s circulating market value of US$1.57 billion into consideration, the broad collateral coefficient can reach approximately 178%.

[Potential negative interest rates will cause USDe collateral to shrink] is not a big problem. According to the theorem of large numbers, as long as time is long enough, the frequency will inevitably converge to probability, and USDe collateral will maintain a growth rate that converges on the average funding rate in the long term.

To put it in a more popular way: you can draw one card from the playing cards an unlimited number of times. If you draw the big or small joker, you will lose 1 dollar. If you draw the other 52 cards, you can earn 1 dollar. With a stake of $100, do you need to worry about going bankrupt because you draw too many big or small jokers? It is more intuitive to look at the data directly. In the past six months, the average contract rate has only been below 0% twice, and the historical winning rate of futures and spot arbitrage is much higher than that of the poker drawing game.

3. Where are the real risks?

1. Market capacity risk

Now we have established that collateral risk is not something to worry about. But that doesn’t mean there aren’t other risks. Of greatest concern is the potential limit on Ethena’s contract market capacity.

The first risk is liquidity risk.

The current issuance of USDe is about 2.04 billion US dollars, of which ETH and LST total about 1.24 billion US dollars. This means that in the case of complete hedging, a short position of 1.24 billion US dollars needs to be opened. The required position size is proportional to the size of USDe.

The current ETH perpetual contract holdings on Binance are approximately US$3 billion, and 78% of Ethena’s USDT reserves are stored in Binance. Assuming that the funds are utilized evenly, this means that Ethena needs to open 2.04 billion61%78% = short positions with a nominal value of 970 million on Binance, accounting for 32.3% of open positions.

If Ethena’s position size is too high on Binance or other derivatives exchanges, it will have many negative impacts, including:

1) It may lead to greater transaction friction;

2) Unable to cope with large-scale redemptions in a short period;

3) USDe pushes up the supply of short positions, leading to a decrease in interest rates and affecting yields.

Although risks may be mitigated through some mechanical design, such as setting time-based minting/burning caps and dynamic rates (LUNA introduced this mechanism), the better way is not to put yourself at risk.

According to these data, the market capacity that the combination of Binance + ETH trading pairs can provide to Ethena is very close to the limit. But this limit can also be exceeded by introducing multiple currencies and multiple exchanges. According to Tokeninsight data, Binance occupies 50.1% of the derivatives trading market. According to Coinglass data, in addition to ETH, the total contract holdings of the Top 10 currencies on Binance are approximately three times that of ETH. It is estimated based on these two data:

USDe market capacity theoretical upper limit = 20.4 (628/800) * 60%/ 4 / 50.1% = 12.8 billion US dollars

The bad news is that the USDe has a capacity limit, but the good news is that there is still 500% room for growth before the limit.

Based on these two upper limits, we can divide the scale growth of USDe into three stages:

(1) 0-2 billion: This scale is achieved through the ETH market on Binance;

(2) 2 billion-12.8 billion: It is necessary to expand the collateral to mainstream coins with the highest market depth + make full use of the market capacity of other exchanges;

(3) More than 12.8 billion: Need to rely on the growth of the Crypto market itself + the introduction of additional collateral management methods (such as RWA, lending market positions);

It should be noted that if USDe wants to truly flip away from centralized stablecoins, it must at least surpass USDC to become the second largest stablecoin. It will be a big challenge because the latter’s current total issuance is approximately US$34.6 billion, which is 2.7 times the potential capacity limit of USDe’s second phase.

2. Custody risk

Another controversial point about Ethena is that the funds of the protocol are escrowed by third-party institutions. This is a compromise based on the current market environment. Coinglass data shows that dydx’s total BTC contract holdings are US$119 million, only 1.48% of Binance’s and 2.4% of Bybit’s. So managing positions through centralized exchanges is inevitable for Ethena.

However, it should be pointed out that Ethena adopts the “Off-Exchange Settlement’’ hosting method. Simply put, the funds managed in this way will not enter the exchange, but will be transferred to a special address for management, usually jointly managed by the principal (i.e. Ethena), the custodian (third-party custodian) and the exchange. At the same time, the exchange generates corresponding quotas in the exchange based on the scale of the custody funds. These funds can only be used for transactions and cannot be transferred; they will be settled according to the profit and loss afterwards.

The biggest advantage of this mechanism is precisely [eliminating the single point risk of centralized exchanges], because the exchange never really controls the funds and requires the signature of at least 2 of the 3 parties before it can be transferred. Under the premise that the custodian institution is trustworthy, this mechanism can effectively avoid exchange RUG (such as FTX) and project party RUG. In addition to Copper, Ceffu, and Cobo listed by Ethena, Sinohope and Fireblocks also provide similar services.

Of course, there is also the theoretical possibility of custodial institutions doing evil, but given that CEX still occupies absolute dominance and security incidents occur frequently on the chain, this kind of semi-centralization is a locally optimal solution, not the final form. But after all, APY is not free. The key is whether you should bear these risks in order to improve profits and efficiency.

3. Interest rate sustainability risk

USDe needs to be staked to obtain income. Since the staking rate will not be 100%, the rate of return of sUSDe will be higher than the derivatives rate. Currently, the USDe staked in the contract is about 470 million US dollars, and the staking rate is only about 23%. The underlying asset APY corresponding to 37.1% nominal APY is about 8.5%.

The current ETH staking yield is about 3%, and the average funding rate in the past three years is about 6-7%. The 8.5% underlying asset APY is completely sustainable, and whether the 37.1% sUSDe APY can be sustained will also depend on whether there are enough applications that commonly carry USDe to reduce the staking rate and bring higher returns.

4. Other risks

There are also contract risks, liquidation and ADL risks, operational risks, exchange risks, etc. You can visit Ethena and Chaos Labs to get more details.

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