Forward the Original Title：Stablecoin Evolution: USDe’s Impact on Decentralized Finance

Opening Remarks

Following the collapse of Terra, its associated UST, and the Anchor protocol in 2022, interest in decentralised USD-pegged options decreased but later recovered. Now, projects like Prisma, Liquity, and Lybra are at the forefront of innovation in the LSD/CDP area. Meanwhile, Maker and Curve have maintained their total value locked (TVL) without much change.

Source: Defillama

Many experts are questioning if the new project, EthenaLabs’ USDe, with its promising ~27% APY, can keep up these returns without leading unsuspecting investors into a situation similar to Anchor.

After announcing its funding on July 12, 2023, EthenaLabs has reignited interest in using LSTs (stETH) to create a US-dollar-linked digital currency for the DeFi world. This raises the question: will it open up new opportunities to make the most of Ethereum’s Layer 1 and its related Layer 2s, or could it quickly become the next major failure in the crypto market?

Why USDe and Stablecoins matter?

Stablecoins have become key players in the decentralised money markets, significantly influencing market dynamics. They are a major part of trading in both spot and futures markets, across centralised and decentralised platforms, highlighting their vital role in enabling transactions and adding stability to the volatile crypto market.

The stablecoin sector has seen remarkable growth, with on-chain transactions exceeding $9.4 trillion this year. Stablecoins represent two of the top five assets in DeFi, accounting for over 40% of the Total Value Locked (TVL). They dominate trading, with more than 90% of order book trades and over 79% of on-chain transactions involving stablecoins.

Source: X: Route2FI

AllianceBernstein, a leading global asset management firm with $725 billion in Assets Under Management (AUM), predicts the stablecoin market cap could reach $2.8 trillion by 2028. This forecast suggests a huge growth opportunity, from the current $138 billion market cap, which previously peaked at $187 billion.

The consistent performance and growing acceptance of stablecoins in both centralised and decentralised contexts highlight their indispensable role in the crypto ecosystem. With an anticipated 2000% increase, this presents a significant opportunity for investors and market participants to engage with projects like EthenaLabs’ USDe.

USDe aims to fulfil this growing demand by offering a censorship-resistant, scalable, and stable option for the market.

Project Overview

Drawing inspiration from Arthur Hayes’ “Dust to Crust” article, EthenaLabs is on a mission to create a derivative-backed stablecoin, addressing the significant issue of crypto’s dependence on traditional banking. Their goal is to provide a decentralized, permissionless savings product for a wide audience. EthenaLabs’ synthetic dollar, USDe, aims to be the first crypto-native, censorship-resistant, scalable, and stable financial solution, achieved through delta-hedging staked Ethereum as collateral.

EthenaLabs plans to introduce what they call the “Internet Bond” alongside USDe. This will be a crypto-native, yield-bearing, dollar-denominated savings tool. It’s built on the returns from staked Ethereum and leverages the funding and basis spread found in perpetual and futures markets, according to the EthenaLabs Gitbook.

EthenaLabs sets itself apart with a unique mission and an innovative approach. Unlike other CDP projects like Maker’s DAI, Liquity’s LUSD, and Curve’s crvUSD, EthenaLabs’ USDe generates its USD value and yields through two main strategies:

• Leveraging stETH and its inherent yield.
• Taking a short position on ETH to balance delta and capitalize on Perpetual/Futures Funding Rates.

This strategy allows the protocol to synthetically create a CDP that is delta-neutral, combining a spot deposit of stETH with a corresponding short position through partnerships with CEXs like ByBit, Binance, and others.

Holding Ethena’s sUSDe (staked USDe) essentially becomes a basis trade, balancing a spot stETH position against a short ETH position in the market. This setup offers users exposure to the yield differential between these positions, currently generating an approximate yield of ~27%.

Source: EthenaLabs Gitbook

USDe: Key Risks & EthenaLabs Mitigation

Before diving into the risk-to-reward analysis of staking USDe, it’s important to address several potential risks associated with EthenaLabs:

• CUSTODIAL RISK

EthenaLabs uses “Off-Exchange Settlement” (OES) providers to custody assets, which creates a reliance on these providers’ operational capabilities. Challenges in executing critical functions like deposits, withdrawals, and exchanges could impact the protocol’s efficiency and the mint/redeem functionality of USDe.

Mitigation Strategy: Diversifying Custody Providers: EthenaLabs minimizes risk by spreading collateral across multiple OES providers to manage concentration risk effectively.

• CENTRALISED EXCHANGE (CEX) FAILURE RISK

The protocol’s use of derivatives on centralised exchanges (e.g., Binance, Bybit) to balance the collateral’s delta poses risks, especially if an exchange becomes unavailable suddenly.

Mitigation Strategy: Diversification of CEX Avenues: By diversifying the exchanges where assets are held, EthenaLabs reduces the risk associated with the failure of any single exchange.

• COLLATERAL RISK:

The difference between the collateral asset (stETH) and the underlying asset in perpetual futures positions (ETH) introduces “Collateral Risk.” A significant bug in an LST could lead to liquidity issues.

Mitigation Strategy: Active Monitoring and Partnerships. EthenaLabs actively monitors the on-chain integrity of stETH and maintains connections with liquidity sources, ready to switch collateral if necessary.

• LIQUIDATION RISK

Staking stETH in short ETHUSD and ETHUSDT positions introduces liquidation risks if the ETH to stETH spread widens significantly.

Mitigation Strategy: Systematic Collateral Management: EthenaLabs has processes for rebalancing collateral, transferring assets, and utilising an insurance fund to protect against liquidation risks:

i. Systematic rebalancing of collateral:
Ethena will systematically delegate additional collateral to improve the margin position of our hedging positions in the event either risk scenario eventuates.

ii. Transfer Assets and Cycling collateral:
Ethena is able to cycle collateral delegated between exchanges temporarily to support specific situations.

iii. Insurance Fund Deployment:
Ethena has access to an insurance fund that we are able to rapidly deploy to support hedging positions on exchanges.

iv. Protect Collateral Value:
In the event of an extreme occurrence, such as a critical smart contract flaw in the staked Ethereum asset, Ethena will immediately mitigate the risk with the sole motivation being that we protect the value of the collateral. This includes closing the hedging derivatives leg to avoid liquidation risk becoming a concern as well as trading out of the affected asset into another.

• FUNDING RISK

Persistently negative funding rates could reduce the yield from Ethena’s operations.

Mitigation Strategy: Insurance Fund as a Yield Protector: An insurance fund acts as a safety net for times when the combined yield is negative, ensuring the collateral’s stability.

• STAKING WITHDRAWAL QUEUE/SLASHING RISK

Potential for long queues for ETH withdrawals and the impact of slashing events on stETH.

Mitigation Strategy: This is largely dependent on stETH and Lido’s performance, with limited direct mitigation strategies available from EthenaLabs.

• REGULATORY RISKS

Concerns over USDT, USDC, and DeFi regulatory controls could impact USDe’s growth in Total Value Locked (TVL) and user attraction and retention.

Mitigation Strategy: EU-Based Operation with MiCA Licensing: By aiming to operate under the EU’s MiCA regulations, EthenaLabs positions itself to adapt to regulatory changes effectively, reducing the impact of potential legal shifts.

EthenaLabs has developed a comprehensive approach to managing the various risks associated with its operations, emphasising the importance of diversification, active monitoring, and strategic planning to safeguard the protocol and its users.

Comparison to Anchor: Is the Yield Worth it?

Investors are encouraged to conduct their own research, particularly when considering USDe, which offers a notably high stablecoin yield of around 27%. This kind of yield draws parallels to the Anchor protocol, highlighting the systemic risks in the market where the failure of a single protocol could lead to broader financial turmoil.

The downfall of Anchor was primarily due to the inherent risks in UST’s design, which relied on a reflexive mechanism tied to the price of Luna. If Luna’s price were to fall significantly, it would risk a catastrophic devaluation of UST. Anchor offered yields on UST (or aUST) based on a fixed TerraExchangeRate, promising borrowers an annual rate of 19.45%, regardless of market conditions.

Moreover, the “real yield” from Anchor, derived from staked bAssets, was only about 5.81%, significantly lower than the payout rates. This discrepancy, coupled with its dependency on Luna’s performance, set the stage for a financial crisis.

For those looking to understand more about the collapse of Luna and UST, including the mechanisms of Anchor, we have previously covered this in detail in our research pieces titled “Demystifying Anchor” and “The Collapse of Anchor.”

For USDe, there are significant distinctions in how its yield is generated, the risks involved, and its marketing strategies, notably different from Anchor:

• Transparent Marketing: Unlike Anchor’s promotion of “risk-free” returns, USDe’s marketing is straightforward about the risks and rewards. The source of its yields, from perpetual contracts (perps) and staked Ethereum (stETH), is clearly communicated, setting realistic expectations.
• Genuine Real Yield: sUSDe doesn’t promise unsustainably high deposit rates. Instead, it offers actual yields derived from its underlying assets, avoiding the trap of incentivizing borrowers with rates that the assets’ yields can’t support.
• Avoiding Self-Collateralization: Differently from some models that use their own token for collateral, sUSDe relies on stETH. This shift in collateral basis from a project’s own token to a more stable asset like stETH changes the risk dynamics significantly. The focus moves from the speculative risk tied to a project’s token to the more manageable liquidity risks of ETH and stETH, along with the other mentioned risks.

Comparing USDe with UST’s downfall is misleading due to the fundamental differences in risk structures and operational models. The focus for USDe investors should be on understanding the specifics of perpetual funding, centralized exchange liquidity, and custodial risks rather than the unsustainable high yield strategies seen in UST’s model.

Overall, USDe’s approach to risk mitigation and product structure presents a more considered and potentially safer option compared to Terra’s UST. By leveraging native yields and carefully managing risks from derivative sources, USDe stands out not just for its yield opportunities but also for its strategic design and risk management practices.

Stellar Team & Support

The Ethena team, under the leadership of @leptokurtic_, has successfully completed three funding rounds, drawing substantial participation from central exchanges, market makers, DeFi innovators, and traditional finance institutions. This wide-ranging support underscores the project’s credibility and potential impact on the ecosystem.

Working under tight deadlines, the team has demonstrated exceptional planning and coordination skills, ensuring the protocol is ready for its mainnet launch. They have prioritized risk management and security, incorporating thorough audits before release.

Source: ICO Analytics: Ethena

The success of their Shard airdrop campaign highlights the market’s interest in decentralised synthetic dollars. With over $410 million in Total Value Locked (TVL) — a 135-fold increase since early December 2023 — the campaign has had an impressive start.

Source: @noxiousq Dune Analytics

This momentum indicates a strong demand for products like USDe, which has not only attracted significant TVL but also the attention of investors keen on supporting its vision. As USDe steps forward, it aims to usher in the next billion dollars in TVL to the DeFi sector, potentially opening up new opportunities akin to those seen during the Luna cycle. The future will reveal if this marks the beginning of another transformative phase in decentralised finance.

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