Recently, the algorithmic stablecoin Ethena, launched on Binance, has once again sparked market discussions. In previous bull cycles, there has always been a wave of hype around algorithmic stablecoins like Basis and Luna. So, what innovations does Ethena bring to the table? Does Ethena have the potential to become the largest algorithmic stablecoin? What potential crises and risks might Ethena face?

What is Ethena

Ethena, the developer behind the Ethereum-based stablecoin USDe, aims to provide a scalable form of crypto-native currency to realize a truly decentralized financial system. Simultaneously, they aim to offer a globally accessible savings tool denominated in USD - the “internet bond.” \

The inspiration for this product originated from a concept proposed by Arthur Hayes, the founder of BitMEX. In March 2023, Arthur outlined the idea of creating a new type of stablecoin called the “Satoshi Dollar,” which would be backed by an equal amount of BTC spot longs and futures shorts. Ethena Labs was inspired by this concept, although they chose ETH instead of BTC as the primary asset underlying USDe. That is, the collateral assets for USDe consist of an equal amount of ETH spot longs and ETH futures shorts. In Ethena, there are three key components: USDe, sUSDe, and internet bonds.

USDe

USDe: An Ethereum-based stablecoin collateralized by derivatives. Ethena allows users to create USDe by collateralizing with USD, ETH, or liquidity tokens.

sUSDe: Rewards obtained by staking Liquid staking chips and funding rates. Initially, 1 sUSDe is equal to 1 USDe, but over time, 1 sUSDe becomes greater than 1 USDe.

Internet Bonds: Built on the foundation of USDe, internet bonds combine Ethereum’s yield rates with funding and price differentials from perpetual swaps and futures markets, creating the first on-chain crypto-native “bonds” that serve as USD-denominated savings tools accessible to users in permissible jurisdictions.

Where does Ethena’s astonishing staking rewards come from?

Currently, sUSDe offers an annualized rate as high as 35.4%. Many people are swapping their USDT, USDC, and other stablecoins for USDe issued on this platform. So, where does this astonishing staking yield come from?

Ethena also supports staking spot ETH through liquidity staking derivatives protocols like Lido, earning an annualized return of 3% to 5%. This is combined with the yield from ETH short positions (funding rates are typically positive for longer periods than they are negative, meaning longs pay fees to shorts). Therefore, the combination of these two yield rates contributes to the significant high yield of USDe. In this process, the core mechanism of Ethena’s product—Delta neutrality—plays a crucial role.

Delta: In finance, it’s a measure of the sensitivity of the value of an asset or portfolio to changes in the price of the underlying asset. It ranges from -1 to 1. Delta neutrality means that if a portfolio is composed of related financial products and its value is not affected by minor changes in the underlying asset’s price, then the portfolio has delta-neutral characteristics. For example, if the price of ETH is $1, when creating 1 USDe, 1 ETH is used as collateral to short 1 ETH in derivatives trading. Regardless of whether the price of ETH falls to $0.1 or rises to $100, through the hedging mechanism of short contracts, the value of 1 ETH in the contract can always be maintained at $1, thus achieving fund balance. This creates a native decentralized and equally collateralized synthetic dollar, ensuring that 1 USDe is always equivalent to $1, reflecting the core value of a stablecoin.

Will Ethena be the next Luna?

Due to Ethena Labs’ efforts in promoting Arthur’s vision, Arthur himself has directly participated in a significant amount of USDe minting. He publicly stated on Platform X: “USDe will surpass USDT to become the largest dollar stablecoin in the market.” However, will Ethena truly become the world’s largest dollar stablecoin? What potential risks and crises does it face?

Collateral Decoupling Risk: If Ethena’s LST collateral becomes decoupled from ETH, it may prevent ETH shorts from effectively capturing market fluctuations, potentially resulting in protocol losses. Historical examples of LST decoupling, such as stETH experiencing discounts of nearly 8% during certain events, have occurred.

Funding Rate Risk: While Ethena’s backtesting shows that using ETH as collateral can reduce the number of days with negative returns, funding rates may turn negative, as seen in protocols failing due to inverted yield curves in the past.

Counterparty Risk: While using OES custody accounts mitigates the risk of deploying users’ collateral to centralized exchanges, exchange bankruptcies could still result in losses. Ethena needs to take measures to reduce exchange capital risks, such as settling profits and losses at least daily.

General Cryptocurrency Risks: Depositors in Ethena face the risk of the protocol team misappropriating funds and risks associated with potential smart contract vulnerabilities. However, Ethena reduces the latter risk by using OES custody accounts, eliminating the need for complex smart contract logic.

Trader Strategy Errors: Trader strategy errors pose risks of losses from opening perpetual contract positions on CEXs and misjudging the trend of stablecoin supply-demand, resulting in making money while stablecoin supply-demand stagnates.

Cryptocurrency influencer Haotian tweeted that Ethena’s entry point, anchored by contract market reverse hedging positions, requires continuous observation. The platform’s intention to expand stablecoin issuance inevitably positions it as a “major short” in the market. While issuing stablecoins may be beneficial in a continuously bullish market, if the platform leans more toward profit motives and seeks to maximize profits through trading strategies, the challenges will be significant in the currently unstable trading market, especially in Ethereum DeFi protocols already facing constraints.

Summary

The cryptocurrency market has a native demand for algorithmic stablecoins, with each bull market cycle giving rise to a wave of enthusiasm. However, after a period of hype, algorithmic stablecoins often experience a major collapse, especially following the collapse of Luna, which caused significant panic in the market. While Ethena has innovation in its design mechanism, it also carries significant potential risks. During bull markets, Ethena may still thrive under capital drive. However, maintaining Ethena’s extremely high yield during bear markets is challenging, and ultimately, it may still face the cycle of spiraling downward.

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