What is Ethena and USDe?

According to Ethena Labs, “Ethena is a synthetic dollar protocol on Ethereum which aims to provide the first censorship resistant, scalable, onchain form of money: USDe”. Ethena is the protocol in which the stablecoin USDe lives.

USDe is backed by cryptocurrencies (ETH and BTC mostly) and it maintains its 1:1 peg to the US dollar by “delta hedging staked Ethereum (and Bitcoin) collateral, eliminating exposure to any fluctuations in value of the collateral backing the synthetic dollar”.

This means that every time someone sends cryptocurrency to Ethena to mint USDe, Ethena will open a short position in centralized exchanges for the same amount. If the collateral increases in value, the short position losses value and vice versa, always cancelling out, and thus maintaining the 1:1 value between USDe and the US dollar.

According to the founder of Ethena Labs, USDe has been the fastest growing stablecoin measured in market capitalization since the time of launch.

Source: https://x.com/leptokurtic_/status/1777352115230224689

Additionally, USDe generates yield from two sources: funding payments from the short positions in centralized exchanges, and rewards from staked ETH. Generating yield for their holders is a major differentiation compared to other stablecoins, as USDT and USDC, the largest stablecoins, don’t pay any “native” yield to their holders.

What are the risks that Ethena faces for maintaining the USDe peg?

Ethena Labs disclosed a series of risks for USDe as a synthetic dollar: funding risk, liquidations risk, custodial risk, exchange failure risk and collateral risk.

In this article we focus on the funding risk. According to Ethena Labs, “Funding Risk relates to the potential of persistently negative funding rates. Ethena is able to earn a yield from funding, but could also be required to pay funding”.

This means that under “normal” market conditions there is a bias in the Ethereum and Bitcoin perpetual futures market for traders to open long positions. As a result, traders with long positions pay a funding rate to traders with short positions (the case of Ethena).

However, risks arise for Ethena when cryptocurrency markets experience sharp price corrections and the funding rate becomes negative as traders liquidate their long positions and others want to open short positions. In this case, traders with open short positions (the case of Ethena) are required to pay to traders with open long positions.

In case of negative funding rates, Ethena will be required to pay traders with long positions in order to keep its short positions open. For this “an Ethena reserve fund exists” to “..protect the spot backing underpinning USDe”. Ethena absorbs all payments due to negative funding rates as holders of USDe are not responsible for any.

The central question is whether Ethena’s reserve fund will be enough to absorb all negative funding rate payments, in order to avoid their short positions being liquidated.

To answer this we asses if the current reserve fund would be appropriate to sustain all funding payments in the event of a large negative funding rate scenario as shown in the chart below. This scenario:

• Takes into account historical Ethereum funding rates one month before and after the Ethereum Merge that occurred in September 15th, 2022 (highly negative funding rates).
• Models funding rates (and payments) at different market caps for USDe, from $2 Billion (around current market cap) to $10 Billion.

Source: CryptoQuant Research.

Under this conditions we conclude that:

• The current reserve fund ($32.7 million) would be enough to cover funding payments in this scenario as long as USDe market cap is not larger than $4 billion (current market cap is $2.4 Billion).
• Funding payments become larger as USDe market capitalization increases (as short positions also become larger).
• To safely manage the extraordinary event of large negative funding rates at larger market capitalizations of $5, $7.5 or $10 billion, the reserve fund would need to increase to about $40, $60 and $80 million, respectively.

This analysis suggest that investors should monitor if Ethena’s reserve fund is appropriate for the market capitalization of USDe in order to handle periods of extremely large negative funding rates.

We extend the previous analysis to also take into account another negative event that occurred a few months after the Ethereum Merge: the collapse of FTX exchange in November 8th, 2022 (see chart below).

Source: CryptoQuant Research.

Under these conditions we conclude that:

• The current reserve fund ($32.7 million) would be enough to cover funding payments as long as USDe market cap is not larger than $3 billion (current market cap is $2.4 Billion).
• To safely manage the extraordinary event of large negative funding rates at larger market capitalizations of $4 billion, $5 billion, $7.5 billion or $10 billion, the reserve fund would need to increase to about $40 million, $50 million, $80 million and $100 million, respectively.

Another important metric to watch: The Keep Rate.

USDe generates yield (revenue) for its users mostly through the funding payments Ethena receives from its open short positions in centralized exchanges. However, some of these revenues are kept by Ethena and go to the reserve fund. How much of the total yield goes to the reserve fund, the keep rate, is a key consideration in order to grow the reserve fund large enough to withstand periods of extremely negative funding rates. For example, a 0.5 keep rate means that Ethena sends 50% of the total yield generated to the reserve fund.

In this sense, we model the funding rate conditions that happened during the previous cryptocurrency bear market from November 2021 to January 2023 (see the chart below) to analyze the cumulative funding revenue Ethena would have had in those conditions and what would have happened to the reserve fund at different keep rates.

Source: CryptoQuant Research.

The key take aways are:

• Even during bear markets, funding payments remain mostly positive (Ethena gets revenue) and the reserve fund grows (November 2021 to August 2022 in the chart).
• However, extreme events like the Ethereum Merge and the collapse of FTX exchange can cause a significant drawdown to the reserve fund in a matter of days.
• In order for Ethena to withstand a bear market period like the one shown here, it would need to sustain a keep rate above 32%. This would allow the reserve fund to be large enough to resist a period of extremely negative funding rates during a bear market.
• The scenario above assumes a market capitalization of $10 billion at the time the bear market starts. Depending on the actual market capitalization of USDe, the minimum keep rate could change. For example, for a market capitalization of $5 billion, a keep rate above 20% could be enough.

This analysis suggest that investors should monitor if Ethena’s keep rate is appropriate for the market capitalization of USDe in order to grow the reserve fund large enough to withstand periods of extremely large negative funding rates during bear markets.

Resources:

• ETH Funding Rates: A Data-Driven Study and Its Effects on USDe’s Financial Safeguards.
• Ethena Labs.

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