There are two DeFi protocols that really excite me this year: EigenLayer and Ethena Labs.

I've covered EigenLayer in detail, and this time I want to take a look at Ethena Labs and their insane 27% annualized return.

Ethena is a synthetic U.S. dollar protocol built on Ethereum that aims to provide a crypto-native solution for currencies that do not rely on traditional banking system infrastructure and provide a globally accessible U.S. dollar-denominated savings instrument - an "internet bond".

Ethena’s synthetic U.S. dollar USDe will provide the first censorship-resistant, scalable, and stable crypto-native currency solution through delta hedging of staked Ethereum.

USDe will be transparently fully guaranteed on the chain and can be freely combined in DeFi.

USDe’s peg stability is ensured through delta-hedging derivatives positions on the collateral held by the protocol, as well as minting and redemption arbitrage mechanisms. “Internet Bonds” will combine returns from staked Ethereum with financing and basis returns from perpetual and futures markets.

Ethena is built to solve the most important and obvious immediate needs in the cryptocurrency space. DeFi attempts to create a parallel financial system, however stablecoins are the most important financial instrument and are completely dependent on traditional banking infrastructure.

Why are stablecoins so important?

Stablecoins are the most important tools in cryptocurrencies.

In all major centralized and decentralized trading venues, whether it is spot or futures markets, the main trading pairs are denominated in stablecoins, with more than 90% of order book transactions and more than 70% of on-chain settlements in stablecoins. valuation.

Stablecoins have over $12 trillion settled on-chain, constitute two of the top five assets in the space, account for over 40% of total value locked (TVL) in DeFi, and are by far the largest player in decentralized currency markets The most widely used asset in .

Centralized stablecoins, such as USDC or USDT, provide stability and capital efficiency, but also introduce some problems:

· Pledge of bonds in regulated bank accounts introduces custody risk that cannot be hedged and is susceptible to scrutiny.

· Critical reliance on existing banking infrastructure and country-specific evolving regulatory requirements.

· Users face a “risk-free return” situation because the issuer internalizes the benefits and transfers the risk of decoupling to the users.

Decentralized stablecoins have historically experienced a series of issues related to scalability, mechanism design, and lack of built-in benefits.

"Hyper-collateralized stablecoins" have historically had problems scaling, as their growth is inevitably tied to the growth in demand for on-chain leverage on Ethereum. Recently, some stablecoins have chosen to siphon off treasuries in order to increase scalability at the expense of censorship resistance.

·"Algorithmic stablecoins" face challenges in their mechanism design and are found to be inherently fragile and unstable. We believe these designs are not sustainably scalable.

· The previous “risk-free synthetic dollar” struggled to scale due to its critical reliance on decentralized trading venues that lacked sufficient liquidity.

Therefore, USDe offers the following benefits:

· Scalability with capital utilization efficiency is achieved by utilizing derivatives, which allows USDe to scale with capital utilization efficiency. Since pledged ETH assets can be perfectly hedged by equivalent short positions, synthetic USD only requires a 1:1 "pledge".

· Stability is provided through hedging operations executed immediately upon issuance, which ensures that USDe’s synthetic U.S. dollar value is supported in all market conditions.

· Achieve censorship resistance by decoupling the backing assets from the banking system and storing trustless backing assets outside of decentralized liquidity venues in an on-chain transparent, 24/7 auditable programmatic escrow account solution .

How does it work?

Users deposit approximately $100 of stETH and instantly receive approximately $100 of USDe, minus any costs of executing the hedge.

Ethena Labs opens a corresponding short-term perpetual position on a derivatives exchange for approximately the same USD value. The assets received are transferred to the OTC clearing service provider. Backing assets remain on-chain and on off-exchange servers to minimize counterparty risk.

Ethena Labs delegates, but never transfers, backing assets to derivatives exchanges for use as collateral for short-term perpetual hedging positions. Ethena Labs generates two sustainable revenue streams from deposited assets.

The revenue returned to qualified users comes from:

· Stake Ethereum to receive consensus and execution layer rewards (3,5% annualized yield)

· Funding and basis spreads from hedging derivatives positions. (5-20% annualized rate of return)

The income from staking Ethereum is floating and denominated in ETH. Returns on funding and basis spreads can be floating or fixed. Funding and basis spreads have historically produced positive returns due to a mismatch between cryptocurrency leverage demand and supply, as well as the presence of positive baseline funding.

If funding rates are deeply negative for an extended period of time, so that the returns from staking Ethereum cannot cover funding and basis spread costs, the Ethena Insurance Fund will bear the cost. Historical earnings can be viewed here .

Once users stake their USDe into sUSDe, they begin earning the protocol’s yield automatically without any further action or cost. The amount of sUSDe a user receives depends on the amount of USDe deposited and the time of deposit. Ethena's sUSDe uses a "token vault" mechanism, the same as Rocketpool's rETH or Binance's WBETH.

The protocol will not re-pledge, lend or otherwise utilize the deposited USDe for any purpose. Since USDe's support mechanism itself generates protocol yields, no such operations are required. If the protocol suffers a loss due to funding or other reasons, Ethena's insurance fund will bear the cost rather than the staking contract.

· When a user mints USDe, Ethena Labs opens a short position on the exchange.

· When a user redeems USDe, Ethena Labs closes the short position on the exchange.

· Ethena Labs closes/opens positions on the exchange to realize unrealized P&L.

If the value of USDe in the external market is lower than the value provided by Ethena Labs, users can:

· Use USDC to buy 1 USDe at Curve for 0.95.

· Redeem 1 USDe from Ethena Labs at a price of 1.00 and obtain ETH.

· Use the earned ETH to sell for USDC on Curve.

· Profit.

If the value of USDe in the external market is higher than the value provided by Ethena Labs, users can:

· Mint USDe using ETH from Ethena Labs.

· Sell USDe in Curve pool for USDC at > 1.00.

· Use USDC to buy ETH on Curve.

· Profit.

What are the risks?

capital cost risk

"Capital cost risk" involves the potential risk of continued negative interest rates. Ethena is able to earn income from funds, but may also be required to pay funds (equal to lower protocol income).

The Ethena Guarantee Fund exists and will step in when returns on combined LST assets (such as stETH) and funding rates for short-term indefinite positions become negative. This ensures that the collateral backing USDe is not affected. Ethena will not pass on any "negative returns" to users who stake their USDe into sUSDe.

Combining the annualized stETH return and funding rate values, only 10.8% of days have a total negative return. This is a positive comparison compared to the ~20.5% days when stETH returns are not taken into account, resulting in negative funding rates.

If you remember Anchor Protocol’s revenue reserve, the Ethena Guaranteed Fund will operate in a similar manner to support returns on “negative” days.

liquidation risk

Ethena uses collateralized Ethereum spot assets that are pledged on short-term derivatives positions. Ethena uses pledged Ethereum assets, such as Lido's stETH, to pledge short-term ETHUSD and ETHUSDT permanent positions on the CeFi exchange. Therefore, the collateral asset used by Ethena is stETH which is different from the underlying asset ETH of the derivative position.

The spread between ETH and stETH must widen to 65%, which has never happened historically, the historical maximum was 8% (before Shapella and before the Luna decoupling in May 2022), and then Ethena's position will Gradual liquidation begins and Ethena will suffer realized losses. USDe’s peg stability is automated through program-based delay-neutral hedging with the underlying staking assets. Refer to " Dust on Crust " by @CryptoHayes.

To mitigate "liquidation risk" resulting from the above risk scenarios:

· Ethena will systematically delegate additional collateral to improve the margin position of our hedging positions in case any risk scenarios arise.

· In the event of any risk scenario, Ethena is able to temporarily cycle delegated collateral between exchanges to provide support in specific situations.

· Ethena can be quickly deployed on exchanges to support hedging positions, leveraging our insurance fund.

· In the event of an extreme situation, such as a critical flaw in a staked Ethereum smart contract, Ethena will immediately take steps to mitigate the risk, with the sole motivation being to protect the value of the collateral. This includes closing hedging derivatives positions to avoid liquidation risks coming into focus, as well as trading affected assets into other assets.

Custody risk

Because Ethena Labs relies on the "Off-Exchange Settlement" provider's solution to store protocol-supported assets, it is dependent on its operational capabilities. Ethena’s capabilities include depositing and withdrawing assets on exchanges and conducting commissioned transactions. If any of these capabilities are unavailable or compromised, it will hinder the transaction process and the availability of USDe's issuance and redemption functions.

Exchange failure risk

Ethena Labs uses derivatives positions to offset the risk of digital asset collateral. These derivatives positions are traded on CeFi exchanges such as Binance, Bybit, Bitget, Deribit and Okx. Therefore, if an exchange suddenly becomes unavailable, such as FTX, Ethena will need to deal with the consequences. This is the "exchange failure risk."

Collateral risk

In this case, "collateral risk" refers to the fact that USDe's collateral asset (stETH) is different from the underlying asset (ETH) of the perpetual futures position.

Currently, all protocols that rely on stETH (and any ETH LST) accept this liquidity risk profile. This means that the amount of stETH that can be unstaking may be delayed, or users may have to accept a slight discount if they need to trade immediately on external markets.

Approved users of Ethena can redeem USDe for stETH (or any ETH LST) on demand at any time, or request alternative assets and tap into Ethena's multiple liquidity pools to access assets.

The loss of confidence in the integrity of LST may be caused by the discovery of critical smart contract vulnerabilities in LST. In this case, users may try to unstake or exchange LST for alternative collateral as soon as possible. This could lead to long exiting validator queues for protocols like Lido, and liquidity drying up on DeFi and CeFi exchanges.

discuss

Okay, this is a pretty technical introduction. Now let's see why this product is interesting.

· 27.6% annual interest rate

· Proceeds from using LSD ETH as collateral for a 1x ETH short position

· LSD ETH income + short ETH financing rate = sUSDe income

· Upcoming airdrop (called Ethena Shards), lasting 3 months or ending when USDe supply reaches $1 billion

· Providing LPs + locking LP tokens = 20x Shards per day

· Buy and hold USDe = 5x Shards per day

· Staking and holding sUSDe = 1x Shards per day

· TVL is currently growing quite rapidly: $300 million to date

· All stable pool capacities are currently full (expect they will lift the limit, just my gut feeling)

· Smart contract risk is lower, but centralization risk is higher (funds are on centralized exchanges), works best in bull markets (when people borrow with leverage) (don’t count on funding rates when everyone wants to short ETH is correct)

Looking further, you will soon be able to use your sUSDe in DeFi, see the following example from Seraphim, Head of Growth at Ethena Labs:

One thing that people have a hard time understanding is why we need financing rates.

The financing rate is set up to ensure that the financing mechanism keeps the futures market price consistent with the index spot price: whenever there is too much demand for long-term ETH, the ETH perpetual price > the ETH spot price, so CEX needs some way to reduce people from continuing to add positions. motivation.

Therefore, the financing rate is a way to maintain a dynamic balance between the futures market price and the index spot price. Since the entire market is tilted towards the bullish side, i.e. longs > shorts, if you are short ETH, you get the profits long ETH, to offset the overwhelming demand that drives the ETH perpetual price closer to the ETH spot price.

AllianceBernstein, a global asset management company with an asset management scale of US$725 billion, predicts that the market value of stablecoins will reach US$3 trillion in 2028. If we look at the market today, the stablecoin market capitalization is currently $138 billion and peaked at $187 billion. This means potential growth of up to 2,000%.

Additionally, Ethena has received $140 million in investment from top global investors, including @binance, @CryptoHayes, @Bybit_Official, @mirana, @lightspeedvp, @FTI_US, and more. Notably, angel investors include @dcfgod, @cobie and @blknoiz06.

Ethena has a really nice dashboard that you can monitor here, which at least gives some peace of mind in terms of risk.

Disadvantages of Ethena

Simply put, it is just a basis trade. When the yield inverts, you start losing money, and the larger the stablecoin, the more money you lose. People who are long ETH now pay people who are short ETH. This situation can last for a long time, especially in a bull market. But at some point, yields will invert and people will short ETH and profit from it. At this point Ethena suddenly has to bear the cost. They have their insurance fund to temporarily fix the problem. But as the yield on sUSDe decreases, I suspect people may be tempted to divest. That being said, this is not a fatal spiral. It's just that people may want to look for gains elsewhere.

Using stETH as collateral provides a margin of safety against negative interest rates. This means that Ethena only cares about those days when ETH financing is more negative than stETH returns. However, stETH liquidity is very important for pegging. Without sufficient stETH liquidity, USDe cannot scale to $100 billion.

Suppose the following happens:

· User redemption

· Insurance funds are available for coverage. According to Ethena, USDe per $1 billion can survive almost any pessimistic funding rate forecast (Chaos Labs says $33 million per $1 billion is needed).

· The biggest risk to this project may not be explosive growth, but that more people will consider locking their funds in a non-yielding coin rather than choosing a "trustworthy" alternative (I'm just pointing out the Lindy stablecoin, Such as USDT or USDC, not saying these are better, but since they have been around for a while, most people trust them more).

· Counterparty risk from CEXs and smart contracts is probably one of the biggest issues. According to @tbr90, the long-term risk is a slow drain, as negative interest rates will eventually deplete the insurance fund and then force a slow unlock.

As Cobie pointed out, people can do this trade themselves.

For example, short ETHUSDT and get funded every 8 hours, while long stETH or mETH (for higher temporary gains). There is no 7-day staking queue, and the risk is your choice, although you will have to rebalance yourself.

Ethena’s founder @leptokurtic_ agreed, but noted: “Ethena Labs is not here to save you the hassle of performing cash transactions. What’s exciting is the ability to tokenize this asset and make it available through DeFi and CeFi It’s extremely liquid and then allows novel use cases to be built on top of it, combining different currency LEGOs together.”

Anyway, I love this project. It brings some new and interesting content. I could see perpetual contract decentralized exchanges implementing their stablecoins and DeFi protocols looking to use them as currency LEGO, similar to what happened with EigenLayer and the recollateral narrative.

People may remember that I was a big fan of Anchor Protocol, and Ethena seems to be the healthier way of doing things. Personally, I believe that chasing a 20% annual return in a bull market is not much better than pursuing larger opportunities, so I may not use this protocol often, but I will participate in airdrops.

Another thing I don't like is that it takes 7 days to redeem from staking and 21 days from LP. If it were possible to unstake immediately, I would consider it if I needed a break from the market, but 7 days is a long time to wait in the crypto space.

Having said that, they may implement sUSDe in several DeFi protocols so that you can earn income while trading or mining etc. I will try to use these solutions more as they are implemented.

Overall, a positive opinion of the product, even if this rant may seem a bit negative.