Decoding Ethena Protocol and USDe's operating mechanism
Dollar-backed, commodity-backed, and even smart contract algorithmic stablecoins already exist in 2024. However, before Ethena Protocol, no one introduced the concept of a Synthetic Dollar. translation: synthetic dollar), where the protocol relies on new technologies such as delta hedging and validated entities such as ETH to maintain the dollar exchange rate. Ethena Protocol aims to change the DeFi landscape with its USDe token, billed as a censorship-resistant Synthetic Dollar with innovative use cases.
This guide delves into the meaning of the Ethena Protocol, what it offers, and the groundbreaking technologies introduced by Ethena Labs – the company behind the protocol.
Decoding Ethena Protocol
Ethena Protocol, led by Ethena Labs, is behind the USDe token concept. As of press time on March 4, the USDe token has climbed to 7th place according to CoinGecko's ranking of global stablecoins by market capitalization.
Ethena Protocol Dashboard. Source: Ethena.fi
However, it is worth mentioning that ETH Labs does not call USDe a stablecoin. Hence the term “Synthetic Dollar”.
“Some comments on positioning USDe as a stablecoin.
Want to make one thing clear: we have moved away from branding the product as a stablecoin since last October when I acknowledged this publicly.”
With USDe, Ethena Protocol aims to liberate the DeFi space by establishing the novel Ethena Finance. The web-based ETHena Finance interface turns ETH into Synthetic Dollar yielding profits through USDe tokens.
Furthermore, the USDe token is not the only thing Ethena Labs is pioneering.
Ethena Protocol started with $6 million in funding as part of its seed round and later raised $14 million, bringing its 2024 valuation to $300 million. The protocol has attracted investments from prominent names in the investment space, including the likes of Arthur Hayes, Brevan Howard Digital, Dragonfly Capital, and more.
ETH Investor: Ethena.fi
Ethereum Finance Internet Bond
Ethena Finance issues Internet Bond, a financial instrument that democratizes investment opportunities and the concept of savings. Internet bonds are a high-yield concept that is a byproduct of the USDe token, combining returns from the derivatives market and staked Ethereum.
Simply put, Ethena Labs' goal of maintaining the USDe exchange rate rests on the shoulders of staked ETH and the derivatives market. And these concepts are not only rate maintenance options but also huge profit generators.
Guy Young, aka Leptokurtic, founder of Ethena Labs, shares:
“The team has been surprised by the interest in Ethena after just 5 days of launch and we are doing our best to balance: i) responsible, controlled and safe product deployment ii ) with fairness, transparency and integrity with our users.”
Important Elements of Internet Bonds
If you want to look at Internet Bonds from a more technical perspective, there are a number of factors involved.
Firstly, it is based on the concept of off-exchange payments, where centralized liquidity sources, or rather CEX, are used while adhering to on-chain custody principles.
So, when you lock LP tokens and mint USDe, the locked LP tokens will be sent to payment service providers or off-exchange custodians, like Copper.co, Fireblocks, etc. They generate receipts, which can be used on CEX to open and close Short ETH positions permanently.
Exchange-based positions to Short Ether. Source: Ethena.fi
Here is a real-life example.
Imagine you have an online savings piggy bank where you put digital money. The savings piggy bank is digitally locked and only opens when you and the bank agree. The bank here is like the OES provider. The pig itself issues receipts that you can use to buy gifts, food, and other items from the store without directly showing the service provider your digital coins.
What is Ethena USDe?
USDe is the heart of the Ethena Protocol. Additionally, it operates the Ethena Finance ecosystem by generating profits. Now let's dig deeper into what USDe is and how it works.
Because Ethena Protocol is built on top of the Ethereum blockchain, USDe qualifies as an ERC-20 cryptocurrency.
USDe is marketed as a Synthetic Dollar, ensuring TradFi's scalability, stability, and censorship resistance. With USDe, which is not a conventional stablecoin, Ethena Labs aims to open up a more accessible financial system.
USDe is fully backed by ETH, used as collateral. Of course, the price of ETH can be volatile, and Ethereum alone could destabilize USDe's exchange rate with the dollar. But Ethena Labs took this into consideration and added another innovative stabilization mechanism – *Delta Hedging.
*Delta Hedging is an options trading strategy that aims to reduce or hedge directional risk associated with price fluctuations of the underlying asset. This approach uses options to offset the risk of another option or an entire portfolio holding.
USDe moves up to 7th place on the stablecoin rankings by market capitalization. Source: Coingecko
Learn about the Delta Hedging strategy: Ethena's novel stability idea
USDe may be a Synthetic Dollar, but for ease of understanding, let's call it a stablecoin expected to maintain peg with USD. Ethena uses the Delta Hedging strategy to keep the exchange rate constant. This financial strategy is not exactly algorithmic. Instead, this is a standard TradFi approach where specific positions are gradually hedged to minimize risk.
How Delta Hedging and Internet Bond work. Source: Ethena Whitepaper
In the case of USDe, the staked ETH is the collateral. However, if the price of ETH drops suddenly, USDe could be vulnerable to systemic risk. In this scenario, a drop in ETH price leads to a rapid loss of pegs, forcing users to withdraw their ETH, leading to a crash. This is something that has been witnessed with UST — the stablecoin of the Luna ecosystem.
Therefore, just having ETH as collateral will not be enough. So, Ethena Labs introduced the Delta Hedging feature, where Ethena also holds a Short position in ETH or ETH-based derivatives. If the price of ETH declines, Short positions will become profitable, helping to lock in the price of ETH.
One thing to note is that Ethena opens a 1:1 Short ETH position on deposited collateral. There is no leverage involved; therefore, it adds another layer of trustworthiness.
The Delta Hedging strategy aims to make things *Delta Neutral, ensuring that the value of the company's portfolio remains the same despite small changes in ETH-based prices. Ethena Finance's Internet Bonds also benefit from the Delta Hedging strategy.
*Delta Neutral is an investment strategy that makes all investment positions almost risk-free or zero-sum.
While the main mission of Delta Hedging is to neutralize risk, strategies such as options charging and arbitrage mining can generate the profits that Ethena Protocol promises.
USDe and associated trading capabilities
USDe is not just an entity pegged to the dollar. In fact, it aims to enable high trading on DeFi platforms like Curve, while also serving as a bridge between digital assets and traditional currencies, thanks to the synthetic dollar.
Since USDe can be staked, it is an attractive asset to lend and trade on through liquidity provision and yield farming. This brings another use case for ETH hodlers and plans to maximize its potential.
USDe and earning opportunities
USDe offers significant earning opportunities for participants. Firstly, locking USDe for sUSDe can generate returns as high as 27.6%. Besides, if and when USDe trades on the external market and the price fluctuates widely, there will be fixed arbitrage opportunities.
Arbitrage trading. Source: Ethena whitepaper
How to mint USDe on Ethena Protocol?
Minting USDe is depositing the correct type of staked ETH as a backup asset. Or, USDT can be used to mint USDe as this is the closest representation of the denomination.
Mint USDe on Ethena Protocol. Source: Ethena whitepaper
First, focus on the right minted assets and approve the minting by connecting the right wallet. The wallet used in this case is MetaMask to receive USDe.
Note: USDe can be further staked in the ETHena Finance ecosystem to strengthen the economy and even earn rewards in the process.
Casting options. Source: Ethena
Here's a quick step-by-step guide:
Go to ETHena.fi and enter using the referral code.
Once done, connect the wallet (in this case MetaMask).
Select the minting option shown right at the top, depending on whether the protocol allows minting new coins or not. You can choose LP tokens like stETH or USDT.
Specify the amount of collateral you want to use for minting.
Lock collateral by pressing “Mint” and approve the transfer. The MetaMask user interface will then ask you to provide an electronic signature – an EIP712 style signature.
Once signed, USDe will be available, corresponding to the asset value.
Ethena Protocol is invite-only. Source: Ethena.fi
Here are the top USDe and sUSDe balances by address and by institution:
Source: Nansen
USDe can be purchased using other stablecoins through connecting a wallet and paying gas fees.
Buy USDt on Athena. Source: ETHena.fi
What is Ethena Shard?
First it should be noted that Ethena Shard has nothing to do with the principle of “Sharding” to enhance blockchain scalability. Instead, it is part of Ethena's Shard Campaign, which aims to promote community engagement. It is like a reward program for activities in Ethena Protocol.
Ethena Protocol's Shard Campaign
Below is a list of activities and corresponding Shard credits.
Shard eligibility on Ethena Protocol
Shard and Epoch: How are they connected?
As mentioned, Shards are like points that are sent to users after completing certain tasks. However, Shards include multiple stages of development within the Ethena ecosystem, with each stage named an Epoch. Shards therefore belong to Ethena's multi-epoch architecture, which, unlike technical elements such as USDe and Delta Hedging, is more focused on community building.
Shards are sold on Whales Market
The Shard campaign could very well be a stepping stone or rather a qualifying gauge for the Ethena token airdrop if and when it comes. Epochs will then be measured as qualifying steps for an airdrop that offers more benefits than just a delta-neutral stablecoin – USDe. Furthermore, capturing the USDe mainnet and using it on Curve or any other DeFi platform to provide liquidity can help improve eligibility for the ETH token airdrop.
However, this is all just speculation as of now.
Is USDe the same as Terra's UST?
To some extent, it seems reasonable to assume that there are similarities between USDe and Terra's UST. Here are the insights that imply similarities:
Pegged in USD
Big discussions about DeFi integration
The yield mechanism with USDe depositors is promised an APY of up to 27.6%, similar to what Terra's Anchor protocol promised UST depositors at 19.5%
But the two have major differences:
UST is an algorithmic stablecoin, rebalanced through the LUNA token, while USDe has actual collateral backing it, stored in an off-exchange custodial account rather than on the exchange.
The peg mechanism, or rather the stabilization mechanism of UST, is limited by code, while USDe actually uses traditional Delta Hedging techniques to compensate for ETH price fluctuations.
UST's way of generating profits is questionable – borrowing/lending, liquidity staking rewards, and ownership. In contrast, USDe clearly mentions how Delta Hedging and smart navigation of a Short Ether strategy can help generate yields as high as 27.6%. Additionally, there are even ETH staking rewards.
Monetization options related to USDe are clearly highlighted by Ethena Protocol.
Additionally, Ethena, while promising the above mentioned yield, calculated the historical average of stETH yield and funding rate based on OI, while keeping derivatives in mind.
Average yield (floating). Source: Ethena whitepaper
Risks related to Ethena Protocol's USDe
It is inevitable that any type of stablecoin always has risks, whether large or small, serious or insignificant, and so is USDe. Below are the detected anomalies:
Sponsorship risks
When opening and closing ETH derivatives Short positions on exchanges, it is important to note the nature of the funding rate. Negative funding rates are not beneficial because Short orders need to pay fees for Long orders, making Short Ether not very promising. If the negative funding rate continues, Ethena Protocol has a $10 million insurance fund.
Having a flexible insurance fund that adjusts itself based on market conditions can be a good approach. This may involve the use of smart contracts.
However, things could get worse if funding rates remain negative for longer.
Liquidation risk
While Ethena Protocol's Delta Hedging aims to handle liquidation risk, concerns could arise if the price of ETH drops significantly in a short period of time.
Custody risks
This risk is related to OES services such as Fireblocks and their business models.
How Ethena Protocol handles custody. Source: Ethena whitepaper
Risk of exchange failure
Short positions are opened on CEX. However, it will be a big trouble if CEX suddenly encounters problems or becomes insolvent at the time of withdrawal. This may be the reason why the USDe claim process has an escrow period of seven days.
All CEX and OES vendors involved. Source: Ethena
Collateral risk
Another issue could be the potential price difference between stETH and ETH. However, Ethena already has mitigation plans in place as the protocol lists a variety of LSTs within the widest possible range of industry support.
While Ethena appears to have addressed these risks for now, it will be interesting to see how things play out in the future.
According to Ethena Labs research director Conor Ryder, there are a lot of new looks at Ethena today and people are right to point out the risks involved. Ryder shared some of the work Ethena has done to address risks in USDe design and in particular funding rate risks.
According to Ryder, USDe is not safer or better than any other project – Ethena is just offering a stablecoin with no ties to the traditional banking system, attracting CeFi flows to the rest of DeFi .
A new design means new risks, so Rydeer has solved the problem that is currently on the public's mind: "What happens when the funding rate goes negative?".
He highlighted the fact that ETH's funding rate has only been negative 20% over the past 3 years, including the 2022 bear market. Using stETH as collateral provides a level of security compared to funding rate is negative, so only days where ETH funding rate is more negative than stETH yield are noticed.
That brings the number of negative yield days down to just 11%.
Looking at the chart below, you can see that positive funding rates (blue bars) tend to last for many consecutive days while negative funding rates (red bars) rarely do. Positive funding rates have existed for 110 days so far this year, with the longest streak of consecutive days being 13 days.
When looking at each quarter, it can be seen that one quarter in 2022 had a negative composite yield (stETH + funding rate Short ETH). That included an outlier event when ETH funding rates dropped as low as -300% thanks to arbitrage opportunities at the time ETH transitioned to Proof of Stake.
Starting in 2024, yields hover around 20%.
There are several main reasons why the funding rate is tilted towards the positive side:
There is a clear need for leveraged Long orders. Pools with abundant liquidity are not willing to lend capital on the Short side of that Long leverage.
Some exchanges (Binance, Bybit) have a positive base funding rate of 11% annually, meaning if the funding rate is within a certain range, it will revert to 11% by default. Those exchanges account for more than 50% of OI (open interest).
The figure below shows the positive impact of the base funding rate on capital allocation on Binance and Bybit in particular.
So what happens when the funding rate goes negative?
1. User redeems (redeem)
USDe supply decreased and Short orders were raised. On a large enough scale, removing the Short order will help the funding rate improve, helping the USDe supply find a balance at its natural scale. At that time, Ethena will consider integrating other collateral assets such as BTC, etc. with an untapped derivatives market of over 20 billion USD.
2. Intraday fluctuations in funding rates do not pose much risk to Ethena's solvency as their impact is a slow and limited erosion of collateral.
For example, the maximum negative funding rate on Binance is -100%, which implies a nominal 0.091% maximum loss in any 8-hour period (when the funding rate is due). This will not be a death spiral type scenario but rather a slow capital withdrawal that lasts for weeks or months, if funding rates remain negative.
3. An insurance fund protects collateral from periods of negative funding rates. After conducting extensive research, Ethena proposed an insurance fund size of 20 million USD over 1 billion USDe.
Chaos Labs has also built its own model and proposed a fund size of 33 million USD for every 1 billion USDe. The majority of the recent $14 million funding round will go into the insurance fund.
In short, according to Ryder, negative funding rates are a feature, not a bug, of the system, and USDe was built with the idea of negative funding rates in mind from the beginning.
