Author: @Web3Mario

In the past few days, the market has been ignited by Ethena, which is a stablecoin protocol that can provide an annualized yield of over 30%. There have been many articles introducing the core mechanism of Ethena, so I won't go into details here. In simple terms, Ethena.fi tokenizes "Delta-neutral" arbitrage trading of ETH by issuing stablecoins representing the value of Delta-neutral positions. Their stablecoin USDe also collects arbitrage profits - thus they claim that this is a way to provide internet-native income, an internet bond. However, this scenario inevitably reminds us of the last crypto cycle when Terra, the catalyst for the transition from bull to bear, issued the algorithmic stablecoin UST. At that time, it quickly attracted deposits with a 20% annualized yield subsidy for UST lenders through its native lending protocol, Anchor Protocol, and then quickly collapsed after suffering a run. Learning from this lesson, the sudden popularity of USDe (the stablecoin issued by Ethena) has also sparked widespread discussion in the crypto community, with skepticism from DeFi opinion leader Andre Cronje attracting widespread attention. Therefore, the author hopes to further explore the reasons for Ethena's sudden popularity and the risks inherent in its mechanism.

Ethena's Success as a CeFi Product: The Savior of Centralized Exchange Perpetual Contract Markets

To discuss the reasons for Ethena's success, I believe the key lies in Ethena's potential to become the savior of the perpetual contract market for centralized cryptocurrency exchanges. First, let's analyze the problems faced by the current mainstream centralized cryptocurrency exchange perpetual contract markets, which is the lack of short positions. We know that futures contracts serve two main purposes: speculation and hedging. Due to the overwhelmingly optimistic market sentiment among most speculators, there are significantly more long positions than short positions in the futures market for cryptocurrencies. This situation leads to a problem where the funding rate for long positions in the perpetual contract market increases, raising the cost of long positions and suppressing market vitality. For centralized cryptocurrency exchanges, the perpetual contract market is one of the most active trading markets and a core source of revenue. The high cost of funds also reduces the exchange's income. Therefore, finding short positions for the perpetual contract market during a bull market becomes crucial for exchanges to increase their competitiveness and boost revenue.

Here, it may be necessary to supplement some basic knowledge, which is the principle of perpetual contracts and the role and collection method of funding rates. Perpetual contracts are a special type of futures contract. Traditional futures contracts usually involve delivery, which entails the transfer of equivalent assets and the associated clearing and settlement, increasing the operational costs for exchanges. For long-term traders, nearing the delivery date also involves operations such as position rolling. As the delivery date approaches, the fluctuation of the mark price is usually larger because with the operation of rolling positions, the market liquidity of the old underlying asset gradually deteriorates, introducing many hidden trading costs. To reduce these costs, perpetual contracts were designed. Unlike traditional contracts, perpetual contracts have no delivery mechanism, so there is no expiration date, and users can choose to hold positions indefinitely. The key to this feature lies in ensuring the correlation between the price of perpetual contracts and the price of the underlying assets. In futures contracts with delivery, the source of correlation is the delivery, as the delivery mechanism transfers physical assets (or equivalent assets) according to the contract's agreed price and quantity, theoretically causing the price of futures contracts to converge with the spot price at the time of delivery. However, perpetual contracts have no delivery mechanism. To ensure correlation, additional design is introduced in the perpetual contract mechanism, which is the funding rate.

We know that prices are determined by supply and demand. When supply exceeds demand, prices rise. This is also true in the perpetual contract market. When there are more long positions than short positions, the price of perpetual contracts will be higher than the spot price, and this price difference is usually referred to as the basis. When the basis is too large, there needs to be a mechanism that can act in the opposite direction, and this is the funding rate. In this design, when a positive basis occurs, indicating that the contract price is higher than the spot price, it means that there are more long positions than short positions. At this time, long positions need to pay fees to short positions, and the rate is directly proportional to the basis (not considering the funding rate composed of a fixed rate and premium). This means that the larger the deviation, the higher the cost for long positions, which suppresses the motivation for long positions and restores the market to a balanced state. The opposite is also true. With this design, perpetual contracts have a price correlation with spot prices.

Returning to the initial analysis, we know that in an extremely optimistic market, the funding rate for long positions is very high, which suppresses the motivation for long positions and market vitality. In general, to alleviate this situation, centralized exchanges need to introduce third-party market makers or become counterparties in the market themselves (as can be seen as a common practice in the aftermath of the FTX incident), to bring the funding rate back to a competitive state. However, this also introduces additional risks and costs, and to hedge these costs, market makers need to hedge the risk of short positions in the perpetual contract market through long positions in the spot market. This is the essence of the Ethena mechanism. However, as the market size at this time is very large, exceeding the capital limit of a single market maker, or in other words, this introduces a very high single-point risk for market makers or exchanges. To mitigate this risk or raise more funds to suppress the basis and make their perpetual contract market funding rate more competitive, centralized exchanges need more interesting solutions to raise funds in the market. This is where the arrival of Ethena comes in!

We know that the core of Ethena lies in accepting cryptocurrencies as collateral, such as BTC, ETH, stETH, etc., and shorting their corresponding perpetual contracts on centralized exchanges to achieve Delta risk neutrality, earning the native income of the collateral and the funding rate of the perpetual contract market. Its stablecoin USDe is essentially similar to an open-market maker fund for Delta risk-neutral cryptocurrency futures arbitrage. Holding shares is equivalent to obtaining the dividend rights of the fund. Users can easily enter this high-threshold track to earn substantial income, while centralized exchanges also obtain a more extensive short position liquidity, reduce the funding rate, and enhance their competitiveness.

There are two phenomena that can support this view. First, this mechanism is not unique to Ethena. The UXD in the Solana ecosystem actually adopted this mechanism to issue its stablecoin assets. However, its influence did not meet expectations due to its collapse before connecting to centralized exchange liquidity, in addition to the low interest rate environment for perpetual contracts caused by the reversal of the entire crypto cycle and the significant impact of FTX's collapse. Second, careful observation of Ethena's investors reveals a significant proportion of centralized exchanges, which also proves their interest in this mechanism. However, in the midst of excitement, we cannot ignore the risks it entails!

Negative rates are just one of the triggers for a possible run, and the basis is the key to the death spiral

We know that the ability to tolerate a run is crucial for stablecoin protocols. In most discussions about the risks of Ethena, we have already understood the damage to the collateral value of USDe caused by the negative interest rate environment in the cryptocurrency futures contract market. However, this damage is usually temporary. Backtesting results across cycles show that negative interest rate environments usually do not last long and are not easy to occur. This has been thoroughly proven in Chaos Labs' official economic model audit report on Ethena. Additionally, the damage caused by negative rates to the collateral value is slow because the contract rate is usually collected every 8 hours. According to backtesting results, even with the most extreme -100% rate estimate, this means that the maximum loss in any 8-hour period is 0.091%. There have been only three occurrences of negative rates in the past three years, with an average duration of 3-5 weeks. The negative rate recovery period in April 2022 lasted about three weeks, with an average level of -3.3%. In June 2022, it lasted about three weeks, with an average level of -4.8%. If we include the extreme funding from September 11th to 15th, this period lasted for 5 weeks, with an average of -17.9%. Considering that rates are positive at other times, this means that Ethena has ample opportunity to accumulate a certain Reserve Fund to address negative rate situations, reduce the erosion of collateral value, and prevent the occurrence of collateral ratios below 100%. Therefore, I believe that the risk of negative rates is not as great as imagined, or that it can be greatly mitigated through certain mechanisms. It can be said that this is just one of the triggers for a possible run. Of course, if we question the statistical significance, this is not within the scope of this article's discussion.

However, this does not mean that Ethena will have a smooth journey. After reading some official or third-party analysis results, I believe that we have all overlooked a fatal factor, which is the basis. This is precisely the key vulnerability of Ethena in dealing with runs, or the key to the death spiral. Looking back at two very typical runs on stablecoins in the cryptocurrency market, the collapse of UST and the decoupling run of USDC in March 2023 due to the bankruptcy of a Silicon Valley bank, it can be seen that in the current era of internet technology development, panic spreads very rapidly, and the runs it triggers are very fast. Usually, when panic occurs, a large amount of redemption will be faced within a few hours or days. This requires the stablecoin mechanism to challenge the ability to tolerate a run. Therefore, most stablecoin protocols will choose to allocate assets with excellent liquidity for collateral, rather than blindly pursuing high returns, such as short-term US Treasury bonds. In the event of a run, the protocol can cope by selling collateral to obtain liquidity. However, considering that Ethena's collateral type is a combination of cryptocurrencies with price fluctuation risk and their futures contracts, this poses a significant challenge to the liquidity of both markets. When Ethena's issuance reaches a certain scale, whether there will be sufficient liquidity in the market to unwind the futures-spot arbitrage combination to meet redemption demands during a large-scale run is the main risk it faces.

Of course, the liquidity issue of collateral is a problem that all stablecoin protocols will face. However, Ethena's mechanism design will introduce additional negative feedback mechanisms to the system, which means that it is more susceptible to the risk of a death spiral. The so-called death spiral refers to the amplification of panic effects due to a certain factor, leading to a larger-scale run. The key to this lies in the basis. The basis refers to the price difference between futures contracts and spot prices. Ethena's collateral design is essentially a shorting investment strategy in the basis of the futures-spot arbitrage, holding spot positions and shorting equivalent futures contracts. When the basis expands in a positive direction, it means that the price increase of the spot will be lower than the price increase of the futures contract, or the price decrease of the spot will be higher than the price decrease of the futures contract. This investment portfolio will face unrealized loss risk. However, when a run occurs, users will sell a large amount of USDe in a short period of time, leading to a significant price decoupling in the secondary market for USDe. To suppress this decoupling, arbitrageurs need to actively close out the open short futures contracts in the collateral and sell the spot collateral to obtain liquidity to repurchase USDe from the secondary market, reducing the market circulation of USDe and restoring the price. However, with the closing out operations, unrealized losses will turn into actual losses, resulting in permanent loss of collateral value. USDe may be in a state of insufficient collateral ratio, and at the same time, the closing out operations will further expand the basis. Closing out short futures contracts will push up their futures prices, while selling spot positions will depress spot prices, further amplifying the basis. The amplification of the basis will lead to larger unrealized losses for Ethena, which will accelerate user panic, leading to a larger-scale run until it reaches an irreversible result.

This death spiral is definitely not an exaggeration. Although backtesting data shows that the basis has mean-reverting characteristics in most cases, the market will eventually reach a balanced state after a period of development. However, this is not suitable as a counterargument to the above reasoning because users have a very low tolerance for price fluctuations in stablecoins. For an arbitrage strategy, users may tolerate a certain degree of drawdown risk, but for stablecoins with the core functions of store of value and medium of exchange, users' tolerance is extremely low. Even for interest-bearing stablecoins with income as their core selling point, they inevitably attract a large number of users who do not understand complex mechanisms and participate based on literal understanding during the project's promotion (this is also one of the core accusations faced by DoKwon, the founder of UST, namely fraudulent promotion). These users are the core user group that triggers runs and are the most severely affected group in the end, so the risk is significant.

When there is sufficient short position liquidity in the futures market and long position liquidity in the spot market, this negative feedback will be mitigated to a certain extent. However, considering the current scale of Ethena's issuance and the high subsidies that come with its deposit-taking ability, we have to be vigilant about this risk. After all, with Anchor offering a 20% savings subsidy, the issuance of UST surged from 2.8 billion to 18 billion in just 5 months, and the growth of the entire cryptocurrency futures contract market during this time is certainly unable to keep up with such an increase. Therefore, there is reason to believe that the open futures contract scale of Ethena will quickly surge to an exaggerated proportion. Imagine that when over 50% of the short position holders in the market are Ethena, the closing out will face very high friction costs because there are no short positions in the market that can bear such a scale of closing out in the short term. This will make the amplification effect of the basis more apparent, and the death spiral will be more intense.

I hope that the above discussion can help everyone have a clearer understanding of the risks of Ethena, maintain a respectful attitude towards risks, and not be swayed by high returns.

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