Ethena Protocol's revenue comes from spot collateral yield + funding rate revenue from short positions.
Written by: @0x0_chichi
Guidance from: @CryptoScott_ETH
TL;DR
Ethena Protocol's revenue comes from spot collateral yield + funding rate revenue from short positions. The introduction of BTC collateral dilutes the collateral yield, and the market's calmness and Ethena's reduced short positions have diminished the funding rate revenue.
Adding collateral types is a necessary step for Ethena's long-term development, but it implies potentially low interest rates in the long term.
The protocol's insurance fund is currently insufficient, posing a high risk.
Ethena has a natural advantage in dealing with negative funding rates.
The total open interest in the market is an important indicator limiting the issuance of USDe.
1. Project Introduction
Ethena is a stablecoin protocol built on the Ethereum blockchain, which provides a "synthetic dollar" USDe through the Delta-neutral strategy.
The working principle is as follows: users deposit stETH into the protocol, minting an equivalent amount of USDe. Ethena uses an off-exchange settlement (OES) scheme to map the stETH balance to a CEX as collateral, taking a short position in an equivalent amount of ETH perpetual contracts. This investment portfolio achieves Delta neutrality, meaning the value of the combination does not fluctuate with the price of ETH. Therefore, theoretically, USDe achieves price stability.
Users can then collateralize their USDe in the protocol to mint sUSDe, and holding sUSDe can generate yield from funding rates. This yield once reached over 30%, serving as one of Ethena's main means of attracting deposits.
As of 2024/5/9, the yield rate for holding sUSDe is 15.3%, and the total issuance of USDe has reached 2.29 billion USD, accounting for approximately 1.43% of the total stablecoin market value, ranking fifth.
2. Revenue Sources
In the Ethena protocol, both stETH collateral and ETH perpetual contract short positions generate revenue (from funding rates). If the combined yield of the two positions is negative, the protocol's insurance fund will make up for the loss.
What is the funding rate?
In traditional commodity futures contracts, both parties agree on a delivery date, which is the deadline for physical exchange. Therefore, in the approach of the delivery date, the futures price theoretically equals the spot price. However, in digital currency trading, to reduce delivery costs, the widely adopted form is perpetual contracts: compared to traditional contracts, the delivery process is eliminated, leading to the disappearance of the correlation between futures and spot prices.
To address this issue, the funding rate is introduced, i.e., when the perpetual contract price is higher than the spot price (positive basis), long positions pay the funding rate to short positions (the funding rate is directly proportional to the absolute value of the basis); when the perpetual contract price is lower than the spot price (negative basis), short positions pay the funding rate to long positions.
Therefore, the further the perpetual contract price deviates from the spot price (the larger the absolute value of the basis), the higher the funding rate, and the stronger the suppression of price deviation. The funding rate becomes the link between futures and spot prices in perpetual contracts.
Ethena holds ETH short positions and stETH, and the revenue comes from funding rates and collateral income. When the combined yield is positive, the insurance fund reserves a portion of the revenue to compensate users when the combined yield is negative.
In the current bull market, the sentiment for long positions is significantly higher than that for short positions, and the demand for long positions in the market exceeds the demand for short positions, leading to a sustained high funding rate. The Delta risk of spot collateral in the Ethena protocol is hedged by short positions, and holding short positions can generate a large amount of funding rate revenue, which is the reason why the Ethena protocol generates risk-free high returns.
3. Project Sustainability and Growth Points
3.1 Use of centralized exchanges for better liquidity
Before the launch of USDe, the stablecoin project UXD on the Solana chain also stabilized the coin in the same way, but UXD hedged on DEX contracts, which also laid the groundwork for UXD's failure.
From the perspective of liquidity, centralized exchanges hold over 95% of the share of open interest. To expand the scale of USDe to the billion-level and to prevent a run on the bank, centralized exchanges are the best choice for Ethena: when the issuance of USDe grows on a large scale or a run on the bank occurs, the price of Ethena's short positions will not cause too much disturbance to the market.
3.2 Off-exchange settlement mechanism
Because Ethena uses centralized exchange hedging, it will inevitably create new centralized risks, so Ethena has introduced a new mechanism, OES, which entrusts the collateral to third-party custody (Copper, Fireblocks), and centralized exchanges do not hold any collateral, similar to depositing users' collateral into a multi-signature wallet, maximizing the reduction of centralized risks.
3.3 Combined yield and insurance fund
The insurance fund is an important component of the Ethena protocol, transferring a portion of the combined yield from stETH positions and ETH short positions to compensate for negative combined yields, to maintain price stability.
The high USDe yield in the bull market of 2021 reflects strong bullish demand, with long positions paying short positions a 40% funding rate annually. As the bear market began in 2022, the funding rate often fell below zero, but did not persist in being negative, with the mean value still being maintained above 0.
In the second quarter of 2022, the collapse of Luna and 3AC had surprisingly little impact on the funding rate, and a brief downturn caused the funding rate to hover around 0 for a period, but it quickly returned to a positive value.
In September 2022, Ethereum's transition from POW to POS triggered the largest black swan event in the history of the funding rate, with the funding rate dropping to 300%. The reason for this was that in this transition, users only needed to hold ETH spot to receive short rewards, leading to a large number of users holding both long positions and short positions in ETH perpetual contracts to hedge a large amount of ETH spot.
The influx of short positions caused the funding rate in ETH perpetual contracts to plummet in a short period, but after the end of the short position distribution, the funding rate quickly returned to a positive level.
The collapse of FTX in November 2022 also led to a drop in the funding rate to around -30%, but it did not persist, and the funding rate quickly returned to a positive level.
Based on historical data, the mean value of USDe's combined yield has always been maintained above 0, demonstrating the long-term viability of the USDe project. However, short-term normal market fluctuations or black swan events leading to a combined yield less than 0 are unsustainable, and sufficient insurance funds can ensure a smooth transition for the protocol.
3.4 Addition of collateral types
Starting from April 2024, users can collateralize BTC in the Ethena protocol to mint the USDe stablecoin. As of 2024/5/9, the current BTC collateral accounts for 41% of the total collateral.
Before the eve of Ethena accepting BTC as collateral, the total amount of ETH short positions in Ethena had already accounted for 21.57% of the total open interest. Despite the strong liquidity of centralized exchanges and Ethena holding ETH short positions on multiple exchanges, the rapid growth of USDe issuance may lead to insufficient liquidity for ETH perpetual contracts on centralized exchanges. Ethena urgently needs new growth points.
Compared to liquidity collateral tokens, BTC does not have native collateral yield. If BTC is introduced as collateral, the collateral yield contributed by stETH will be diluted. However, the open interest in BTC perpetual contracts on centralized exchanges exceeds 20 billion USD. After introducing BTC collateral, the short-term expansion capacity of USDe will increase rapidly. However, in the long term, the growth rate of the total open interest in BTC and ETH perpetual contracts is the main factor limiting the growth of USDe.
Although BTC collateral dilutes the collateral yield of stETH, historical data shows that the mean funding rate of BTC perpetual contracts is lower than that of ETH in bull markets and higher than that of ETH in bear markets. This serves as a hedge against the low funding rate in bear markets, increases the diversification of the investment portfolio, and reduces the risk of USDe deviating from its peg in bear markets.
4. Risks
4.1 Prolonged Basis Downturn
Currently, the yield rate of sUSDe has rapidly dropped from over 30% to around 10%, due to the overall market sentiment and the significant impact of the rapid expansion of USDe on the market from a large number of short positions.
It is well known that the terrifying growth rate of USDe comes from the super high funding rate payments in bull markets. However, as a stablecoin, USDe still lacks significant use cases, and the existing trading pairs are only associated with some other stablecoins. Therefore, the vast majority of USDe holders are only interested in earning high APY and participating in airdrops.
Although the insurance fund mechanism enters when the overall yield is negative, users providing stETH will redeem when the overall yield is lower than the stETH collateral yield. On the other hand, users providing BTC will be more cautious. As the basis gradually decreases and the funding rate yield remains low, without extremely high APY, a large number of redemptions may occur after the second round of airdrops, similar to the dilemma faced by Bitcoin L2: many users (especially large holders) view BTC as a target for value storage and have extremely strict requirements for fund security.
Therefore, it is believed that if the stablecoin use case of USDe has not made a breakthrough development before the end of the second quarter airdrop event of Ethena, combined with the gradual reduction of the funding rate, USDe is likely to falter.
4.2 Insufficient Insurance Fund
The Ethena team has simulated and concluded the following about the insurance fund:
In Figure 5, green, yellow, and red represent initial insurance fund sizes that are less than 20 million USD, between 20 million and 50 million USD, and greater than 50 million USD, respectively, to ensure fund safety.
The vertical axis represents the expected final issuance amount of USDe within two and a half years (2021/4~2023/10), reaching 1 billion USD, 2 billion USD, and 3 billion USD, respectively. The horizontal axis represents different scenarios of linear growth in USDe issuance, with insurance fund withdrawal rates set at 50%, 20%, and 10%. The fourth scenario represents exponential growth in the first year, followed by a constant issuance amount, with an insurance fund withdrawal rate set at 20%. The fifth scenario represents continuous exponential growth in USDe issuance, with an insurance fund withdrawal rate set at 20%.
From Figure 5, it is concluded that for an initial insurance fund of 20 million USD, a 50% withdrawal rate is very safe and can almost always ensure the adequacy of the insurance fund capital in all scenarios and growth levels. If a black swan event occurs before the insurance fund has the opportunity to be capitalized through positive fundraising, early exponential growth may pose a danger to the solvency of the insurance fund. Late-stage exponential growth is safer because it provides more time for the growth of the insurance fund.
However, the actual situation is that the initial insurance fund is only 1 million USD, and the supply of USDe is growing much faster than the early exponential growth scenario in the model. Currently, the 38.2 million USD insurance fund (only 1.66% of the USDe issuance) has increased by nearly half in the past month. It is evident that the rapid issuance of USDe has resulted in a severe deficiency in the early insurance fund of the Ethena project compared to the official model calculation.
An insufficient insurance fund will have two consequences:
Lack of confidence from users in the project. If high returns start to decline, the Total Value Locked (TVL) of the project will gradually decrease.
High TVL and low insurance fund. The project team must increase the insurance fund withdrawal rate (to at least 30% or higher) to quickly replenish the insurance fund. However, in the current situation of gradually declining funding rate yield, users' yield will be further affected, potentially exacerbating the first consequence.
4.3 Run on the Bank Caused by Black Swan Events
Referring to the ETH Pow arbitrage event in the third quarter of 2022 in Figure 1, the funding rate experienced a significant drop in a short period, with an annualized rate exceeding 300%. In such black swan events, a run on the bank of USDe is almost inevitable. However, the unique mechanism of USDe seems to have a natural advantage in dealing with a run on the bank.
In the early stages of a significant drop in the funding rate, a run on the bank may have already occurred. Due to the run on the bank, the Ethena protocol needs to return a large amount of spot collateral and close an equivalent amount of short positions. As the short positions decrease, the expenditure of the insurance fund also decreases, allowing the insurance fund to be maintained for a longer period.
From a liquidity perspective, when a run on the bank occurs, Ethena needs to close short positions. In a market with a negative funding rate, it means that long position liquidity is exceptionally sufficient, and closing short positions will almost not be troubled by liquidity issues.
Additionally, the Ethena protocol has a 7-day cooling-off period for sUSDe (collateral cannot be liquidated within a week), which can serve as a buffer during market volatility.
However, all of this is contingent on the sufficiency of the insurance fund.
4.4 Total Open Interest in the Market
The total open interest (OI) in the market has always been a key factor limiting the issuance of USDe and a potential risk for USDe in the future. As of 2024/5/9, the ETH OI in the Ethena protocol accounts for 13.77% of the total OI, and the BTC OI accounts for 4.71%. The significant amount of short positions generated by the Ethena protocol has already caused some disturbance in the futures market. The subsequent expansion of USDe may face liquidity issues.
The best way to address this issue is to increase as many high-quality collateral types as possible (with a long-term funding rate greater than 0), which can not only raise the upper limit of USDe supply but also increase the diversification of the portfolio and reduce risk.
5. Conclusion
In conclusion, the Ethena protocol demonstrates its unique stablecoin mechanism and sensitive response to market dynamics. Despite facing challenges such as prolonged basis downturn, insufficient insurance fund, and potential run on the bank risks, Ethena has maintained its competitiveness in the market through innovative off-exchange settlement mechanisms and diversified collateral types.
As the market environment continues to change and technological innovations within the industry continue, Ethena must continuously optimize its strategies and enhance its risk management capabilities to ensure the sufficiency of the insurance fund and the stability of liquidity. For investors and users, understanding the operational mechanism of the protocol, its revenue sources, and potential risks is crucial.
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