Back in December, I started to read about Ethena and their ambitions to create a synthetically-backed fiat stablecoin that could act an an “internet bond” in its staked format. I shared some initial thoughts here.

Now, several months after Ethena’s public launch and $3B in TVL later, I am suggesting that DAOs consider dedicating a portion of their stablecoin reserves to sUSDe. Specifically, I am speaking to investment DAOs that already hold most of their unallocated treasury in stable assets like USDC, USDT, DAI, and others.

In short, there is still time to get on board. What Lido has done for Ethereum staking yield, Ethena is doing for the funding rate. They offer a tokenized wrapper around this source of yield that comes with its own set of inherent risks. However, Ethena appears to have carefully designed their protocol to mitigate many of the most significant threats.

Therefore, given the yield that Ethena is currently paying stakers, holding a small percentage of your DAO’s reserves in USDe appears to be favorable from a risk / reward perspective.

First, what is Ethena's USDe?

USDe is a synthetically-backed fiat stablecoin

Unlike USDC, which is a physically-backed fiat stablecoin supported by US Dollar deposits and short-term Treasurys, Ethena’s USDe has no exposure to the fiat financial system. Instead, USDe is backed by crypto reserves like ether LSTs and BTC that are hedged 1:1 with a short derivative. The result is a delta-neutral position that should synthetically maintain its peg with a fiat currency like the US Dollar.

In other words, instead of directly holding US Dollar deposits, Ethena holds crypto reserves (both long & short) that in aggregate, maintain their peg with the US Dollar. For example, if their stETH reserves appreciate by 25% relative to the US Dollar, their Ethena’s short position on ETH will counterbalance the gain. The result is a net change of $0.

USDe is a more scalable alternative to overcollateralized stablecoins

Additionally, USDe does not suffer from the same scalability issues as anchored stablecoins like Maker’s DAI. When you mint one unit of DAI, you end up removing some liquidity from the system due to the nature of overcollateralized loans. Whereas when you mint one unit of USDe, this is not the case.

Through its staked equilvalent, USDe distributes protocol yield with holders

Unlike fiat-backed stablecoin alternatives such as USDC and USDT which do not distribute treasury yield to token holders, Ethena allows users to capture a portion of the protocol’s yield by locking USDe in their staking contract. Right now, stakers can earn a 34% annualized yield by doing so. But how exactly is this yield generated?

In short, sUSDe is effectively a tokenized wrapper around two sources of yield. First, the Ethereum staking yield, and second the ETH and BTC funding rates. To understand how yield is generated in more detail, let’s consider what happens when a user deposits $10,000 of USDC into the protocol.

Example: Yield generation on a $10,000 deposit

1. The user deposits USDC: Ethena will take the user’s 10,000 units of USDC and exchange it for $10,000 worth of stETH. Next, Ethena will use this stETH as collateral to take the short side of an ETH/USD perpetual futures contract worth $10,000 in notional value. Note that Ethena is not taking any leverage here, and fully collateralizes its short position.

2. Ethena mints USDe: After exchanging the user’s USDC for stETH and then using that to open an offsetting short ETH/USD position, the protocol will mint 10,000 USDe and transfer it to the user.

3. Ethena earns yield on stETH: While the value of the protocol’s two assets will move in opposite directions, each one generates real yield while they are held. First, stETH will accrue the Ethereum staking yield (4%), net of the node operator’s fee (1%). I discuss this in more detail here.

4. Ethena collects the funding rate on its short positons: Second, Ethena will capture the funding rate for ETH/USD perpetual contracts during periods in which longs pay shorts. You can think of the funding rate as a periodic interest payment that is used to keep perpetual futures contract prices in line with spot prices based on demand / supply factors. According to the protocol dashboard, Ethena’s yield from funding rates has averaged around 10% APY during the month of May.

5. Ethena directs protocol yield to stakers: While the protocol’s funding rate income averaged around 10% APY in May, Ethena was able to return upwards of 30% to stakers throughout the period. This 3x multiple is attributable to two factors. First, Ethena also distributes the ETH staking yield (3%) to stakers. Second, only 1.2B of the 3B USDe in circulation is currently staked in the sUSDe contract. In other words, USDe holders who have not staked their tokens are subsidizing the yield earned by those holding sUSDe. Refer to the bottom of this post for a deeper dive into the funding rate and the risks surrounding it.

6. Stakers see their sUSDe appreciate in value: Assuming our user had locked their USDe in the staking contract immediately, they would see the value of their sUSDe increase in the same way as non-rebasable tokens like wstETH. Qfter a month of holding thier position under the conditions mentioned above, our user who deposited $10,000 into Ethena would see no change in the quantity of sUSDe tokens they held. Instead, they would see the redemption value of each token grow in proportion to their share of the protocol’s yield. In this case, their $10,000 of sUSDe would be worth $10,250 based on a 30% APY.

Unpacking Some Important Risks Factors

What if the funding rate turns negative for shorts?

Since Ethena hedges its crypto deposits by taking the short side of perpetual swap contracts, the protocol is exposed to “funding risk”. Specifically, this means that if the funding rate for shorts were to turn negative for an extended period of time, Ethena would be in trouble. That is because the funding rate currently accounts for the majority of the protocol’s real yield. Now you may be wondering, what are the odds of seeing a prolonged period of negative funding rates?

Over the past three years, funding rates have experienced a natural positive bias, allowing shorts to earn interest income for keeping their positions open. Intuitively, this trend makes sense as traders are most often optimistic about future prices, even during market downturns. According to Ethena, the average annualized funding rate between 2021-2023 for ETH was between 6% - 7.5% on a volume weighted basis. More recently, data from The Block shows that annualized funding rates for shorts have consistently remained above 0% in recent months. To learn more about how the funding rate is calculated, see here.

Currently, Ethena has been able to distribute three times the market funding rate to its USDe stakers because only a third of the USDe in circulation is being staked. This is attributable to the fact that during season 2 of Ethena’s Sats campaign, they are offering more points to holders who do not stake their USDe and instead deploy it in other DeFi avenues such as lending pools and AMMs. Consequently, it is expected that the funding rate captured by sUSDe will decline once Ethena’s S2 campaign ends and the benefits for holding USDe diminish.

Now what if we enter a period where shorts must pay longs? While it may be unlikely that funding rates remain negative for an extended period of time (ex: several months), there is still a chance that these rates fall into negative territory from time to time, especially during a bear market. However, Ethena appears to have carefully considered how to mitigate this risk in the following ways.

1. Staking yield: Ethena can utilize ether’s liquid stake yield as a buffer during any periods where the funding rate is negative. By holding ETH reserves in LSTs like stETH, Ethena’s ETH-denominated crypto reserves will accrue the staking yield which is currently around 3% - 4%.

2. Reserve fund: Ethena introduced a reserve fund that can be drawn down to offset any short-term losses due to negative net yield. To capitalize the insurance fund, a portion of Ethena’s protocol revenue is sent directly to this wallet.

3. Exogenous yield: If the funding rate becomes negative for a short period of time, therefore lowering Ethena’s protocol yield, then we could expect at least a portion of investors to exit from their USDe / sUSDe positions. This will lower Ethena’s TVL, and thus, the total size of their short position on perpetual futures markets. By lifting these short positions, this would naturally relieve some pressure on the short side of the perpetual market, forcing the funding rate to revert back to its long-term mean.

For a more in-depth analysis of Ethena’s exposure to funding risk, see this thread from their founder.

Could the value of Ethena’s reserves fall below that of outstanding USDe?

First of all, Ethena’s perpetual contracts are extremely unlikely to be liquidated since they are backed 1:1 with crypto collateral. Although, when it comes to Ethena’s ETH reserves, there is an asset mismatch between the collateral and the offsetting short - LSTs are being used as collateral against a short ETHUSD perp. This means that if an LST like stETH were to fall from its peg relative to ETH, then the risk of Ethena’s reserves being liquidated rises.

However, it is worth noting that Ethena estimates the risk of liquidation to be significant only in the event that stETH diverges from ETH by more than 25%. This has never happened before. See here to learn more about this risk factor.

Are there centralization risks that pose a significant threat to Ethena’s protocol?

Ethena is not a decentralized protocol. Not only does Ethena rely on liquidity across the largest CEXs, but they rely on centralized custodians and a small core team to manage operations.

To mitigate exchange failure risk, which would technically result in a loss of reserves, Ethena has placed all funds in segregated accounts within bankruptcy remote legal structures. This means that if either an exchange or a custodian goes bankrupt, Ethena’s reserves are insulated.

However, as Blockanalytica outlined here, there is still a risk that custodians could become accountable to jurisdictions that enforce the freezing of assets based on court orders or other legal processes. Thus, while both exchange failure risk and custodial risk may not be material, they are not insignificant.

To mitigate for business risks that are inherent to a centralized org structure, Ethena plans to decentralize protocol governance via its ENA token when their second airdrop campaign comes to an end in September 2024.