Financing 14 million USD, analyzing the mechanism, risks, and prospects of EthenaLabs (USDe)

Original Title: Stablecoin Evolution: USDe's Impact on Decentralized Finance
Original Source: Greythorn Asset Management

· Project Name: EthenaLabs

· Network: Ethereum L1

· Current TVL (Total Value Locked): $410 million

· Project Type: CDP (Collateralized Debt Position)

· Code Name: $USDe & $ENA

· Cryptocurrency Ranking: #NA

· Market Cap: NA

· Fully Diluted Market Cap (FDV): NA

· Circulating Supply: NA

· Total Supply: NA

Introduction

Following the collapse of Terra and its associated UST and Anchor protocols in 2022, interest in decentralized stablecoins has sharply declined. However, with the ongoing development of Web3, sectors are continuously rotating and evolving. Now, the Greythorn team sees projects like Prisma, Liquity, and Lybra at the forefront of innovation in the LSD/CDP space. Meanwhile, Maker and Curve remain stable in terms of total value locked (TVL).

Many experts are questioning whether EthenaLabs' new project USDe can maintain its ~27% annual percentage yield (APY) while avoiding investors falling into a situation similar to Anchor.

After EthenaLabs announced its funding on July 12, 2023, it reignited enthusiasm for DeFi by creating a dollar-pegged digital currency using LST (stETH). This raises a question: will it fully leverage Ethereum's Layer 1 and Layer 2, or will it follow in LUNA's footsteps and become the next major failure in the crypto market?

Why are USDe and Stablecoins Important?

Stablecoins have become key players in decentralized currency markets, significantly influencing market dynamics. They are an essential component of spot and futures market trading, playing a crucial role in supporting transactions and enhancing the stability of the crypto market, especially in the context of ongoing volatility.

In the past two years, the stablecoin sector has seen significant growth, with on-chain transaction volumes exceeding $9.4 trillion this year; they account for two of the top five assets in DeFi, representing over 40% of total value locked (TVL). They dominate trading, with data showing that over 90% of order book trades and over 79% of on-chain transactions involve stablecoins.

Source: X: Route2FI

AllianceBernstein, a leading global asset management firm with $725 billion in assets under management (AUM), predicts that the stablecoin market could reach $2.8 trillion by 2028. This forecast indicates a significant growth opportunity from the current market cap of $138 billion (which previously peaked at $187 billion).

The growing acceptance of stablecoins and their consistent performance in both centralized and decentralized environments demonstrate their indispensable role in the crypto ecosystem. Optimistically, their growth potential could reach 2000%, presenting significant opportunities for investors and market participants to engage with projects like EthenaLabs' USDe.

Specifically, USDe aims to meet this growing demand by providing a censorship-resistant, scalable, and stable market option.

Project Overview

EthenaLabs draws inspiration from Arthur Hayes' article "Dust to Crust," aiming to create a derivatives-backed stablecoin that addresses the significant issue of cryptocurrency reliance on traditional banking. Their goal is to provide a decentralized, permissionless savings product for a broad audience. EthenaLabs' synthetic dollar USDe aims to be the first crypto-native, censorship-resistant, scalable, and stable financial solution, achieved through Delta hedging of collateralized Ethereum.

EthenaLabs plans to introduce a product they call "Internet Bond" alongside USDe. According to the EthenaLabs Gitbook, this will be a collateral-based Ethereum yield tool that generates returns and utilizes funding and basis differentials in perpetual contracts and futures markets.

EthenaLabs stands out with its unique mission and innovative approach. Unlike other CDP projects (such as Maker's DAI, Liquity's LUSD, and Curve's crvUSD), EthenaLabs' USDe generates its USD value and yield through two main strategies:

1. Utilizing stETH and its inherent yield.
2. Taking short positions in ETH to balance Delta and leverage perpetual/futures funding rates.

This strategy allows the protocol to create a Delta-neutral CDP by combining spot deposits of stETH with corresponding short positions established through partnerships with CEXs like ByBit and Binance.

Holding Ethena's sUSDe (collateralized USDe) essentially becomes a basis trade, balancing the spot stETH position with the short ETH position in the market. This setup provides users with exposure to the yield differential between these positions, currently generating an approximate yield of ~27%.

Source: EthenaLabs Gitbook

USDe: Key Risks and EthenaLabs' Mitigation Measures

Before delving into the risk and return analysis of collateralizing USDe, it is important to address several potential risks associated with EthenaLabs:

● Custodial Risk

EthenaLabs uses "Over-the-Counter Settlement" (OES) providers to custody assets, creating a dependency on the operational capabilities of these providers. Challenges in executing key functions such as deposits, withdrawals, and exchanges could impact the efficiency of the protocol and the minting/redeeming of USDe.

Mitigation Strategy: Diversifying Custodial Providers: EthenaLabs effectively manages concentration risk by diversifying collateral across multiple OES providers, minimizing risk.

● Centralized Exchange (CEX) Risk

The protocol uses derivatives on centralized exchanges (e.g., Binance, Bybit) to balance the Delta of collateral. If an exchange suddenly becomes unavailable, this poses a risk.

Mitigation Strategy: Diversifying CEX Channels: By diversifying the exchanges where assets are held, EthenaLabs reduces the risk of failure from any single exchange.

● Collateral Risk

The difference between the collateral asset (stETH) and the underlying asset (ETH) in perpetual futures positions introduces "collateral risk." Significant errors in LST could lead to liquidity issues.

Mitigation Strategy: Active Monitoring and Partnerships. EthenaLabs actively monitors the on-chain integrity of stETH and maintains contact with liquidity sources, ready to replace collateral if necessary.

● Liquidation Risk

Collateralizing stETH in short ETHUSD and ETHUSDT positions introduces liquidation risk if the price spread between ETH and stETH widens significantly.

Mitigation Strategy: Systematic Collateral Management: EthenaLabs has processes in place for rebalancing collateral, transferring assets, and utilizing insurance funds to guard against liquidation risk.

i. Systematic Collateral Rebalancing

Ethena will systematically delegate additional collateral in any risk scenario to improve our margin position on hedged positions.

ii. Asset Transfer and Cycling Collateral

Ethena is able to temporarily cycle collateral between exchanges to support specific situations.

iii. Insurance Fund Deployment

Ethena has the capability to rapidly deploy insurance funds to support hedged positions on exchanges.

iv. Protecting Collateral Value

In extreme situations, such as critical smart contract flaws in collateralized Ethereum assets, Ethena will take immediate action to mitigate risk, with the sole motivation of protecting the value of the collateral. This includes closing hedged derivative positions to avoid liquidation risk becoming a concern and converting affected assets into another asset.

● Funding Risk

Ongoing negative funding rates may reduce Ethena's yield.

Mitigation Strategy: Insurance Fund as a Yield Protector: The insurance fund acts as a safety net when overall yields are negative, ensuring the stability of collateral.

● Withdrawal Queue/Slashing Risk

ETH withdrawals may experience long queues, which could negatively impact stETH.

Mitigation Strategy: This largely depends on the performance of stETH and Lido, and EthenaLabs does not have direct mitigation strategies.

● Regulatory Risk

Concerns over regulatory controls on USDT, USDC, and DeFi may impact USDe's growth in total value locked (TVL), including difficulties in attracting and retaining users.

Mitigation Strategy: EU-based Operations with MiCA Licensing: By operating under the EU's MiCA regulations, EthenaLabs positions itself to effectively adapt to regulatory changes, minimizing the impact of potential legal shifts.

EthenaLabs has developed a comprehensive approach to managing various risks in its operations, emphasizing the importance of diversification, active monitoring, and strategic planning in protecting the protocol and its users.

Comparison with Anchor: Is the Yield Worth It?

Investors are encouraged to conduct their own research, especially when considering USDe, which offers a high stablecoin yield of about 27%. This yield is comparable to that of the Anchor protocol, highlighting the systemic risk in the market, where the failure of a single protocol could lead to broader financial turmoil.

The decline of Anchor was primarily due to the inherent risks in the design of UST, which relied on a reflexive mechanism tied to the price of Luna. If Luna's price fell significantly, it risked catastrophic devaluation of UST. Anchor provided UST (or aUST) yields to borrowers based on a fixed Terra rate, promising an annualized rate of 19.45% regardless of market conditions.

Additionally, Anchor's "real yield," derived from collateralized bAssets, was only about 5.81%, far below the payout rate. This discrepancy, combined with its reliance on Luna's performance, set the stage for a financial crisis.

For those looking to learn more about the collapse of Luna and UST, including the Anchor mechanism, we have previously detailed this in articles titled "Demystifying Anchor" and "The Collapse of Anchor."

For USDe, its yield generation, associated risks, and marketing strategy are significantly different from Anchor:

Transparent Marketing: Unlike Anchor's promotion of "risk-free" returns, USDe's marketing directly addresses risks and returns. Its yield sources, derived from perpetual contracts (perps) and collateralized Ethereum (stETH), are clearly communicated, setting realistic expectations.

Real Yield: sUSDe does not promise unsustainable high deposit rates. Instead, it offers actual yields from its underlying assets, avoiding the trap of incentivizing borrowers with rates unsupported by asset earnings.

Avoiding Self-Collateralization: Unlike some models that use their own tokens as collateral, sUSDe relies on stETH. This shift from a project’s own token to a more stable asset like stETH significantly alters the risk dynamics. The focus shifts from speculative risks associated with project tokens to more manageable liquidity risks of ETH and stETH, along with other risks mentioned above.

Comparing USDe with the collapse of UST is misleading, as they have fundamentally different risk structures and operational models. USDe investors should focus on understanding the specifics of perpetual funding, centralized exchange liquidity, and custodial risks, rather than the unsustainable high-yield strategies seen in the UST model.

Overall, compared to Terra's UST, USDe presents a more thoughtful and potentially safer option in terms of risk mitigation and product structure. By leveraging native yields and effectively managing risks from derivative sources, USDe stands out not only for its yield opportunities but also for its strategic design and risk management practices.

Outstanding Team and Support

Under the leadership of @leptokurtic_, the Ethena team successfully completed three rounds of funding, attracting significant participation from centralized exchanges, market makers, DeFi innovators, and traditional financial institutions. This broad support underscores the project's credibility and its potential impact on the ecosystem.

Under tight deadlines, the team demonstrated exceptional planning and coordination, ensuring the protocol was ready for mainnet launch. They prioritized risk management and security, conducting thorough audits before the release.

Source: ICO Analytics: Ethena

The success of the Shard airdrop event reflects the market's interest in decentralized stablecoins. Since early December 2023, total value locked (TVL) has increased 135 times, reaching over $410 million, marking an impressive start for the event.

Source: @noxiousq Dune Analytics

This momentum indicates strong demand for products like USDe, attracting not only significant TVL but also the attention of investors supporting its vision. As USDe moves forward, it aims to introduce the next billion-dollar TVL into the DeFi space, potentially opening up new opportunities similar to those seen during the Luna cycle. It raises the question: does this signify the beginning of another transformative phase in decentralized finance?