Background
Ethena emerged in 2023 as a decentralized stablecoin protocol offering a synthetic dollar to be used within DeFi and Web3. It leverages an innovative hedging mechanism to back USDe, a derivatives-based stablecoin.
Their native token, ENA, used for governance and rev share, currently holds the 49th spot in the market cap ranking with a fully diluted valuation of $9.88B. Alongside their native token, their stablecoin USDe holds a TVL of $6.04B which makes it the third largest stablecoin by market cap.
Core metrics showcase the strong support the protocol has received. As an example, out of the 6.04 billion USDe tokens currently in circulation, 70.6% are being staked by holders, while only 9.4% of the supply (569.4M USDe) is held on centralized exchanges (CEXs). These metrics indicate robust holder confidence and commitment to the protocol. Given that a high staking rate leads to a reduction in circulating supply, combined with a relatively small percentage held in exchanges, it can be inferred that the token is not actively held for trading by its holders.
Let’s dive into how Ethena and its derivatives-based stablecoin work.
Delta Hedging
The core component that Ethena employs is known as Delta Hedging. It serves as a risk management strategy that effectively offsets the collateral’s price change risk by taking short futures positions on CEXs and DeFi platforms. This is primarily achieved by strategically putting short positions in futures contracts across both CEXs and DEXs.
By taking these short orders, Ethena effectively offsets the potential losses that could arise from a decrease in the value of the collateral assets. This hedging mechanism acts as a counterweight that ensures that the overall portfolio value remains relatively stable even in the case of volatility.
The implementation of delta hedging across both CEX and DeFi platforms is the example of Ethena's commitment to robust risk management. Their dual approach ensures that potential risks associated with price movements are addressed across the entire array of exchanges, further enhancing the overall stability and security of the platform.
Bitcoin was officially adopted by Ethena as a collateral asset for USDe in April of 2024, primarily to expand USDe’s scalability and stability by leveraging BTC’s liquidity and solid derivatives market. Furthermore, after a governance proposal from October 2024, SOL now holds a spot in USDe’s collateral basket.
Tokens
ENA
- It’s the governance token launched by Ethena in April of 2024.
- As of November 30th, 2024, a portion of protocol revenue started to be allocated to sENA, the staked version of ENA. After the proposal, the token’s price increased by approximately 45% in a couple of days, and it experienced a significant prolonged uptrend after that.
- ENA has the following utilities:
- Revenue-sharing mechanism where a portion of revenue flows into the staked ENA tokens.
- Governance (participants take place in adjustments to the treasury and collateral basket, and protocol upgrades).
- Incentives for providing liquidity for USDe across DEXs and lending protocols.
USDe
- Fully-backed and free to compose throughout CeFi & DeFi, USDe is backed with liquid staking tokens (LSTs) that generate yield from Ethereum staking rewards
- A synthetic dollar-pegged asset is created by holding LSTs (long exposure) to offset ETH price movements (short exposure).
- USDe has the following utilities:
- It can be used as collateral in DeFi protocols
- Holders can stake their USDe to receive sUSDe, which accrues yield from staking rewards and funding rate arbitrage.
- USDe is the main transactional asset within the Ethena ecosystem, and it’s also fully integrated across exchanges, allowing seamless conversions and liquidity.
- USDe is backed by yield generation from diverse sources
- Ethereum staking yield earned from LSTs
- Funding rate arbitrage
- Protocol incentives and fees
Ethena Flow
- Users can mint USDe by depositing collateral, mainly in the form of LSTs into Ethena.
- Based on the collateral value, USDe is minted at a 1:1 ratio (or close, as the ratio can be dynamically adjusted as part of the delta hedging strategy).
- While the LSTs are held as collateral, they generate yield from Ethereum staking while Ethena dynamically maintains a delta-neutral position. Such yield backs USDe, and a portion also flows to ENA.
- Users can also stake USDe to receive sUSDe, which earns the protocol’s real yield, allowing holders to earn passive income while keeping exposure to a dollar-pegged token.
- Users can use USDe in DeFi as collateral, to provide liquidity, use it in lending protocols, or even perform swaps with other cryptocurrencies.
- Lastly, users can redeem USDe for LSTs at any time, effectively burning USDe and reducing supply.
- During this process, Ethena closes the corresponding short positions on exchanges to release collateral.
Are There Any Risks?
This aspect has been a hot topic of discussion, as many users and industry experts have made emphasis on potential risks that Ethena’s attractive model and yield entail. Below are some of the key risks:
- Exposure to ETH
- Ethena’s USDe relies heavily on ETH and derivatives, exposing the protocol to price volatility as any disruptions in the staking portion of the protocol (withdrawal delays, slashing events, or depegs) could impact its backing and stability.
- Counterparty Risks
- If any of the exchanges where Ethena manages positions on experiences any problems (liquidity issues, sudden regulatory crackdowns), Ethena’s Delta Hedging may be less reliable, causing system-wide losses.
- Leveraged Trading & Liquidation Risks
- The risky nature of leveraged trading poses a potential risk for Ethena’s reliance on perpetual futures.
- Not only the inherent risk of leveraged trading, but if the hedging mechanisms fail or markets become excessively volatile, forced liquidations could create a negative feedback loop, worsening any potential USDe instability.
- Codependent Systemic Risk (Luna Flashbacks)
- Codependent potential issues that could lead to a cascading collapse like that of Luna in May of 2022.
- A cascading failure could occur if funding rates turn sharply negative, leading to yield collapse, mass redemptions, and potential protocol insolvency.
- Mass Redemptions & Exchange Reliance
- One of the main concerns, where large amounts of USDe are burned in exchange for the underlying collateral.
- While Ethena guarantees that the protocol is designed to maintain stability, a sudden surge in redemptions could expose weaknesses.
- Not only “naturally”, but if LSTs’ liquidity dries up could also lead to mass redemptions of USDe.
- What would happen in such a scenario is tied with how Ethena manages USDe redemptions. When users redeem USDe, Ethena closes its short ETH perpetual futures positions to release collateral. If too many positions are closed simultaneously, this could create price slippage, increasing redemption costs and potentially breaking USDe’s peg. If the hedge positions cannot be closed efficiently, the system could face major imbalances.
- Ethena’s dependency on CEXs means that, during extreme volatility, withdrawals or trading may be halted or delayed.
- Yield Dependency on Market Conditions
- As aforementioned, Ethena’s yield comes from staking rewards + funding rate arbitrage.
- These yield generation sources are dependent on favorable market conditions and positive funding rates.
- A strong bear market or detrimental regulatory changes affecting derivatives trading could threaten Ethena’s ability to generate returns, making USDe less sustainable.
- Nevertheless, Ethena launched a Reserve Fund to act as a buffer against negative funding rates
- The fund is made up of stable, uncorrelated assets, including USDC and USDT, Smaller allocation of ETH, and other assets determined by governance.
- The fund is designed to cover negative funding payments when funding rates turn unfavorable, as well as a safety mechanism in case USDe depegs
- Initially modeled with a $20M reserve, Ethena has since expanded it to $46.6M as of Q4 2024