Locking volume exceeds 5 billion magnesium! Ethena's advantages and crisis: Is it a time bomb or a savior?

Ethena is the most successful protocol in the history of Decentralized Finance. About a year ago, its Total Value Locked (TVL) was less than $10 million, and today it has grown to $5.5 billion. It integrates with multiple protocols in various ways, such as @aave, @SkyEcosystem (including Maker/Sparklend), @MorphoLabs, @pendle_fi, and @eigenlayer. There are so many protocols collaborating with Ethena that I had to change the cover multiple times when reminiscing about another partner. Among the top ten protocols in TVL, six are either collaborating with Ethena or are Ethena itself (Ethena ranks ninth). If Ethena fails, it will have a profound impact on many protocols, especially AAVE, Morpho, and Maker, which will face varying degrees of insolvency in terms of functionality. At the same time, Ethena's growth of billions of dollars has significantly increased the adoption of Decentralized Finance as a whole, similar to the impact of stETH on Ethereum Decentralized Finance. So, is Ethena destined to destroy the Decentralized Finance we know, or will it bring Decentralized Finance into a new renaissance? Let's delve into this question.

How does Ethena actually work?

Image source: Block unicorn

Despite being launched for over a year, there is still a widespread misunderstanding of Ethena's working principles. Many claim it to be the new Luna and refuse to elaborate further. As someone who has warned against Luna, I find this viewpoint very one-sided, but at the same time, I also believe that most people lack a sufficient understanding of how Ethena operates in managing Delta-neutral positions, custody, and redemption. If you think you fully understand how Ethena manages Delta-neutral positions, custody, and redemption, please skip this section. Otherwise, this is essential reading material for a comprehensive understanding.

Overall, Ethena, like Bitcoin, benefits from financial speculation and the bull market of cryptocurrencies, but in a more stable manner. As the price of cryptocurrencies rises, more and more traders want to go long on Bitcoin and Ether, while fewer and fewer traders are willing to go short. Due to the supply and demand relationship, the cost is paid by the traders who go short, to the traders who go long. This means that traders can hold Bitcoin while also shorting the same amount of Bitcoin, achieving a neutral position. When the price of Bitcoin rises, the gains and losses of the long and short positions offset each other, and traders can still earn interest income. Ethena operates entirely based on this mechanism; it takes advantage of the lack of sophisticated investors in the cryptocurrency market who prefer to profit by earning returns rather than simply going long on Bitcoin or Ether.

However, a major risk of this strategy lies in the custodial risk of the exchange, as evidenced by the collapse of FTX and its impact on the first-generation Delta neutral managers. Once the exchange closes, all funds may be lost. This is why, despite how efficiently and securely mainstream managers manage capital, they are greatly affected by the closure of FTX, as exemplified by @galoiscapital, and this is not their fault. Exchange risk is one of the important reasons for Ethena to choose to use @CopperHQ and @CeffuGlobal. These custodial service providers act as trusted intermediaries, responsible for holding assets and assisting Ethena in interacting with the exchange, while avoiding exposing Ethena to the custodial risk of the exchange. In turn, the exchange can rely on Copper and Ceffu because they have legal protocol with custodial institutions. The total profit and loss (i.e., the amount Ethena needs to pay to long traders, or the amount long traders owe Ethena) is periodically settled by Copper and Ceffu, and Ethena systematically rebalances its positions based on these settlement results. This custodial arrangement effectively reduces exchange-related risks while ensuring the stability and sustainability of the system.

Image source: glassnode

The minting and redemption of USDe/sUSDe is relatively simple. USDe can be purchased or minted using USDC or other major assets. USDe can be staked to generate sUSDe, which earns income. sUSDe can then be sold on the market by paying the corresponding exchange fee, or redeemed for USDe. The redemption process usually takes seven days. USDe can then be exchanged for supporting assets at a 1:1 ratio (corresponding to a value of $1). These supporting assets come from asset reserves and collateral used by Ethena (mainly Bitcoin and Ether or derivatives of Ether). Given that some USDe is not staked (many of which are used for Pendle or AAVE), the income generated by assets supporting these unstaked USDe helps enhance the income of sUSDe.

Image source: Block unicorn

So far, Ethena has been able to handle a large volume of withdrawals and deposits relatively easily, despite sometimes experiencing slippage of up to 0.30% for USDe-USDC. While this slippage is relatively high for stablecoins, it is far from reaching a significant level of decoupling and does not pose a risk to lending protocols. So why are people so concerned?

Okay, if there is a large withdrawal demand, such as 50%

How to make Ethena 'fail'?

Image source: Block unicorn

Given our understanding that the yields of Ethena are not 'illusory' and how it operates at a more subtle level, what is Ethena's primary real concern? Basically, there are several scenarios. First, the interest rate may become negative. In this case, if Ethena's insurance fund (currently about $50 million, enough to cover a 1% slippage/fund loss under the current TVL) is insufficient to cover the loss, Ethena will ultimately incur losses instead of profits. This situation seems relatively unlikely, as most users may stop using USDe when the yield decreases, which has also happened in the past.

Another risk is custodial risk, namely the risk that Copper or Ceffu may attempt to operate with Ethena's funds. The fact that the custodian does not have full control over the assets mitigates this risk. The exchange has no signing authority and cannot control any wallet holding the underlying assets. Both Copper and Ceffu are 'composite' wallets, meaning that the funds of all institutional users are mixed in hot/warm/cold wallets and have multiple risk prevention measures such as governance (i.e., control) and insurance. From a legal perspective, this is a structure of bankruptcy remote trusts, so even if the custodian goes bankrupt, the assets held by the custodian do not belong to the custodian's property, and the custodian has no claim to these assets. In practice, there are still simple negligence and centralization risks, but there are indeed many preventive measures to avoid this problem, and I believe the likelihood of such a situation occurring is equivalent to a black swan event.

Third, and also the most commonly discussed risk, is liquidity risk. In order to manage redemptions, Ethena must simultaneously sell its derivative financial product positions and spot positions. If there is a sharp fluctuation in the price of Ether/Bitcoin, this could be a difficult, expensive, and potentially time-consuming process. Currently, Ethena has prepared hundreds of millions of dollars to be able to exchange USDe for dollars at a 1:1 ratio, as it holds a large stable position. However, if Ethena's share of the total open contracts (i.e. all open derivative financial products) becomes larger, this risk becomes relatively serious, and may lead to a decrease in Ethena's net asset value (NAV) by several percentage points. However, in this case, the insurance pool is likely to fill this gap, and this alone is not enough to cause catastrophic failure of the protocol using it, which naturally leads to the next topic.

What are the risks of using Ethena as a protocol?

Image source: Block unicorn

Broadly speaking, Ethena's risks can be divided into two core risks: USDe liquidity and USDe solvency. USDe liquidity refers to the actual cash available that is willing to purchase USDe at a value of 1 US dollar or at a price lower than that benchmark value by 1%. USDe solvency refers to the ability of Ethena to obtain this cash even if it may not have cash at a given moment (such as after a period of withdrawals), provided that there is enough time to liquidate assets. For example, if you lend $100,000 to a friend who has a house worth $1 million. Indeed, your friend may not have the money readily available, and he may not be able to produce it tomorrow, but if given enough time, he is likely to raise enough money to pay you back. In this case, your loan is sound, and your friend simply lacks liquidity, which means that his assets may take a long time to sell. Bankruptcy essentially means that liquidity should not exist, but limited liquidity does not imply asset bankruptcy.

When Ethena collaborates with some protocols, such as EtherFi and EigenLayer, it will only face significant risks if Ethena is insolvent. Other protocols, like AAVE and Morpho, may face significant risks if Ethena's products lack liquidity for a prolonged period. Currently, the on-chain liquidity of USDe/sUSDe is approximately $70 million. Although quotes can be obtained through the use of aggregators, allowing up to $1 billion of USDe to be exchanged for USDC at a 1:1 ratio, this is likely due to the current high demand for USDe, which is intention-based demand. When Ethena experiences large-scale redemptions, this liquidity may dry up. In the event of liquidity depletion, Ethena will face pressure to manage redemptions to restore liquidity, but this may take time, and AAVE and Morpho may not have enough time.

To understand why this situation occurs, it is important to understand how AAVE and Morpho manage liquidation. Liquidation occurs when the debt position on AAVE and Morpho becomes unhealthy, meaning it exceeds the required loan-to-value ratio (the ratio between the loan amount and the collateral). Once this happens, the collateral is sold to repay the debt, fees are charged, and any remaining funds are returned to the user. In short, if the value of the debt (principal + interest) is close to the predetermined ratio compared to the value of the collateral, the position will be liquidated. When this happens, the collateral will be sold/converted into debt assets.

Currently, many people use these lending protocols to deposit sUSD as collateral in order to borrow USDC as debt. This means that if liquidation occurs, a large amount of sUSD / USDe will be sold for USDC / USDT / DAI. If all of this happens at the same time, and accompanied by other drastic market fluctuations, USDe is likely to lose its peg to the dollar (if the scale of liquidation is very large, certainly around $1 billion). In this scenario, theoretically, a large number of bad debts may arise. For Morpho, this is acceptable because the treasury is used to isolate risks, although certain income-type treasuries will be negatively affected. For AAVE, the entire core pool will be negatively affected. However, in this potential scenario, which is purely a liquidity issue, adjustments may be made to the liquidation management.

If liquidation could result in bad debt instead of immediately selling the underlying assets into an illiquid market and leaving AAVE holders with the difference, AAVE DAO can take responsibility for the tokens and positions without selling the collateral immediately. This would allow AAVE to earn more money (rather than net losses) during the liquidation process and enable users to receive funds (rather than getting nothing due to bad debt), as AAVE waits for prices and liquidity to stabilize. Of course, this system only works if USDe returns to its previous value; otherwise, the situation with bad debt would be worse. However, if there is a high probability event that could cause the token value to go to zero, which has not yet been discovered, liquidation is less likely to be better than waiting to gain more value, potentially resulting in a 10-20% difference as individual holders realize and start selling positions at a faster rate than the parameter changes. This design choice is crucial for assets that may encounter liquidity issues in a bubble market and may be a good design choice for stETH before its withdrawal is enabled on the Beacon Chain, and if successful, it could also be a great way to enhance AAVE's treasury/insurance system.

The risk of bankruptcy is relatively reduced, but not zero. For example, if one of the exchanges used by Ethena goes bankrupt. Of course, Ethena's collateral is safe with the custodian, but it suddenly loses its hedge and now has to hedge in a potentially volatile market. Custodians can also go bankrupt, as pointed out to me by @CryptoHayes when I was talking to him in Korea. Regardless of the protection measures around the custodian, there may still be serious hacker attacks or other issues. Cryptocurrencies are still cryptocurrencies, with potential risks, even if these risks are highly unlikely to occur and may be covered by insurance, the risk is still not zero.

What are the risks of not using Ethena?

Image source: Block unicorn

Since we have already discussed the risks of using Ethena, what are the risks of not using the Ethena protocol? Let's look at some statistics. Half of Pendle's TVL (at the time of writing) is attributed to Ethena. For Sky/Maker, 20% of revenue is to some extent attributed to Ethena. About 30% of Morpho TVL comes from Ethena. Ethena is now one of the main drivers of AAVE revenue and new stablecoins. Well-known platforms that do not use Ethena or interact with its products in any way are basically being left behind.

In the protocol, there are some interesting similarities between the adoption of Ethena and Lido. Around 2020 and 2021, the competition for the largest lending protocol became more intense. However, Compound focuses more on minimizing risk, possibly to the point of absurdity. AAVE integrated stETH as early as March 2022. Compound had been discussing adding stETH since 2021, but it was not until July 2024 that a formal proposal was made. This coincided with AAVE's surpassing of Compound. Although Compound is still relatively large, with a total locked value of $2 billion, it is now only slightly more than a tenth of the size of AAVE, which it once dominated.

To some extent, this can also be seen from the relative approaches of @MorphoLabs and @AAVELabs to Ethena. Morpho started integrating Ethena in March 2024, while AAVE didn't integrate sUSDe until November. There is an 8-month gap in between, during which Morpho has grown significantly while AAVE has lost relative control over the lending industry. Since AAVE integrated Ethena, TVL has increased by $8 billion and users' earnings have also significantly increased. This has resulted in the 'AAVETHENA' relationship, where Ethena's product generates higher returns, incentivizing more deposits and consequently creating more demand for borrowing, etc.

Ethena's 'risk-free' interest rate, or at least its 'normal' interest rate, is about 10%. This is far more than twice the value of the risk-free rate (FFR), which is currently around 4.25%. Introducing Ethena into AAVE, especially sUSD, has functionally improved the equilibrium interest rate for borrowing, as AAVE's 'base' interest rate now inherits Ethena's base interest rate, even if not entirely 1:1, it will be closer. This was also the case when AAVE introduced stETH earlier, with the borrowing rate for Ether coins roughly equivalent to the yield for stETH, which has occurred before.

In short, not using Ethena's protocol may face the risk of lower yield and lower demand, but to avoid the risk of severe detachment or collapse of USDe price, which is unlikely. Systems like Morpho, with their independent structure, may better adapt and avoid potential collapse. Therefore, it is understandable that systems like AAVE, based on larger liquidity pools, take longer to adopt Ethena. Now, although most of the content is a retrospective, I would like to present some perspectives that focus more on the future. Recently, Ethena has been working hard to integrate DEX. Most DEX lack short-selling demand, meaning users who want to short contracts. Generally, the only type of user that can sustainably achieve this on a large scale is delta-neutral traders, among which Ethena is the largest. I believe that a sustainable contract platform that can successfully integrate Ethena while maintaining a good product can escape competition from smaller competitors in a way similar to Morpho by closely collaborating with Ethena.

【Disclaimer】There are risks in the market, and investment needs to be cautious. This article does not constitute investment advice. Users should consider whether any opinions, views, or conclusions in this article are suitable for their specific circumstances. The responsibility is at your own risk.

This article is authorized for reprinting from: "PANews"

Original author: DC | In SF

The lock-up volume exceeds 5 billion magnesium! Ethena's advantages and crises: Is it a time bomb or a savior? This article was first published in 'Crypto City'.