Historically, on-chain stablecoins have had a tough time competing with centralized stablecoins. As a result, USDC and USDT have absolutely dominated the stablecoin space, with a cumulative market share of over 95%. The problem with on-chain stablecoins is that they either have difficulty scaling due to their over-collateralized nature or have difficulty maintaining their pegs due to under-collateralization.
In March 2023, Arthur Hayes wrote an article titled “Dust on the Earth’s Crust” in which he talked about the rise of stablecoins and their use among traders and market makers. He then proposed the idea of an on-chain fully decentralized stablecoin called the “Satoshi Dollar”, a delta-neutral, 1:1 collateralized synthetic dollar created by equal amounts of spot long and futures short Bitcoin exposure.
This idea has been realized by Ethena Labs, which is building USDe, a synthetic dollar backed by ETH collateral yield and perpetual swaps. In short, USDe is collateralized 1:1 by ETH LST (such as Lido's stETH), and its risk is hedged by shorting an equal amount of ETH perpetual futures. USDe generates high yields (currently over 20%) and is labeled an "Internet bond."
Ethena is backed by Dragonfly, Wintermute, OKX Ventures, and investors including Cobie, Arthur Hayes, and Anthony Sassano. I had the pleasure of speaking with Ethena founder Guy to learn more about the underlying design and upcoming roadmap, including mainnet launch, DeFi integration, and upcoming airdrop plans.
USDe and Ethena Disassembly
The “stablecoin trilemma” was proposed a few years ago, which states that stablecoins cannot have all three of the following properties at the same time:
Maintaining the peg to the underlying asset
Scalable
Decentralization
Stablecoins like USDC and USDT are scalable and can maintain their peg to the dollar, but they are not decentralized.
On the other hand, LUSD from Liquity is highly decentralized and maintains its peg to the USD very well, but struggles to scale due to over-collateralization.
Terra’s UST is both decentralized (to some extent) and highly scalable, but is unable to maintain its peg.
Ethena’s USDe aims to encompass all three properties, thereby solving the stablecoin trilemma. USDe has not yet been publicly released (only whitelisted users can access the product during the pre-release phase), but despite this, its supply has grown to over $115 million in just over a month. Here’s how it works:
There are two ways users can get USDe. First, by buying it through decentralized exchanges like Uniswap or Curve. Second, by minting it through the Ethena protocol. With the public launch, users will be able to mint USDe with various assets through the Ethena frontend, which convert it to ETH LST on the backend, such as stETH, mETH, and wbETH, which are then deposited with custodians as collateral and used to create ETH short positions on centralized exchanges. This hedge creates a USD position against which USDe is issued.
There is no leverage used on the collateral short side, as the focus of USDe is to be a secure base layer:
“The idea behind the product is to try to make it as safe as possible at the base layer. You can start doing some interesting things with leverage to try to boost returns in some way, but we really just want to create a solid foundation that others can build on and start using leverage in other interesting ways, whether it’s in currency markets or on perpetual Dex.”
USDe maintains its peg through arbitrage. If USDe is trading below the peg on exchanges like Curve, Uniswap, or Binance, arbitrageurs can buy USDe and redeem the collateralized asset for $1 on the Ethena front end for a profit. If USDe is trading above the peg on an exchange, arbitrageurs can mint USDe on Ethena and sell it on an exchange in a similar manner. As long as USDe is collateralized at a 1:1 ratio, the peg will remain stable.
Growing US dollar liquidity
In order for stablecoins to maintain their peg to the underlying asset, liquidity is very important. Ethena aims to increase the liquidity of USDe on various decentralized exchanges such as Curve Finance, which is the main DEX for stable assets. In the public launch later in January, Ethena will put incentives in place to ensure deep liquidity for USDe on Curve. As of the time of writing, there are several USDe liquidity pools on Curve, including USDe/USDC, USDe/FRAX, and USDe/crvUSD.
Revenue Flywheel
As outlined earlier, both long and short positions on USDe collateral generate yields that are distributed to users who choose to stake USDe. The sources of yield are:
Spot Long: Ethereum Staking Yield (Consensus Layer and Execution Layer Rewards).
Futures Short: Funding and basis earned on derivatives positions.
The annualized rate of return on ETH staking is usually in the range of 3-5%, while the funding rate of ETH derivatives fluctuates violently and is highly dependent on the market demand for futures trading. As shown below, as the market rebounds, the ETH futures funding rate has recently soared to over 70%, and traders who want to go long on ETH are willing to pay high fees for this position. Funding fees are paid by longs to shorts.
In a strongly bullish funding scenario, it is very possible that the yields generated by USDe collateral could exceed 30-40%. However, historically, over longer time frames, yields have proven to be closer to 5-15% APY.
Dual Token Design
As mentioned earlier, users can only receive the yield generated by USDe if they pledge stablecoins as sUSDe. If the yield on USDe collateral is 15%, but only half of USDe is pledged, the sUSDe staker will receive (15%/50%) = 30% APY.
Since USDe's liquidity will be incentivized on DEXs such as Curve and further integrated into various money markets and other DeFi applications, it is expected that not all USDe will receive protocol returns. As shown in the figure below, the total collateral yield is "Protocol APY" and the sUSDe yield is "sUSDe APY".
Additionally, Ethena will focus specifically on integrating USDe into centralized exchange order books as a way to differentiate the product from other on-chain stablecoins and create wider adoption.
DeFi Integration and the Road to Decentralization
“We want to separate the most important tool in cryptocurrency, namely stablecoins, from the banking system. The purpose of everything we do is to create a self-sufficient system, but the most important assets are completely centralized.”
Ethena's core thesis is simple: separate the largest crypto product (stablecoins) from the traditional banking system. With USDe, there is no collateral risk of centralized assets like USDC or US Treasuries. The only risk is ETH, which is one of the most decentralized and permissionless assets in the world.
But today Ethena still has centralized aspects. One of them is to hedge the risk of staking ETH on centralized exchanges. The reason for this is that most of the liquidity is still on centralized exchanges. Ethena is working towards full decentralization, but is still waiting for DEX derivatives to mature. The first step seems to be to use Synthetix and the Synthetix frontend as the first DEX for this hedge, which is part of the roadmap for later this year.
USDe/sUSDe integration makes sense in some verticals:
USDe can be used as collateral for other stablecoins. Both FRAX and DAI rely heavily on the returns of traditional assets, and they may want to diversify their investments and obtain crypto-native returns from sUSDe.
Money markets, such as lending platforms like Aave. Leveraged recycling strategies can bring potential high returns to sUSDe holders by increasing leverage.
sUSDe as a high-yield collateral for CEX and DEX leveraged trading
2024 Roadmap
In the short term, Ethena is preparing for a public launch, where users will be able to mint and redeem USDe on the protocol, and stake USDe to earn the yield generated by the collateral. In addition, Ethena will incentivize liquidity on various DEXs to ensure that users can buy and sell stablecoins with minimal slippage. The expected time is late January, when an airdrop plan for the upcoming governance token may also be announced.
In the medium and long term, Ethena plans to integrate USDe into various DeFi protocols and centralized exchanges to increase supply and create strong utility. Ethena also plans to further decentralize by moving short positions from centralized exchanges to DEX.
In addition, Ethena will also explore other assets as collateral for USDe, such as BTC and jitoSOL. These assets will also be Delta hedged, and the integration ultimately depends on whether these assets have deep liquidity and whether the financing fee is favorable from a yield perspective.
in conclusion
All in all, I’m very excited about the full launch of Ethena. Given the current yields generated by staking and funding rewards, USDe seems likely to grow into one of the largest on-chain stablecoins in crypto. I personally look forward to first seeing the USDe and sUSDe flywheels created through various DeFi integrations, and second, Ethena’s move to a more decentralized model. As USDe grows, we pray that the Ethena smart contracts have been extensively audited and that the CEXs that Ethena uses for hedging do not collapse. As with any other DeFi protocol, there are obvious risks with Ethena and USDe, but their potential this year is worth looking forward to.
