Author: DC | In SF
Compiled by: Block unicorn
Ethena is the most successful protocol in DeFi history. About a year ago, its total locked value (TVL) was less than $10 million, and it has now grown to $5.5 billion. It has integrated into multiple protocols in various ways, such as @aave, @SkyEcosystem (i.e. Maker/Sparklend), @MorphoLabs, @pendle_fi, and @eigenlayer. There are so many protocols collaborating with Ethena that I had to change covers multiple times when recalling another partner. Among the top ten protocols by TVL, six either collaborate with Ethena or are Ethena themselves (Ethena ranks ninth). If Ethena fails, it will have profound implications for many protocols, especially AAVE, Morpho, and Maker, which will functionally find themselves insolvent to varying degrees. At the same time, Ethena has significantly increased the usage of the entire DeFi with billions of dollars in growth, similar to the impact of stETH on Ethereum DeFi. So, is Ethena destined to destroy DeFi as we know it, or will it lead DeFi into a new renaissance? Let's delve into this question.
How exactly does Ethena operate?
Despite being launched for over a year, there is still a general misunderstanding about how Ethena works. Many claim it is the new Luna and then refuse to elaborate further. As someone who warned against Luna, I find this view very one-sided, but at the same time, I believe that most people lack sufficient understanding of the details of how Ethena operates. If you think you fully understand how Ethena manages delta-neutral positions, custody, and redemptions, please skip this section; otherwise, this is important reading material for full understanding.
Overall, Ethena benefits from financial speculation and the cryptocurrency bull market like BTC, but in a more stable manner. As cryptocurrency prices rise, more and more traders want to go long on BTC and ETH, while there are fewer traders willing to short. Due to the supply-demand relationship, short traders are paid fees by long traders. This means that traders can hold BTC while shorting the same amount of BTC, thereby achieving a neutral position, where the gains and losses of the long and short positions offset each other, while traders still earn interest income. Ethena operates entirely based on this mechanism; it leverages the current lack of sophisticated investors in the crypto market who would rather profit from earning yields rather than simply going long on BTC or ETH.
However, a significant risk of this strategy is the custodial risk of exchanges, as demonstrated by the collapse of FTX and its impact on first-generation Delta-neutral managers. Once an exchange goes down, all funds could be lost. This is why, regardless of how efficiently and safely mainstream managers operate capital, they were negatively affected by the collapse of FTX, with @galoiscapital being the most obvious example, which is not their fault. Exchange risk is one of the important reasons Ethena chose to use @CopperHQ and @CeffuGlobal. These custodial service providers act as trusted intermediaries, responsible for holding assets and assisting Ethena in interacting with exchanges, while avoiding exposing Ethena to custodial risks of exchanges. Exchanges, in turn, can rely on Copper and Ceffu because they have legal agreements with custodians. The net profit and loss (i.e., the amount Ethena needs to pay to long traders or the amount long traders owe Ethena) is regularly 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.
Minting and redeeming USDe/sUSDe is relatively straightforward. USDe can be purchased or minted using USDC or other major assets. USDe can be staked to generate sUSDe, which earns yields. sUSDe can then be sold on the market by paying the corresponding swap fees 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 (primarily BTC and ETH derivatives). Given that part of USDe is not staked (many of which are used in Pendle or AAVE), the yields generated by the assets backing these unstaked USDe help enhance the yields of sUSDe.
So far, Ethena has been able to handle a large number of withdrawals and deposits relatively easily, although sometimes the slippage of USDe-USDC can be as high as 0.30%, which is relatively high for stablecoins, but far from reaching a significant decoupling degree and poses no danger to lending protocols. So why are people so worried?
Well, if there is a large demand for withdrawals, say 50%
How can Ethena 'fail'?
Given that we now understand that Ethena's yields are not 'illusory' and how it operates on a more nuanced level, what are Ethena's main real concerns? There are essentially a few scenarios. First, the funding rate could turn negative, in which case if Ethena's insurance fund (currently around $50 million, sufficient to absorb a 1% slippage/fund loss under the current TVL) is not enough to cover the losses, Ethena will ultimately incur losses instead of gains. This situation seems relatively unlikely because most users may stop using USDe when yields decrease, which has happened in the past.
Another risk is custodial risk, which is the risk that Copper or Ceffu may attempt to operate with Ethena's funds. The fact that custodians do not have complete control over the assets mitigates this risk. Exchanges do not have signing authority and cannot control any wallets holding the underlying assets. Both Copper and Ceffu are 'integrated' wallets, meaning that the funds of all institutional users are mixed in hot/warm/cold wallets, with multiple risk prevention measures such as governance (i.e., control) and insurance. Legally, this is the structure of a bankruptcy-isolated trust, so even if a 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 remains simple negligence and centralization risk, but indeed there are many safeguards in place to avoid this issue, and I believe the probability of this happening is akin to a black swan event.
The third and most commonly discussed risk is liquidity risk. To manage redemptions, Ethena must sell both its derivative positions and spot positions simultaneously. If the price of ETH/BTC experiences dramatic fluctuations, this could be a difficult, costly, and potentially very time-consuming process. Currently, Ethena has prepared hundreds of millions of dollars to be able to redeem USDe for dollars on a 1:1 basis, as it holds a large number of stable positions. However, if Ethena's share of total open contracts (i.e., all open derivatives) keeps increasing, this risk becomes relatively serious and could 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 unlikely to lead to catastrophic failures for the protocols that use it, which naturally leads to the next topic.
What are the risks of using Ethena as a protocol?
Broadly speaking, the risks of Ethena can be divided into two core risks: USDe liquidity and USDe solvency. USDe liquidity refers to the actual available cash willing to buy USDe at a peg value of $1 or at a price lower than that peg value by 1%. USDe solvency means that even if Ethena may not have cash at a given time (like after a prolonged withdrawal period), it can obtain that cash if given enough time to liquidate assets. For example, if you lend your friend $100,000 and he has a house worth $1 million. Indeed, your friend may not have the cash readily available, and he may not be able to come up with it tomorrow, but if given enough time, he is very likely to raise enough funds to pay you back. In this case, your loan is healthy, and your friend just lacks liquidity, meaning his assets may take a long time to sell. Bankruptcy essentially means that liquidity should not exist, but limited liquidity does not imply that assets are bankrupt.
Ethena faces significant risks only if it becomes insolvent when collaborating with some protocols (like EtherFi and EigenLayer). Other protocols, such as AAVE and Morpho, may face significant risks if Ethena's products lack liquidity for a long time. Currently, the on-chain liquidity of USDe/sUSDe is about $70 million. While quotes can be obtained through aggregators, stating that up to $1 billion of USDe can be exchanged for USDC at a 1:1 ratio, this is likely due to the current huge demand for USDe, as this is based on intended demand. When Ethena experiences large-scale redemptions, this liquidity could dry up. When liquidity dries up, 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 is the case, it is important to understand how AAVE and Morpho manage liquidations. When debt positions on AAVE and Morpho become unhealthy, i.e., exceed the required loan-to-value ratio (the ratio of loan amount to collateral), liquidations occur. Once this happens, collateral is sold to repay the debt, and fees are charged, with any remaining funds returned to the user. In short, if the value of the debt (principal + interest) approaches the predetermined ratio compared to the value of the collateral, the position will be liquidated. When this occurs, the collateral will be sold/converted into debt assets.
Currently, many people use these lending protocols to deposit sUSDe as collateral to borrow USDC as debt. This means that if a liquidation occurs, a large amount of sUSDe/USDe will be sold for USDC/USDT/DAI. If all this happens simultaneously, along with other severe market fluctuations, USDe is likely to lose its peg to the dollar (especially in cases of very large liquidations, certainly in the range of around $1 billion). In this case, a large amount of bad debt could theoretically arise, which is acceptable for Morpho, as the treasury is used to isolate risks, although certain income-generating treasuries would be negatively impacted. For AAVE, the entire core pool would be negatively affected. However, in this potential scenario, which is purely a liquidity issue, there may be adjustments to the liquidation management approach.
If liquidations could lead to bad debts instead of immediately selling the underlying assets into an illiquid market and letting AAVE holders bear the difference, the AAVE DAO could take responsibility for the tokens and positions without immediately selling the collateral. This would allow AAVE to wait for prices and Ethena's liquidity to stabilize, allowing AAVE to make more money during the liquidation process (rather than net losses) and let users receive funds (instead of ending up with nothing due to bad debts). Of course, this system only works if USDe returns to its previous value; otherwise, the situation of bad debts would be worse. However, if there is a high probability event that has not been discovered that could lead to the token's value dropping to zero, then liquidation is less likely to yield more value than waiting, which could present a 10-20% difference, as individual holders realize and begin selling their positions faster than parameters can be changed. This design choice is crucial for assets that may encounter liquidity issues in bubble markets, and it could also be a good design choice for stETH before the Beacon Chain enabled withdrawals, and if successful, it could be a great way to enhance AAVE's treasury/insurance system.
The risk of bankruptcy is relatively mitigated, but not zero. For example, suppose one of the exchanges that Ethena uses goes bankrupt. Of course, Ethena's collateral is safe with the custodian, but it suddenly loses hedging, and must hedge in a potentially turbulent market. The custodian could also go bankrupt, as pointed out to me by @CryptoHayes when I spoke with him in South Korea. Regardless of what kind of protections are in place around the custodian, there can still be severe hacking or other issues. Cryptocurrency is still cryptocurrency, and there remains 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?
Now that we have discussed the risks of Ethena, what are the risks of protocols that do not use Ethena? 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 revenues are attributed to Ethena to some extent. About 30% of Morpho's TVL comes from Ethena. Ethena is now one of the main drivers of AAVE's revenues and new stablecoins. Well-known platforms that have not used Ethena or interacted with its products have essentially been left behind.
In the protocols, there are some interesting similarities between the adoption of Ethena and that of Lido. Around 2020 and 2021, the competition for the largest lending protocol was more intense. However, Compound focused more on minimizing risks, possibly to the point of absurd extremes. AAVE integrated stETH as early as March 2022. Compound started discussing adding stETH in 2021 but did not formally propose it until July 2024. This timing coincided with AAVE's beginning to surpass Compound. Although Compound is still relatively large, with a total locked value of $2 billion, it is now just over one-tenth the size of AAVE, which once dominated.
To some extent, this can also be seen from the relative approaches of @MorphoLabs and @AAVELabs towards Ethena. Morpho started integrating Ethena in March 2024, while AAVE did not integrate sUSDe until November. There was an 8-month gap during which Morpho grew significantly, while AAVE lost relative control in the lending space. Since AAVE integrated Ethena, TVL has increased by $8 billion, and the yields for product users have also increased significantly. This has led to the 'AAVETHENA' relationship, where Ethena's products generate higher yields, incentivizing more deposits, which in turn leads to more lending demand, etc.
Ethena's 'risk-free' interest rate, or at least its 'normal' interest rate, is about 10%. This is more than double the value of FFR (risk-free rate), which is currently around 4.25%. Bringing Ethena into AAVE, especially sUSDe, functionally raised the equilibrium interest rate for borrowing, as AAVE's 'benchmark' rate now inherits Ethena's benchmark rate, which is not exactly 1:1 but is quite close. This was similar to when AAVE introduced stETH, where the borrowing rate for ETH was roughly equivalent to the yield of stETH, as had been the case before.
In short, protocols that do not use Ethena may face the risk of lower yields and demand, but they seek to avoid the risk of USDe significantly decoupling or collapsing, which is a risk that may be minimal. Systems like Morpho, due to their independent structure, may be better able to adapt and avoid potential collapses. Therefore, it is understandable that systems based on larger pools of capital, like AAVE, take longer to adopt Ethena. Now, while most of this content reflects on the past, I would like to present some forward-looking perspectives. Recently, Ethena has been working to integrate DEXs. Most DEXs lack the demand to short, that is, users who want to short contracts. Generally speaking, the only type of user that can consistently do this on a large scale is delta-neutral traders, of which Ethena is the largest. I believe that a perpetual contract platform that can successfully integrate Ethena while maintaining a good product can eliminate competition in a very similar way to how Morpho has outmaneuvered its smaller competitors by closely collaborating with Ethena.
