Is Ethena destined to destroy DeFi as we know it, or will it usher in a new renaissance for DeFi? Let's delve into this question.
Ethena is the most successful protocol in DeFi history. About a year ago, its total value locked (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 collaborate with Ethena or are Ethena itself (Ethena ranks ninth). If Ethena fails, it will have profound effects on many protocols, especially AAVE, Morpho, and Maker, which would functionally fall into varying degrees of insolvency. Meanwhile, Ethena has significantly increased the overall usage of DeFi with billions of dollars in growth, akin to the impact of stETH on Ethereum DeFi. So, is Ethena destined to destroy DeFi as we know it, or will it bring DeFi into a new renaissance? Let's explore this question in depth.
How does Ethena actually work?
Despite being launched for over a year, there remains a general misunderstanding of 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 I also believe that most people lack sufficient understanding of the details of how Ethena operates. If you believe you fully understand how Ethena manages delta-neutral positions, custody, and redemption, please skip this section; otherwise, this is important reading material for full comprehension.
Overall, Ethena benefits from financial speculation and the cryptocurrency bull market like BTC, but in a more stable manner. As cryptocurrency prices rise, more traders want to go long on BTC and ETH, while those willing to short are decreasing. Due to supply and demand, short traders are paid fees by long traders. This means traders can hold BTC while shorting the same amount of BTC, achieving a neutral position where the profit and loss of long and short positions offset each other, while traders still earn interest income. Ethena operates entirely based on this mechanism; it takes advantage of the lack of sophisticated investors in the crypto market, who are more inclined to profit by earning yields rather than simply going long on BTC or ETH.
However, a significant risk of this strategy lies in the custodial risk of the exchanges, as exemplified by the collapse of FTX and its impact on the first generation of delta-neutral managers. Once an exchange goes down, all funds could be lost. This is why no matter how efficiently and safely mainstream managers handle capital, they are negatively affected by the collapse of FTX, the most obvious example being @galoiscapital, and this is not their fault. The exchange risk is one of the key 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 from the exchanges. The exchanges, in turn, can rely on Copper and Ceffu because they have legal agreements with custodians. Total profits and losses (i.e., the amount Ethena needs to pay to long traders or the amount long traders owe Ethena) are settled regularly 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 simple. USDC or other major assets can be used to purchase or mint USDe. USDe can be staked to generate sUSDe, and sUSDe earns yields. sUSDe can then be sold on the market by paying the corresponding swap fee or redeemed for USDe. The redemption process typically 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 the asset reserves and the collateral used by Ethena (primarily BTC and ETH/ETH derivatives). Given that part of the USDe is not staked (many of which are used for Pendle or AAVE), the income generated by the assets supporting these unstaked USDe helps enhance the yield of sUSDe.
So far, Ethena has been able to handle a large volume of withdrawals and deposits relatively easily, although sometimes the slippage between USDe and USDC is as high as 0.30%, which is relatively high for stablecoins but far from a significant decoupling 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 to make Ethena 'fail'?
Now that we understand Ethena's yields are not 'fake,' and how it operates on a more nuanced level, what are the main real concerns regarding Ethena? Essentially, there are several scenarios. First, the funding rate could turn negative, in which case, if Ethena's insurance fund (currently around $50 million, enough to withstand a 1% slippage/funds loss under the current TVL) is insufficient to cover losses, Ethena would ultimately incur losses rather than profits. This scenario seems relatively unlikely, as most users may stop using USDe when yields decrease, as has happened in the past.
Another risk is custodial risk, meaning the risk of Copper or Ceffu attempting to operate with Ethena's funds. The fact that custodians do not have complete control over the assets mitigates this risk. The exchanges do not have signing authority and cannot control any wallets holding the underlying assets. Copper and Ceffu are both 'comprehensive' wallets, meaning the funds of all institutional users are mixed in hot/warm/cold wallets, with various risk mitigation measures such as governance (i.e., control) and insurance. From a legal perspective, this is a structure of bankruptcy-isolated 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 remain simple negligence and centralization risks, but indeed, there are many measures in place to prevent this issue, and I believe the likelihood of this happening is akin to that of a black swan event.
The third and often most discussed risk is liquidity risk. To manage redemptions, Ethena must sell both its derivative and spot positions simultaneously. If the price of ETH/BTC fluctuates wildly, this can be a difficult, expensive, and potentially very time-consuming process. Currently, Ethena has prepared hundreds of millions of dollars to be able to redeem USDe for dollars at a 1:1 ratio, as it holds a large number of stable positions. However, if Ethena's proportion of total open contracts (i.e., all open derivatives) grows increasingly large, this risk becomes relatively severe and could lead to a several percentage point drop in Ethena's net asset value (NAV). However, in such a scenario, the insurance pool is likely to fill this gap, and this alone is not enough to cause catastrophic failure for protocols using it, which naturally leads to the next topic.
What is the risk 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 cash available that is willing to purchase USDe at a baseline value of $1 or at a price lower than that baseline value by 1%. USDe solvency means that even if Ethena may not have cash at a given moment (e.g., after a prolonged period of withdrawals), it can still 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 cash on hand, and he may not be able to get it tomorrow, but if given enough time, he is likely able to come up with enough money to repay you. 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 be nonexistent, but limited liquidity does not mean asset bankruptcy.
Ethena faces significant risks only when collaborating with certain protocols (e.g., EtherFi and EigenLayer) if Ethena becomes insolvent. Other protocols, such as AAVE and Morpho, may face significant risks if Ethena's products lack liquidity for an extended period. Currently, the on-chain liquidity of USDe/sUSDe is about $70 million. Although quotes can be obtained through aggregators that claim up to $1 billion of USDe can be exchanged for USDC at a 1:1 ratio, this is likely due to the current high demand for USDe, as this is based on intended demand, and this liquidity could dry up when Ethena experiences large-scale redemptions. 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 grasp how AAVE and Morpho manage liquidations. When debt positions on AAVE and Morpho are unhealthy, i.e., exceed the required loan-to-value ratio (the ratio of the loan amount to collateral), liquidation occurs. Once this happens, 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) approaches the designated 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 are using these lending protocols to deposit sUSDe as collateral to borrow USDC as debt. This means that, in the event of liquidation, a large amount of sUSDe/USDe will be sold for USDC/USDT/DAI. If all this happens simultaneously, accompanied by other significant market fluctuations, USDe is very likely to lose its peg to the dollar (if the scale of liquidation is very large, of course around $1 billion). In this case, a large number of bad debts may theoretically arise; this is acceptable for Morpho because the treasury is used to isolate risk, although some income-generating treasuries will be negatively affected. For AAVE, the entire core pool will be negatively impacted. However, in such a potential scenario that is purely a liquidity issue, adjustments may be made to the way liquidations are managed.
If liquidation could lead to bad debts rather than immediately selling the underlying assets into an illiquid market and letting AAVE holders bear the difference, 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 earn more money in the liquidation process (instead of a net loss) and let users receive funds (instead of getting nothing due to bad debts). Of course, this system only works if USDe returns to its previous value; if not, the situation of bad debts gets worse. However, if there is a high-probability event that has not yet been discovered that could lead to a token value of zero, then liquidation is less likely to be preferable to waiting for more value, potentially with a 10-20% discrepancy, as individual holders realize and begin selling positions faster than parameter changes.
The risk of bankruptcy is relatively mitigated but not zero. For example, suppose one of the exchanges Ethena uses goes bankrupt. Of course, Ethena's collateral is safe with the custodian, but it suddenly loses its hedging and must hedge in a potentially turbulent market. The custodian could also go bankrupt, as pointed out by @CryptoHayes when I spoke with him in Korea. Regardless of the protective measures around the custodian, there can still be severe hacking attacks or other issues; cryptocurrency is still cryptocurrency, and there are inherent risks, even if these risks are extremely unlikely to occur and may be covered by insurance, the risks are not zero.
What is the risk of not using Ethena?
Since we have discussed the risks of Ethena, what are the risks of not using Ethena's 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 somewhat attributed to Ethena. About 30% of Morpho's TVL comes from Ethena. Ethena is now one of the main drivers of AAVE's revenue and new stablecoins. Well-known platforms that have not used Ethena or interacted with its products in some way have essentially been left behind.
In the protocol, 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 risk, possibly to an absurd extreme. AAVE integrated stETH as early as March 2022. Compound began discussing adding stETH in 2021 but did not propose a formal proposal until July 2024. This timing coincides with AAVE starting to surpass Compound. Although Compound remains 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 began integrating Ethena in March 2024, while AAVE did not integrate sUSDe until November. There is 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 led to the 'AAVETHENA' relationship, where Ethena's products generate higher yields, incentivizing more deposits, thereby creating more lending demand, and so on.
Ethena's 'risk-free' interest rate, or at least its 'normal' rate, is about 10%. This is far more than double the value of the FFR (risk-free rate), which is currently around 4.25%. Introducing Ethena into AAVE, especially sUSDe, functionally raises the equilibrium borrowing rate because AAVE's 'benchmark' rate now inherits Ethena's benchmark rate, even if not exactly 1:1, it is quite close. This was previously evident when AAVE introduced stETH, where the borrowing rate for ETH was roughly equivalent to the yield on stETH, which had also occurred in the past.
In short, protocols that do not use Ethena may face risks of lower yields and lower demand, but they may avoid the risk of severe decoupling or collapse of USDe, which could be negligible. Systems like Morpho, due to their independent structure, may adapt better and avoid potential collapses. Thus, it is understandable that systems like AAVE, based on larger pools of funds, take longer to adopt Ethena. Now, while most of the content is retrospective, I would like to present some future-oriented views. Recently, Ethena has been working hard to integrate DEXs. Most DEXs lack shorting demand, i.e., users wanting to short contracts. Generally, the only type of users capable of consistently doing this on a large scale are delta-neutral traders, of which Ethena is the largest. I believe that a perpetual contract platform capable of successfully integrating Ethena while maintaining a good product can escape competition in a very similar way to how Morpho has escaped its smaller competitors by closely collaborating with Ethena.
