In the rapidly developing world of cryptocurrency, stablecoins have always been an important tool for investors and users. They provide a stable value digital currency, making crypto trading and payments more convenient. However, traditional USD-backed stablecoins (such as USDC and USDT) rely on assets from the traditional financial system, which may bring regulatory and scrutiny risks. The emergence of Ethena provides an innovative solution to these issues.
Ethena is a protocol designed to create the synthetic USD stablecoin USDe. This stablecoin is achieved through Delta hedging of collateralized Ethereum (ETH) assets, providing an anti-scrutiny, scalable, and stable native cryptocurrency solution.
Key Concepts and Operations of Ethena
Delta Hedged Collateral:
Collateral: Ethena uses liquidity-pooled ETH tokens as collateral. This means users can pledge their ETH to the Ethena protocol and receive corresponding liquidity-pooled tokens (such as stETH).
Delta Hedging: To maintain stability, Ethena creates a portfolio with a Delta of zero by shorting an equivalent amount of ETH. This way, when the price of ETH fluctuates, the value changes of the pledged ETH and the short position offset each other, ensuring the net value of Ethena's held assets does not fluctuate with the market.
Revenue Generation: Despite the portfolio having a Delta of zero, Ethena can still generate revenue from ETH collateral yields and financing payments from the short position. This dual revenue mechanism allows Ethena to provide stablecoins while also earning a certain profit.
Off-Exchange Settlement (OES):
Custodians: To ensure fund security, Ethena utilizes an Off-Exchange Settlement (OES) scheme, where reputable third-party custodial institutions hold the funds. The custodians only map account balances to centralized exchanges (CEX) to provide trading margins, without actually depositing the funds into these exchanges.
Security: This design ensures that funds are never directly deposited into centralized exchanges, reducing counterparty risk and preventing potential bankruptcy or regulatory issues of exchanges from affecting user funds.
Minting and Burning of USDe:
Minting:
Currently, Ethena accepts stETH Lido, Mantle mETH, Binance WBETH, and ETH as collateral. When users deposit these collaterals into Ethena, Ethena automatically sells the corresponding value of ETH/USD perpetual swap contracts to lock in the USD value of ETH or ETH LSD.
Subsequently, the protocol mints an equivalent amount of USDe based on the locked USD value, ensuring each USDe is backed by sufficient USD value.
Burning:
When users wish to burn USDe, they need to deposit USDe into Ethena. Ethena automatically offsets a portion of its short ETH/USD perpetual swap position, unlocking the corresponding USD value.
Then, the protocol burns these USDe and returns a certain amount of ETH or ETH LSD to the user based on the unlocked USD value minus execution fees.
Advantages of Ethena
Scalability:
Efficiency: By leveraging the derivatives market, Ethena can achieve efficient scalability. This approach allows USDe to be expanded with capital efficiency similar to USD-backed stablecoins like USDC and USDT.
1:1 Collateral Ratio: Due to the ability to perfectly hedge collateralized ETH with an equivalent short position, Ethena only requires a 1:1 collateral ratio to mint synthetic USD, greatly increasing capital utilization.
Stability:
- Hedging: Ethena ensures the stability of the synthetic USD value behind USDe under various market conditions by immediately hedging asset transfers upon USDe issuance. This real-time hedging mechanism ensures that the value of USDe is not affected by market fluctuations.
Anti-scrutiny:
- Separation from Banking System: Ethena supports asset storage on-chain, using a transparent, auditable custodial account solution independent of traditional banking systems. This design not only increases anti-scrutiny capabilities but also enhances system transparency and security.
Risks of Ethena
Collateral Decoupling:
LST and ETH: Ethena's hybrid collateralization using liquidity-pooled tokens (LST) and regular ETH increases the risk of LST decoupling from ETH. If the market price of LST deviates from ETH, it may lead to ineffective hedging of collateral fluctuations by Ethena's short position, resulting in losses.
Margin Pressure: During periods of intense market volatility, LST decoupling events may put pressure on Ethena's margin requirements, potentially leading to forced liquidation.
Financing Rate Risk:
Yield Curve Inversion: Historically, there have been protocols attempting to expand synthetic USD stablecoins but failed due to financing rate inversions. Although Ethena reduces the number of days with negative financing rates by collateralizing ETH, financing rate inversions may still occur, affecting the protocol's revenue-generating capability.
Negative Financing Yield: Fluctuations in financing rates may lead to periods of negative financing yield for Ethena, posing a challenge to the protocol's long-term stability and revenue-generating capability.
Counterparty Risk:
Centralized Exchanges: Despite Ethena using OES custodial accounts to reduce the risk of directly depositing user funds into centralized exchanges, counterparty risk still exists. If an exchange goes bankrupt, Ethena may need to use leverage on other platforms to maintain its Delta-neutral investment portfolio.
Custodian Risk: If one of Ethena's custodians goes bankrupt, fund retrieval may be delayed, requiring the protocol to hedge the investment portfolio with leverage on other accounts.
General Crypto Risks:
Team Trust: Currently, Ethena's project key ownership is not fully decentralized, exposing users to the risk of the team misappropriating funds.
Smart Contract Vulnerabilities: While Ethena reduces the usage of complex smart contract logic to mitigate the risk of hacking attacks, it does not completely eliminate potential technical vulnerabilities.
Valuation and Future Plans of Ethena
Recent Financing: In February 2024, Ethena Labs announced the completion of a $14 million strategic round of financing, valuing the company at $3 billion. This financing was jointly led by Dragonfly and the family office of Arthur Hayes, the founder of BitMEX, Maelstrom.
- Potential Future Valuation: Based on the revenue model and potential income generated by the protocol, Ethena's fully diluted valuation (FDV) is estimated to reach $200 billion. This valuation is based on predictions of future protocol income and market expectations for the technology and model.
Through innovative Delta hedged collateral and advanced security measures, Ethena provides an important solution for the cryptocurrency finance sector. Despite facing some inherent risks, the design and operational model of Ethena demonstrate its enormous potential in the stablecoin market. In the future, with further development and refinement, Ethena is poised to become a significant pillar in the world of cryptocurrency, driving the advancement and popularization of stablecoin technology.
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