<p>Fully collateralized semi-decentralized stablecoin USDe, what potential risks does it have?</p>

Original author: Bewater Giga-Brain, 0xLoki (ABCDE researcher)

Editor's note: EthenaLabs is committed to creating a derivative-supported stablecoin to address the significant issue of cryptocurrency's reliance on traditional banks. Its synthetic dollar, USDe, aims to be the first encrypted native, censorship-resistant, scalable, and stable financial solution achieved through Delta hedging of Ethereum collateral. Yesterday, official data showed that the total value of Bitcoin collateral assets for USDe has exceeded $550 million. However, while this new product in the Defi space is making strides, it is not without skepticism. For more information, refer to "DeFi 'King of the Old Days' AC Questions Ethena (USDe): The Next UST?" In this article, the two authors provide a detailed analysis of USDe and its potential risks. The full article reprinted by BlockBeats is as follows:

1. Definition of USDe: Fully Collateralized Semi-Decentralized Stablecoin

Stablecoins can be classified in various ways, such as:

(1) Fully collateralized and non-fully collateralized;

(2) Centralized custody and decentralized custody;

(3) On-chain issuance and centralized institution issuance;

(4) Permissioned and permissionless;

There may be some overlap and variations, for example, in the past, we considered algorithmic stablecoins like AMPL, UST, where the supply and circulation are entirely regulated by algorithms. According to this definition, most stablecoins belong to the non-fully collateralized stablecoin category, but there are exceptions, such as Lumiterra's LUAUSD. Although its minting and burning prices are adjusted by algorithms, the protocol treasury provides collateral (USDT & USDC) worth no less than the anchoring value of LUAUSD, making LUAUSD a hybrid of algorithmic stablecoin and fully collateralized stablecoin.

Another example is DAI, when DAI's collateral is 100% on-chain assets, DAI belongs to non-centralized custody stablecoins. However, with the introduction of RWA, some collateral is effectively controlled by real entities, transforming DAI into a stablecoin with a mix of centralized and decentralized custody.

Based on this, we can simplify the complex classifications into whether there is full collateral, whether there is permissionless issuance, and whether there is custody. Compared to other common stablecoins, USDe differs in these three core indicators. If we consider "decentralization" to require both "permissionless issuance" and "no custody," then USDe does not meet this criteria. Therefore, classifying it as a "fully collateralized semi-decentralized stablecoin" is appropriate.

2. Collateral Value Analysis

The first question is whether USDe has sufficient collateral, and the answer is clearly yes. As stated in the project documentation, USDe's collateral consists of synthetic assets of encrypted assets and corresponding short futures positions.

- Synthetic asset value = spot value + short futures position value

- Initially, spot value = X, futures position value = 0, assuming the basis is Y

- Collateral value = X + 0

- Assuming after a certain time the spot price rises by a dollars, and the futures position value rises by b dollars (a, b can be negative), position value = X + a - b = X + (a-b), the basis becomes Y + ΔY, where ΔY = (a-b)

It can be seen that if ΔY remains constant, the intrinsic value of the position will not change. If ΔY is a positive number, the intrinsic value of the position will rise, otherwise it will fall. In addition, for delivery contracts, the basis is generally negative at the initial stage, and by the delivery date, the basis will gradually become 0 (excluding trading friction), which means ΔY will inevitably be a positive number. Therefore, if the basis is Y when synthesized, the value of the synthetic position will be higher than the initial state on the delivery date.

Having a portfolio of holding spot and shorting futures assets is also known as "cash and carry arbitrage," which itself carries no risk (but has external risks). Based on current data, constructing this investment portfolio can yield approximately around 18% low-risk annualized return.

Returning to Ethena, I did not find a precise definition on whether to use delivery contracts or perpetual contracts on the official website (considering the issue of trading depth, the probability of perpetual contracts is higher), but they have disclosed the on-chain address of collateral and CEX distribution.

In the short term, these two methods will have some differences. Delivery contracts will provide a more "stable and predictable" yield, with the end-of-term yield always positive. Whereas perpetual contracts are a product with fluctuating rates, and daily rates may be negative under specific circumstances. However, from experience, the historical arbitrage return of perpetual contracts is slightly higher than that of delivery contracts, and both are positive:

1) Delta-neutral futures airdrops essentially involve lending funds, and lending funds cannot maintain a 0 interest rate or negative interest rate for a long time. Moreover, this position stacks USDT risk, centralized exchange risk, so the necessary yield > risk-free yield of the dollar.

2) Perpetual contracts need to bear variable end-of-term rates and pay an additional risk premium.

Based on this, worrying that "USDe" is undercollateralized or comparing USDe to UST is completely wrong. According to the collateral risk assessment framework introduced at the beginning of the article, USDe's current core/narrow collateral ratio is 101.62%, and after considering the circulating market value of ENA 1.57 billion, the broad collateral ratio can reach approximately 178%.

"Potential negative rates will cause USDe collateral to shrink" is also not a major issue. According to the law of large numbers, as long as the time is long enough, the frequency will inevitably converge to probability, and USDe collateral will maintain a growth rate converging to the average funding rate in the long term.

Switching to a more straightforward explanation: you can draw a card an infinite number of times from a deck, losing $1 if you draw a joker, and earning $1 if you draw any other of the 52 cards. With an initial capital of $100, do you need to worry about going bankrupt from drawing too many jokers? Looking directly at the data is more intuitive; in the past 6 months, the average contract rate has been below 0% only twice, with the historical success rate of cash and carry arbitrage far exceeding drawing cards.

3. Where Are the Real Risks?

1. Market Capacity Risk

Now that we have clarified that collateral risk is not a concern, it does not mean there are no other risks. The most significant concern is the potential limitations of contract market capacity on Ethena.

The first risk is liquidity risk.

Currently, the circulation of USDe is approximately $2.04 billion, with ETH and LST totaling about $1.24 billion. This means that in a fully hedged scenario, a short position of $1.24 billion needs to be opened, and the required position size is directly proportional to the size of USDe.

Currently, Binance's ETH perpetual contract position size is approximately $3 billion, with 78% of Ethena's USDT reserve funds stored on Binance. Assuming the fund utilization is uniform, this means Ethena needs to have a position on Binance.

Established a short position with a nominal value of 9.7 billion, accounting for 32.3% of the position, based on 20.4 billion * 61% * 78%.

If Ethena's position size in Binance or other derivative exchanges is too high, it can lead to several negative impacts, including:

1) Increased trading friction;

2) Inability to cope with large-scale redemptions in a short period;

3) USDe pushing up the supply of short positions, leading to a decrease in rates and affecting yields.

Although some mechanized designs may help mitigate risks, such as setting time-based minting/burning limits and dynamic rates (as introduced by LUNA), the best approach is to avoid putting oneself in danger.

Based on this data, the combination of Binance + ETH trading pair is already very close to the market capacity limit for Ethena. However, this limit can be surpassed by introducing multiple currencies and exchanges. According to Tokeninsight data, Binance holds a 50.1% share of the derivative trading market, and according to Coinglass data, apart from ETH, the total contract position of the Top 10 currencies on Binance is about three times that of ETH. Based on these two estimates:

USDe market capacity theoretical limit = 20.4 * (628/800) * 60% / 4 / 50.1% = 128 billion US dollars

The bad news is that USDe has a capacity limit, but the good news is that there is still a growth space of 500% from the limit.

Based on these two limits, the growth of USDe's scale can be divided into three stages:

(1) 0-20 billion: Achieve this scale through the ETH market on Binance;

(2) 20 billion-128 billion: Need to expand collateral to mainstream coins with deep market depth + fully utilize the market capacity of other exchanges;

(3) Above 128 billion: Need to rely on the growth of the Crypto market itself + introduce additional collateral management methods (such as RWA, lending market positions);

It should be noted that if USDe wants to truly flip centralized stablecoins, it needs to surpass USDC and become the second largest stablecoin at least. The current total issuance of USDC is about 34.6 billion US dollars, which is 2.7 times the potential capacity limit of USDe in the second stage, posing a significant challenge.

2. Custodial Risk

Another point of controversy for Ethena is that the protocol's funds are custodied by third-party institutions. This is a compromise based on the current market environment. Coinglass data shows that dydx's BTC contract position total is 119 million US dollars, only 1.48% of Binance's, and 2.4% of Bybit's. Therefore, it is unavoidable for Ethena to manage positions through centralized exchanges.

However, it should be noted that Ethena adopts an "Off-Exchange Settlement" custody method. Simply put, funds managed in this way do not actually enter the exchange but are transferred to a dedicated address for management, usually jointly managed by the grantor (Ethena), the custodian (third-party custodian), and the exchange. The exchange generates corresponding quotas based on the size of the custodial funds, which can only be used for trading and cannot be transferred; settlement is then made based on the profit and loss situation.

The biggest advantage of this mechanism is that it 【eliminates the single-point risk of centralized exchanges】, as the exchange never truly controls these funds. At least 2 out of 3 parties need to sign for a transfer to take place. Given the trustworthiness of the custodial institution, this mechanism can effectively prevent rug pulls by exchanges (such as FTX) and projects. In addition to the services listed by Ethena, Copper, Ceffu, and Cobo, Sinohope and Fireblocks also offer similar services.

Of course, there is a theoretical possibility of misconduct by custodial institutions. However, given that CEX still dominates and on-chain security incidents are frequent, this semi-centralized approach is a local optimal solution rather than a final form. Ultimately, APY is not free, and the key question is whether these risks should be taken on for the sake of increased returns and efficiency.

3. Sustainable Interest Rate Risk

USDe needs to be collateralized to earn returns, and since the collateralization rate will not be 100%, the yield of sUSDe will be higher than the derivative fee rate. Currently, about 470 million US dollars of USDe are collateralized in contracts, with a collateralization rate of only about 23%, corresponding to a nominal APY of 37.1%, with an underlying asset APY of around 8.5%.

The current ETH collateral yield is about 3%, while the average funding rate over the past 3 years is about 6-7%. An underlying asset APY of 8.5% is entirely sustainable, but whether the 37.1% sUSDe APY can be sustained will depend on whether there are enough applications to bear USDe, to reduce the collateralization rate and bring higher returns.

4. Other Risks

These include contract risks, liquidation and ADL risks, operational risks, exchange risks, etc. Ethena and Chaos Labs provide a more detailed explanation.

Original article link

Welcome to join the official community of BlockBeats:

Telegram subscription group: https://t.me/theblockbeats

Telegram communication group: https://t.me/BlockBeats_App

Twitter official account: https://twitter.com/BlockBeatsAsia