USDe: Solution to the stablecoin trilemma? Or a profitable Hedge Fund model?

What problem is USDe trying to solve?

In a world where most crypto is struggling to justify its utility, stablecoins are one asset class that has found product-market fit. (i) They serve as a bridge between crypto and traditional finance (tradfi). (ii) The most liquid trading pairs in Centralized Exchanges (CEXes) and Decentralized exchanges (DEXes) are denominated in stablecoins. (iii) They facilitate instant peer-to-peer payments, particularly cross-border payments. (iv) They serve as a store of value for those forced to hold wealth in weak currencies.

The current designs of stablecoins however suffer from some challenges:

Fiat-backed stablecoins are NOT DECENTRALIZED

The most widely used stablecoins today are fiat-backed. These are centrally controlled.

(i) They are issued by centralized entities vulnerable to censorship.

(ii) The fiat currencies backing them are held in banks that can go bankrupt, in deposit accounts that are not transparently observable, and can be frozen.

(iii) The securities backing them are under the custody of entities that are subject to government dictate and whose processes are opaque.

(iv) The value of these stablecoins is beholden to rules and laws that may change depending on the direction the political wind is blowing.

Ironically, the most widely used token of an asset class that is supposed to facilitate decentralized, transparent, and censorship-resistant transactions is issued by centralized institutions, backed by assets stored within tradfi infrastructure and prone to capture and reversal by governments.

Crypto-backed stablecoins are NOT SCALABLE

Till it started being backed by Real World Assets (RWAs), MakerDAO’s DAI was a somewhat decentralized stablecoin the backing of which could be verified on-chain.

DAI is collateralized by volatile assets like ETH. To ensure a margin of safety, minting DAI requires one to lock in 110–200% of collateral. This makes DAI capital inefficient and less scalable.

Algorithmic Stablecoins are NOT STABLE

Algorithmic stablecoins like UST (of Terra Luna Infamy) are scalable, capital efficient, and decentralized but not stable as is clear from its spectacular demise that sent all of crypto into a multi-year down-cycle.

Ethena Labs’ USDe is an attempt at solving these identified challenges. I evaluate below if it achieves this.

What is USDe?

USDe is a scalable synthetic dollar, backed by a delta-neutral portfolio of long spot and short derivative positions, usable across Defi protocols, that does not rely on traditional banking infrastructure.

How does USDe maintain its peg to the dollar?

USDe is backed by:

Long Spot collateral: LSTs (Liquid staking tokens) like stETH and rETH, BTC and USDT
+
Short derivatives positions: on the same collateral.

This is how it works

KYCed institutions in permitted jurisdictions mint USDe when they deposit LSTs, BTC, or USDT with Ethena Labs.

For Example:

• Assume that 1ETH = US$3,000
• A whitelisted user mints 3,000 units of USDe by depositing 1ETH.
• Ethena Labs uses the deposited ETH as collateral to open hedge positions using perpetuals or futures on a derivatives exchange.

• At the outset, 3000 units of USDe is backed by :

1ETH worth US$3,000
+
1 short ETH short future (strike price of $3,000) worth US$0 (For now we ignore the funding rate or basis spread that sellers of short position receive)

• If the price of ETH rises by US$1,000, 3000 units of USDe is backed by :

1ETH now worth US$4,000
+
1 short ETH future now worth (-) US$1,000

• If the price of ETH falls by US$1,000, 3000 units of USDe is backed by :

1ETH now worth US$2,000
+
1 short ETH future now worth US$1,000

The value of the portfolio backing USDe is always worth $3,000.

How is USDe able to offer yields above 25%?

USDe has 2 sources of returns:

1. Staking Returns — LSTs offered as collateral generate staking returns in the form of (i) consensus layer inflation, (ii) execution layer transaction fees, and (iii) MEV. Now that BTC has also been included as acceptable collateral to mint USDe, it must be pointed out that BTC does not generate staking returns.
2. Basis Spread and Funding Rate — Basis trade is one of the best-understood arbitrage strategies. Futures usually trade at a premium to spot. Hence buy the spot, sell the future at a premium and the difference called basis spread is your profit. With regards to perpetuals, usually when the perpetual is trading higher than the underlying, traders with long positions pay a funding rate to traders with short positions.

Not all USDe earns a yield

Note that NOT all USDe earns yield by default. Only stUSDe earns yield. Users from eligible jurisdictions must stake USDe to be eligible to have returns distributed to them. This boosts yield as the return is created on all minted USDe but distributed only to those who stake.

Consider a situation where only 20% of USDe is staked

• Total USDe minted: 100
• Staking returns: 4%
• Funding rate: 3%,
• Return on total protocol: 7%
• Yield on stUSDe: 7/20*100 = 35%

USDe ≠ UST

The high yields have led to suspicions that USDe is similar to Terra Luna’s UST.

I hope that the above explanation clarifies that such comparisons are wrong. UST was a Ponzi scheme where new investor money was distributed as yield to old investors. USDe generates a true yield that can be understood mathematically. There are risks involved and we will discuss those below but for those with the tools to manage the risk, the yield is real.

Does USDe solve the stablecoin trilemma and offer scale, decentralization, and stability?

1. Scale

Since USDe backing comprises spot + derivatives, we need to consider the scalability of both legs.

• Spot: USDe’s advantage in scalability over DAI is that it does not require over-collateralization. On the other hand, USDe only accepts ETH, BTC, and USDT as collateral while DAI accepts several other crypto tokens and even Real World Assets (RWAs). Fiat-backed stablecoins like USDT are substantially more scalable as the market caps of BTC and ETH are minuscule compared to the $30 trillion Treasuries market.
• Derivatives: Scalability would have been constrained if Ethena Labs had limited itself to DEXes. Instead, it chose to leverage CEXes which offer 25x the liquidity.

USDe will have scaling limits but there’s sufficient room to grow from current market cap

2. Decentralization

Unlike fiat-backed stablecoins like USDC and USDT, USDe is not reliant on the walled gardens of traditional banking infrastructure for custody of backing collateral. The LSTs, USDT, or BTC backing USDe can be transparently observed on-chain.

Regarding the derivatives position, transparency would have been higher if only DEXes were used. However, as mentioned above, Ethena Labs made the calculated decision to use CEXes to achieve scale. This resulting centralization and counterparty risk to CEXes is mitigated by using “Off-Exchange Settlement” Providers. When opening a derivatives position with a Centralized Derivatives Exchange, the ownership of collateral is not transferred to the Exchange. Instead, it is held with “Off-Exchange Settlement” Providers which enable more frequent settlement of outstanding P&L and reduce exposure to Exchange failure.

Now while the collateral position may be transparently observable on-chain, the value of the actual derivatives is not. One would be reliant on Ethena Labs’ disclosure processes to track hedge positions in ledgers across multiple exchanges. The value of derivatives can be quite volatile and often deviate from theoretical prices. For Example: When the price of ETH halves, the price of the short position may rise but not to the extent that offsets the ETH price drop.

3. Stability

The cash-and-carry strategy of going long spot and short futures to capture the pricing discrepancy has been used in tradfi for decades. The derivatives market in top crypto assets has reached a sufficient level of maturity to support this tried-and-tested strategy.

But how stable is stable enough? If USDe aspires to be used as a “means of payment” then it isn’t sufficient to hold a 1:1 peg to the US Dollar 98% of the time. It needs to hold its peg even in the most volatile of markets.

The banking system is so trusted because we know that a dollar with Wells Fargo is the same as a dollar with Bank of America which is the same as the physical dollar bill in your wallet “at all times”.

I don’t think the cash-and-carry model can support this level of stability.

To mitigate against market volatility and negative funding rates, USDe enjoys two protections:

1. Staking returns serve as the seatbelt providing the 1st level of protection to the USD peg.
2. If the staking returns are insufficient to cover the negative funding rates then the Reserve Fund serves as the airbag offering a second layer of protection to the USD peg.

If the higher negative funding rate lasts even after the Reserve Fund is exhausted then the peg is likely to break.

Historically, funding rates have been mostly positive averaging 6–8% over the last 3 years including the 2022 bear market. Quoting from the Ethena website “the longest streak of consecutive days with negative funding lasting just 13 days. The longest streak of positive funding days has been 108 days”. This however is no guarantee that funding rates will remain positive.

Ethena Labs is like a Hedge Fund

Ethena Labs is like a Hedge Fund managing the risks of a complex portfolio. The returns are real but users are exposed not only to market volatility but also to the ability of Ethena Labs to manage the technical aspects of running a delta-neutral portfolio.

Maintaining a delta-neutral position in a portfolio of long-spot and short derivatives is a continuous activity. Derivative positions are opened when USDe is minted and then continuously opened and closed to (i) realize PNL (ii) optimize the different contract specifications and capital efficiency offered by the exchanges, or (iii) move between coin-margined inverse contracts and USD-margined linear contracts. Derivative prices often move contrary to theoretical values. Every time a transaction is executed, one pays transaction fees and may incur slippage.

One is trusting the pedigreed team at Ethena Labs to manage the portfolio responsibly.

The real limits to scaling may be the lack of incentive to mint USDe

Any Hedge Fund aims to attract AUM (Assets Under Management). Attracting AUM for Ethena Labs means getting more people to mint USDe.

I can see why one would want to “stake” USDe. The returns are compelling even after factoring in the risk. I’m not clear though on why one would want to “mint” USDe.

In the tradfi world, when someone needs cash, they borrow against property or stocks instead of selling those assets because they want to retain the potential upside from the price appreciation of those assets.

Similarly with DAI, when you mint (borrow) DAI, you know that you’ll get back the original collateral when you burn (repay) DAI.

When one mints USDe, one doesn’t get back the original collateral. One gets back collateral equivalent to the value of USDe minted.

Let’s say 1ETH = $3,000 and you mint 3000 units of USDe. If you decide to redeem in 6 months when the value of ETH has risen to $6000, you’ll receive only 0.5ETH. If the value of ETH falls to $1500, you’ll get back 2ETH.

The payoff is the same as selling your ETH today. If the price of ETH rises, you buy back less ETH for the same money in the future. If the price of ETH falls then you buy back more.

The returns generated are captured by those able to stake USDe. The only upside for minters of USDe is the possibility of receiving ENA token airdrops.

Without a clear incentive to mint USDe, I don’t understand how they’ve attracted over $2bn in market cap.

I’d point out Regulatory Uncertainty is probably the reason behind the design choice of not offering yield on all minted USDe. Yield would make USDe a security leading to all sorts trouble with the SEC.

Conclusion

USDe is a credible attempt at solving the stablecoin trilemma. However, any temptation to market it to retail as a stable token offering risk-free returns must be thwarted.

There were several attempts at a Digital Currency before Bitcoin. These included eCash, DigiCash, and HashCash. While they may have failed, they made a huge contribution to furthering the research on cryptography and digital currency, and many of their attributes were eventually incorporated into Bitcoin.

Similarly, USDe may not be perfect, but I see its attributes being incorporated into what eventually emerges as a more robust synthetic dollar.