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Why is Ethena the best choice for synthesizing USD based on a public blockchain?
Author: Arthur Hayes, Medium; Compiler: Deng Tong, Golden Finance
The dust on the earth's crust returned to Hokkaido, Japan as scheduled. It was sunny and warm during the day, but at night it was freezing cold. This weather pattern creates a miserable snow condition known as dust on the Earth's crust. Beneath the seemingly beautiful, untouched power slabs lurk ice and crispy snow. This is nasty stuff.
As winter turns to spring at an accelerated pace, I would like to review the article "Dust on the Earth's Crust" published a year ago. In this article, I propose ways to create a comprehensively supported fiat stablecoin that does not rely on the TradFi banking system for its existence. My idea is to combine a long cryptocurrency hedge with a short perpetual swap position to create a synthetic fiat currency unit. I named it Nakadollar because I envisioned using Bitcoin and short-term XBTUSD "perpetual" swaps as a way to create a synthetic dollar. I end the article by pledging to support a solid team trying to do everything I can to turn this idea into a reality.
What a difference a year makes. Guy is the founder of Ethena. Prior to Ethena, Guy worked at a $60 billion hedge fund investing in special situations including credit, private equity and real estate. Guy caught shitcoins during the DeFi summer that started in 2020 and never looked back. After reading "Dust on the Earth's Crust," he was inspired to launch his own synthetic dollar. But as all great entrepreneurs do, he wanted to improve upon my original idea. Instead of using Bitcoin, he is creating a synthetic USD stablecoin using Ethereum.
Guy chose Ethereum because the Ethereum network provides native revenue. To provide security and process transactions, Ethereum network validators are paid a small amount of ETH per block directly through the protocol. This is what I call ETH staking yield. Additionally, since Ethereum is now a deflationary currency, there are fundamental reasons why ETH/USD forwards, futures, and perpetual swaps trades continue to trade at a premium to spot. Holders of short-term perpetual swaps can capture this premium. Combining physically collateralized ETH plus a short ETH/USD perpetual swap position creates high-yielding synthetic USD. As of this week, staked Ethena USD (sUSDe) is currently earning around >50% APY.
The best idea is meaningless without a team to execute it. Guy named his synthetic dollar Ethena and assembled a team of rock stars to launch the protocol quickly and securely. Maelstrom became a founding advisor in May 2023, and in exchange we received governance tokens. I have worked with many high quality teams in the past and the staff at Ethena got the job done without cutting any corners. Fast forward 12 months, and just 3 weeks after launching on mainnet, Ethena’s stablecoin USDe is approaching 1 billion units (TVL of $1 billion; 1 USDe = 1 USD).
I believe Ethena can surpass Tether and become the largest stablecoin. This prophecy will take many years to come true. However, I would like to explain why Tether is the best and worst stablecoin in cryptocurrency. It's the best because it's probably the most profitable financial intermediary per employee in TradFi and crypto. This is the worst, because Tether exists to keep its poorer TradFi banking partners happy. Bank jealousy and the problems Tether poses for the guardians of America’s peaceful financial system could lead to immediate The end of Tether.
To all those misinformed Tether FUDsters out there, I want to be clear. Tether is not a financial fraud, nor does Tether lie about its reserves. Additionally, I have the utmost respect for the founders and operators of Tether. But IMHO, Ethena will rock Tether.
This article will be divided into two parts. First, I will explain why the Federal Reserve (Fed), the U.S. Treasury Department, and large politically connected U.S. banks want to destroy Tether. Second, I’m going to discuss Ethena in depth. I will provide a brief overview of how Ethena is built, how it maintains its peg to the U.S. dollar, and its risk factors. Finally, I will provide a valuation model for the Ethena governance token.
After reading this article, you will understand why I believe Ethena is the best choice in the crypto ecosystem for providing synthetic dollars based on a public blockchain.
Note: Physically backed fiat stablecoins are tokens in which the issuer holds fiat currency in a bank account, i.e. Tether, Circle, First Digital, etc. A synthetic-backed fiat stablecoin is a token in which the issuer holds the cryptocurrency and hedges it with short-term derivatives, namely Ethena.
Jealous Green
Tether (ticker: USDT) is the largest stablecoin measured in circulating tokens. 1 USDT = 1 US dollar. USDT is sent between wallets on various public blockchains such as Ethereum. To maintain the peg, Tether holds $1 in bank accounts for every unit of USDT in circulation.
Without a USD bank account, Tether cannot fulfill its functions of creating USDT, escrow USDT USD, and redeeming USDT.
Creation: Without a bank account, USDT cannot be created as traders cannot send USD.
USD Custody: Without a bank account, there is nowhere to hold USDT-backed USD.
Redemption of USDT: Without a bank account, USDT cannot be redeemed, because there is no bank account to send USD to the redeemer.
Having a bank account is not enough to ensure success because not all banks are created equal. There are thousands of banks around the world that accept U.S. dollar deposits, but only some have master accounts with the Federal Reserve. Any bank wishing to clear U.S. dollars through the Federal Reserve to fulfill its obligations as a U.S. dollar correspondent bank must hold a master account. The Federal Reserve retains complete discretion over which bank master accounts are granted.
I'm going to quickly explain how agent banking works.
There are 3 banks: A, B and C. Banks A and B are located in two non-U.S. jurisdictions. Bank C is a US bank with a master account. Banks A and B want to be able to move dollars within the fiat financial system. They each applied to use Bank C as their correspondent bank. Bank C evaluates the bank's customer base and approves it.
Bank A needs to send $1,000 to Bank B. The funds flow is a transfer of $1,000 from Bank A's account at Bank C to Bank B's account at Bank C.
Let's change the example a little and add Bank D, which is also a US bank with a master account. Bank A uses Bank C as its correspondent bank, and Bank B uses Bank D as its correspondent bank. Now, what happens when Bank A wants to send $1,000 to Bank B? The flow of funds is that Bank C transfers $1,000 from its account at the Federal Reserve to Bank D's account at the Federal Reserve. Bank D eventually deposits $1,000 into Bank B's account.
Typically, banks outside the United States use correspondent banks to wire U.S. dollars worldwide. This is because once dollars move between jurisdictions, they must be cleared directly through the Fed.
I have been in crypto since 2013 and typically the bank of the crypto exchange you deposit fiat to is not a US registered bank which means it relies on having the main account Bank of America to handle fiat deposits and withdrawals. These smaller, non-U.S. banks are eager to deposit and bank cryptocurrency companies because they can charge high fees and pay nothing for deposits. Globally, banks are often desperate for cheap U.S. dollar financing because the U.S. dollar is the global reserve currency. However, these smaller foreign banks must interact with their correspondent banks to handle U.S. dollar deposits and withdrawals outside of their domicile. While correspondent banks tolerate these crypto-related fiat flows, sometimes certain crypto clients are kicked out of smaller banks at the behest of correspondent banks, for whatever reason. If smaller banks fail to comply, they lose correspondent banking relationships and the ability to move dollars internationally. A bank that loses the ability to move dollars is a zombie. Therefore, smaller banks will always drop cryptocurrency customers if asked to do so by correspondent banking.
This correspondent banking is crucial when we analyze the strength of Tether’s banking partners.
Tether banking partners: British Bank Trust, Cantor Fitzgerald, Capital Alliance, Ansbacher, Deltec Bank and Trust.
Of the five banks listed, only Cantor Fitzgerald is a bank registered in the United States. However, none of these five banks has a Fed master account. Cantor Fitzgerald is a primary dealer who helps the Fed conduct open market operations, such as buying and selling bonds. Tether’s ability to move and hold U.S. dollars is entirely dependent on the whims of fickle correspondent banks. Given the size of Tether's U.S. Treasury portfolio, I believe their partnership with Cantor will be critical to continued access to this market.
These banking CEOs are fools if they didn’t negotiate a stake in Tether in exchange for providing banking services. You'll see why when I introduce Tether's revenue per employee metric later.
This is why Tether’s banking partners are underperforming. Next, I want to explain why the Fed doesn’t like Tether’s business model and why, fundamentally, it has nothing to do with cryptocurrencies but Has to do with how the U.S. dollar currency market works.
Full banking reserved
From a TradFi perspective , Tether is a fully reserved bank, also known as a narrow bank. Fully set-aside banks take deposits without lending them out. The only service it provides is sending money back and forth. Since savers face no risk, it pays almost no interest on their deposits. If all depositors request a refund at the same time, the bank can fulfill this request immediately. Therefore, this name - totally reserved. In contrast to fractional reserve banks, the bank's loan base is larger than its deposit base. If all depositors simultaneously demanded their funds from a partially retained bank, the bank would go bankrupt. Fractional reserve banks pay interest to attract deposits, but savers face risks.
Tether is essentially a fully-reserved U.S. dollar bank that provides U.S. dollar trading services powered by a public blockchain. No loans, no funny stuff.
The Fed dislikes fully-reserve banks, not because of who their customers are, but because of how these banks handle deposits. To understand why the Fed hates the full reserve banking model, I have to discuss the mechanics of quantitative easing (QE) and its impact.
Banks failed during the 2008 financial crisis because they did not have enough reserves to cover losses on bad mortgages. Reserves are funds held by banks with the Federal Reserve. The Fed monitors bank reserves based on total outstanding loans. After 2008, the Fed ensured that banks would never run short of reserves. The Fed does this through quantitative easing.
Quantitative easing is the process by which the Federal Reserve purchases bonds from banks and credits the banks with the reserves they hold at the Fed. The Fed engaged in trillions of dollars worth of quantitative easing bond purchases, causing bank reserve balances to swell. Long live!
Quantitative easing does not significantly cause inflation because bank reserves remain at the Fed. Pandemic stimulus payments go directly to people to spend as they please. If banks instead lent out these reserves, inflation would rise immediately after 2008 because the money would be in the hands of businesses and individuals.
Some banks exist to make loans; if they don't lend money, they don't make money. So, other things being equal, fractional reserve banks prefer to lend their reserves to paying customers rather than leave them at the Fed. The Fed has a problem. How do they ensure that the banking system has nearly unlimited reserves without causing inflation? The Fed chose to "bribe" the banking industry rather than lend.
Bibbing banks to require the Fed to pay interest on excess reserves in the banking system. To calculate the amount of the bribe, multiply the total bank reserves held by the Fed by the interest on reserve balances (IORB). The IORB must hover between a lower and upper bound on the federal funds rate.
Loans are risky. Borrower defaults. Banks would rather receive risk-free interest income from the Fed than lend to the private sector and suffer possible losses. As a result, as QE proceeds, the banking system's outstanding loans are growing at a different rate than the Fed's balance sheet. However, success does not come cheap. Bribery costs are not high when the federal funds rate is 0% to 0.25%. But now, with the federal funds rate at 5.25% to 5.50%, IORB bribes are costing the Fed billions of dollars every year.
The Fed maintains “high” policy rates to curb inflation; however, due to the higher cost of IORB, the Fed becomes Unprofitable. The U.S. Treasury Department and the American public are directly financing the Federal Reserve's bribery of banks through the IORB program. When the Fed makes money, it sends those payments to the U.S. Treasury. When the Fed loses money, the U.S. Treasury borrows money and sends it to the Fed to cover the losses.
QE solved the problem of insufficient bank reserves. The Fed now wants to reduce bank reserves to curb inflation. Enter quantization tightening (QT).
QT is when the Fed sells bonds to the banking system and pays for them with reserves held by the Fed. Quantitative easing increases bank reserves, while quantitative easing decreases bank reserves. As bank reserves fall, so do IORB bribery costs. Obviously, the Fed won't be happy if bank reserves increase while paying high interest rates to the IORB.
The operation of the full reserve banking model runs counter to the stated goals of the Federal Reserve. Fully-reserve banks do not make loans, meaning 100% of deposits are held as reserves at the Fed. If the Fed starts granting fully reserved banking licenses to banks doing business similar to Tether, it will exacerbate the central bank’s losses.
Tether is not a U.S. authorized bank, so it cannot deposit funds directly with the Federal Reserve and earn IORB. But Tether can deposit cash into a money market fund, which can use a reverse repurchase program (RRP). The RRP is similar to the IORB in that the Fed must pay an interest rate between the federal funds floor and ceiling in order to accurately determine the direction of short-term interest rate trades. Treasury bills (T-bills) are zero-coupon bonds with maturities of less than one year that trade at yields slightly above the recommended retail price (RRP) interest rate. So while Tether is not a bank, its deposits are invested in instruments that require interest payments from the Federal Reserve and the U.S. Treasury. Tether has nearly $81 billion invested in money market funds and Treasury bonds. Tether is killing the Fed. Neither can the Fed.
Tether arbitrages the Fed because Tether pays 0% on USDT balances but earns around the upper limit of the federal funds rate. This is Tether’s net interest margin (NIM). As you can imagine, Tether is very happy about the Fed raising interest rates because in less than 18 months (March 2022 to During September 2023), the net interest margin rose from basically 0% to nearly 6%.
Tether is not the only stablecoin issuer targeting the Federal Reserve. Circle (USDC) and all other stablecoins that accept USD and issue tokens are doing the same thing.
If banks abandon Tether for some reason, the Fed will provide no help.
What about Bad Gul Yellen? Does her treasury have any conflicts with Tether?
Tether is too big
U.S. Treasury Secretary Janet Yellen needs a functioning U.S. Treasury market. This allowed her to borrow the funds necessary to pay for the government's trillion-dollar annual deficit. After 2008, the size of the U.S. Treasury market expanded dramatically along with the fiscal deficit. The bigger it grows, the more fragile it becomes.
This chart from the U.S. Government Securities Liquidity Index clearly shows the declining liquidity in the U.S. Treasury market since the pandemic (higher numbers mean worse liquidity conditions). It only takes a small amount of selling to disrupt the market. What I mean by disrupting the market is a rapid drop in bond prices or a rise in yields.
Tether is currently one of the 22 largest holders of U.S. Treasuries. If Tether had to quickly reduce its holdings for whatever reason, it could send global bond markets into chaos. I say global because all fiat debt instruments are priced in some way, shape, or form independent of the U.S. Treasury curve.
If Tether’s banking partners launch Tether, Yellen may intervene in the following ways:
strong>Perhaps she would stipulate that Tether be given a reasonable period of time to retain its customer status so that it is not forced to sell assets to quickly satisfy redemption requests.
Maybe she will freeze Tether’s assets , making it impossible to sell anything until she thinks the market can absorb Tether's assets.
But Yellen certainly won’t help Tether find another long-term banking partner. The growth of Tether and similar stablecoins serving the cryptocurrency market poses risks to the U.S. Treasury market.
Perhaps Yellen might side with Tether if they decide to buy bonds that no one wants (i.e. long-term bonds with maturities over 10 years) instead of short-term notes that everyone wants . But why would Tether take this duration risk to earn less money than a shorter-maturity Treasury bond? This is due to an inverted yield curve (where long-term interest rates are lower than short-term interest rates).
The most powerful sectors of American-style financial institutions would rather Tether did not exist. And none of this has anything to do with cryptocurrencies.
Tether is too rich
The talented analysts at Maelstrom have created the following speculative balance sheet for Tether statement and profit and loss statement. They used a combination of Tether’s public disclosures and their judgment to create this outcome.
The table below lists the eight “too big to fail” (TBTF) banks that run the American-style Pax economic and political system and their fiscal year 2023 net profits.
Cantor Fitzgerald is not a bank, but a primary dealer and trading company. There are only 23 primary dealer banks. So, in the Total Deposits column, this number for Cantor represents the value of its balance sheet assets. I obtained estimates of Cantor's net profit and headcount from Zippia.
Tether’s revenue per employee is $62 million. No other bank on the list comes close. Tether’s profitability is another example of how cryptocurrencies will impact the largest transfer of wealth in the history of human civilization.
Why don’t these TBTF banks offer competing fiat-pegged stablecoins? Tether earns more per employee than any of these banks, but Tether would not exist without these banks and others like them.
Perhaps one of these banks could purchase Tether instead of requiring Tether to be debanked. But why do they do this? This is certainly not suitable for technology. Thanks to the transparency of public blockchains, the code to deploy Tether smart contract clones is already on the internet.
If I were the CEO of a US bank supporting the existence of Tether, I would immediately unbank them and offer a competing product. The first US bank to offer stablecoins will soon dominate the market. As a user, holding JPMorgan stock is less risky than Tether. The former is the responsibility of too-big-to-fail banks, but is essentially the responsibility of empires. The latter is the responsibility of a private company, scorned by the entire U.S. banking system and its regulators.
I have no reason to believe that a US bank is plotting to overthrow Tether. But doing so is trivial. Why did Tether, owned by a crypto stooge hanging out in the Bahamas and whose existence relies 100% on access to the U.S. banking system, earn more than Jamie Dimon in a few trading days?
As the cryptocurrency bull market progresses, any stock not related to the cryptocurrency business will rise. A U.S. bank, whose stock price is falling due to market panic over bad commercial real estate loans, could gain a valuation boost by entering the crypto stablecoin market. This could be all the motivation Bank of America needs to finally compete directly with Tether, Circle, and others.
If Circle's IPO goes well, the banking system is expected to face challenges. Stablecoin businesses like Circle and Tether should trade at a discount to earnings because they have no competitive moats. That Circle was even able to IPO is a comedy in itself.
There is no higher mountain than this...
I just explained why the US banking system destroyed Tether than beating Caroline Ellison at the Math Olympiad Ellison) is easier. But why would we as a crypto ecosystem create a different type of fiat-pegged stablecoin?
Thanks to Tether, we know that the crypto capital market is hungry for a fiat-pegged stablecoin. The problem is that banks provide poor services because there is no competition to make them better. With Tether, anyone with an internet connection can make USD payments 24/7.
Tether has two main problems:
User does not Any share of Tether's NIM will be received.
Even if Tether acts according to the regulations, Could be shut down by the U.S. banking system overnight.
To be fair, users of any currency generally do not share in seigniorage revenue. Holding physical cash dollar bills doesn't entitle you to the Fed's profits... but it definitely can afford its losses. Therefore, USDT holders should not expect to receive any net interest margin from Tether. However, one user group that should be compensated are cryptocurrency exchanges.
Tether’s primary use case is as a funding currency for cryptocurrency transactions. Tether also provides a near-instant way to transfer fiat currencies between trading venues. Exchanges provide utility to Tether as a place to trade cryptocurrencies, but they get nothing in return. There are no Tether governance tokens available for purchase that provide holders with NIM claims. Unless an exchange somehow acquired a stake in Tether in its early days, it wouldn't be able to share in Tether's success. This isn’t a sob story about why Tether should provide funds to exchanges. Instead, this would prompt exchanges to support stablecoin issuers, passing on a large portion of NIM to holders, and provide exchanges with the opportunity to purchase governance tokens at cheap valuations in the early stages of an issuer’s development.
Quite simply, if you want to surpass Tether, you have to pay stablecoin holders a large portion of NIM and sell cheap governance tokens to exchanges. This is how vampire squid attacks physical fiat-backed stablecoins.
Ethena followed this script to the letter. USDe holders can stake it directly to Ethena and earn the majority of their NIM. Major exchanges have invested in Ethena in early funding rounds. Ethena’s cap table includes Binance Labs, Bybit via Mirana, OKX Ventures, Deribit, Gemini, and Kraken as exchange partner investors.
In terms of market share represented by these exchanges, they cover approximately 90% of ETH open interest on major exchanges.
How does Ethena work?
Ethena is a comprehensively backed fiat cryptocurrency USD.
ETH = Ether
stETH = ETH derivatives pledged by Lido
ETH = stETH
ETH = stETH = $10,000
ETH/USD perpetual swap contract value = 1 USD worth of ETH or stETH = 1 / ETH or stETH USD value
pegged
USDe is issued by Ethena A stablecoin designed to be pegged 1:1 to the U.S. dollar.
Ethena joins various Authorized Participants (APs). AP can mint and burn USDe at a ratio of 1:1 USD.
Coining:
Currently, stETH Lido, Mantle mETH, Binance WBETH and ETH are accepted. Ethena then automatically sells the ETH/USD perpetual swap to lock in the USD value of ETH or ETH LSD. The protocol then mints an equivalent amount of USDe that matches the dollar value of the short’s permanent hedge.
Example:
AP deposits 1 stETH, worth $10,000.
Ethena sells 10,000 ETH/USD per swap contract = 10,000 USD/1 USD contract value.
AP receives 10,000 USDe because Ethena sold 10,000 ETH/USD per swap contract.
Burning:
To destroy USDe, AP deposits USDe into Ethena. Ethena then automatically covers a portion of its short ETH/USD perpetual swap position, thereby unlocking a certain amount of USD value. The protocol will then destroy USDe and return an amount of ETH or ETH LSD based on the total USD value unlocked minus execution fees.
Example:
AP deposits 10,000 USDe.
Ethena buys back 10,000 ETH/USD per swap contract = 10,000 USD/1 USD contract value
AP receives 1 stETH = 10,000 * $1 / $10,000 stETH/USD minus execution fees
To understand why, initially USDe was in stablecoins such as Curve The trading price on the exchange should be at a slight premium to USD and I will explain why users would want to hold USDe.
USD Yield
The combination of ETH staking yield and ETH/USD perpetual swap funds is comparable on high synthetic dollar yields. To earn this yield, USDe holders stake it directly on the Ethena application. It takes less than a minute to start earning money.
Because sUSDe’s yield of approximately 30% at launch is very high; users who already hold USD stablecoins with much lower yields will switch to sUSDe. This puts pressure on the buyers and will drive up the price of USDe in the Curve pool. When the trading premium of USDe is large enough, AP will step in and arbitrage the difference.
Imagine this: 1 USDe = 2 USDT. If an AP can create 1 USDe with 1 USDT worth of ETH or stETH, they can earn a risk-free $1 profit. Here is the process:
Put $ Wire transfer to the exchange.
Sell $1 for ETH or stETH.
Deposit ETH or stETH on the Ethena app and receive 1 USDe.
Deposit USDe on Curve and sell it for 2 USDT.
Sell 2 USDT at the exchange for $2 and withdraw the USD to the bank account.
If users believe that Ethena is safe and the rate of return is real, then in this hypothetical example, the USDT in circulation will decline, while the USDe in circulation will rise.
Terra USD (UST) Yield
Too many people in the cryptocurrency space believe that Ethena will be like UST Same failure. UST is a stablecoin attached to the Terra/Luna ecosystem. Anchor is a decentralized money market protocol in the Terra ecosystem that offers a 20% annual yield to those who stake UST. People can deposit UST and Anchor will lend that deposit to borrowers.
Any stablecoin issuer must convince users why they should switch from (usually Tether) to the new product. High production volumes are what prompted this shift.
UST is supported by Luna, and Bitcoin is purchased by selling Luna. Luna is the governance token of the ecosystem. The foundation owns a majority stake in Luna. Due to the high price of Luna, the foundation sold Luna as UST to pay high UST interest. The interest rate is not paid in physical dollars, but you earn more UST tokens. While UST maintains a 1:1 peg to the U.S. dollar, the market believes that if you hold more UST, you also hold more dollars.
As the total value of Anchor’s locked UST grows, its UST interest expenses also grow. The foundation's continued sale of Luna to subsidize Anchor's UST rewards became unsustainable. The yield comes only from the market's belief that Luna should be worth trillions of dollars.
The death spiral for algorithmic stablecoins began when the price of Luna began to drop. Because Luna is minted and burned in such a way as to maintain a 1:1 peg of UST to the U.S. dollar, as Luna depreciates, it becomes more difficult to maintain a peg of UST to the U.S. dollar. Once the anchor exchange rate breaks violently, all UST interest accumulated on Anchor becomes worthless.
Ethena Yield
USDe generates yield in a completely different way than UST. Ethena holds two income-producing assets.
Staking ETH:
ETH is staked using liquid staking derivatives like Lido (stETH). stETH earns ETH staking income. Deposit ETH into Lido. Lido runs validator nodes capitalized on ETH deposits and remits ETH paid by the Ethereum network to stETH holders.
Perp Swaps:
Perpetual swaps are a series of consecutive short-term futures contracts. Funding rates for most perpetual contracts reset every 8 hours. Funding rates are based on a PR vs. PR premium or discount. If the perpetual contract has traded at a 1% premium to other perpetual contracts in the past 8 hours. The funding rate for the next period is +1%. If the funding rate is positive, longs pay shorts; if interest rates are negative, the opposite is true.
Ethena holds a short perpetual swap position to lock in the USD value of its staked ETH holdings. Therefore, if funds are positive, Ethena will earn interest income. If it is negative, interest is paid. Obviously, as USDe holders we want to be confident that Ethena will receive interest rather than pay interest. The question is why is ETH/USD forward trading at a premium?
Ethereum is now a deflationary currency. The dollar is an inflationary currency. If ETH decreases but USD increases in the future, then ETH/USD forwards should trade higher. This means that any leveraged forward derivatives, such as perpetual swaps, should trade at a premium to spot. Funds should be mostly positive, meaning Ethena will receive interest. The data supports this.
What will cause Ethereum to transform from a deflationary currency to an inflationary currency? If Ethereum's network usage drops significantly, much less ETH Gas will be burned per block. In this case, the Ethereum block reward will be greater than the Ethereum burned.
What will cause the dollar to change from an inflationary currency to a deflationary currency? American politicians need to stop spending tons of money just to get re-elected. The Fed must reduce its balance sheet to zero. This will lead to a serious contraction in the circulation of US dollar credit currency.
I think both scenarios are unlikely. Therefore, it is reasonable to expect funding rates to be positive for most periods in the foreseeable future.
USDe is not UST.
The combination of ETH staking yield and positive perpetual swap funding generates the USDe yield. The yield is not based on the value of the Ethena governance token. USDe and UST generate revenue in completely different ways.
Ethena Risk
Ethena is subject to counterparty risk. Ethena is not decentralized, nor does it attempt to be. Ethena holds short-term perpetual swap positions on the Centralized Exchange for Derivatives (CEX). If these CEXs are unable to pay out profits on swap positions or return deposited collateral for a variety of reasons, Ethena will suffer capital losses. Ethena attempts to reduce direct counterparty risk by placing funds with third-party custodians, such as:
Tether’s counterparty risk comes from TradFi Bank. Ethena’s counterparty risk comes from derivatives CEXs and cryptocurrency custodians.
CEX is an investor in Ethena and has a vested interest in not being hacked and ensuring that its derivatives are properly paid out. Derivatives CEX are the most profitable cryptocurrency companies and they want to keep it that way. Fucking your customers is not good business. As Ethena develops, growth in derivatives open interest will increase CEX’s fee income. All incentives are aligned. CEX wants Ethena to do well.
Tether’s products help the functioning of crypto capital markets. Cryptocurrency exists to disintermediate TradFi Bank. TradFi Bank Wants Cryptocurrencies to Fail. From a fundamental perspective, banking Tether hastened the demise of TradFi. Incentives are inconsistent. TradFi Bank doesn’t want Tether to do well, and regulators don’t want Tether to do well.
Ethena belongs to us, aka FUBU.
Tether is ours, aka FUBAR.
LSD Smart Contracts and Risk Reduction
Ethena holds ETH LSD. It faces smart contract risks. For example, Lido could have issues that render stETH worthless. Additionally, there is the risk of being axed. Slashing occurs when an Ethereum node network validator breaks certain rules. As a penalty, the ETH capital held by validators is reduced, also known as a slash.
Negative Funding
As I mentioned before, perpetual swap funding rates can be negative for long periods of time. Financing rates could become so negative that the net asset value of Ethena assets is less than the amount of USDe issued. USDe will then break the downside peg.
Ethena Smart Contract Risks
Like Tether, Ethena runs smart contracts on a public blockchain. There may be bugs in the code that cause unexpected behavior and ultimately lead to losses for USDe holders. Typically, hackers will try to mint large amounts of stablecoins for free and then trade them for another cryptocurrency on platforms like Uniswap or Curve. As the supply of stablecoins increases without a corresponding increase in the assets backing the stablecoins, this can lead to the peg being broken.
However, Ethena smart contracts are relatively simple and most of their complexity lies in off-chain engineering. The on-chain mint/redemption contract is only about 600 lines of code, and only approved participants can interact with the most sensitive contracts on the chain, which helps reduce the risk of blocking malicious unknown counterparties from interacting with them.
Limits to Growth
The circulating supply of USDe can only grow up to the exchange’s total open interest in Ethereum futures and currency swap contracts. The circulating supply of physically-backed fiat stablecoins is approximately $130 billion. Ethereum has $8.5 billion in open interest across all exchanges. $12 billion across all exchanges, and another $31 billion in open interest in Bitcoin contracts that could be tapped into once Ethereum decides to use Bitcoin as collateral. With the combined open interest of Bitcoin and Ethereum being approximately $43 billion, it is unlikely that Ethereum will occupy the number one position given the current market conditions. While Ethena started with ETH, BTC and SOL were very easy to add to their system, it was just a matter of sequencing.
As cryptocurrencies grow as an asset class, total open interest will grow exponentially. Some believe that cryptocurrencies as an asset class will reach $10 trillion in this cycle. At this level, it’s not ridiculous that Ethereum’s open interest could exceed $1 trillion, considering it is the second-largest cryptocurrency by fiat market cap.
Ethereum will grow as cryptocurrencies grow.
Insurance Fund
The purpose of an insurance fund is to mitigate financial losses due to some of the risks mentioned above. If funding rates become negative or the synthetic USD depegs, these funds will act as bidders for USDe on the open market. The fund consists of stablecoins (USDT and USDC), stETH and USDe/USD LP positions. Currently, the insurance fund is capitalized by funding from Ethena Labs’ funding round, as well as an uncollateralized portion of proceeds generated by USDe. In the future, as the circulating supply of USDe grows, these funds will be capitalized through long-term yields. As of this writing, the insurance fund is $16 million.
Neither USDT nor USDe is risk-free. However, the risks are different. Tether and Ethena may eventually fail, but for different reasons.
When people begin to believe that the yield on USDe is not high, the circulation of USDe will increase.
This is where the upcoming Ethena governance token comes into play.
Value Ethena
Like any currency issuer, Ethena lives or dies by seigniorage. This is the difference between the cost of creating money and the cost of creating money. I would like to propose a simple model to value Ethena based on these seigniorage revenues. For those who might be purchasing the Ethena governance token in the coming months, you should at least try to build a model to evaluate the protocol.
Any USDe issued can be staked and earn ETH staked plus perpetual funding returns. As of now, Ethena will distribute the income generated by assets backing sUSDe, while the income generated by assets backing uncollateralized USDe will be sent to the insurance fund after the end of this sharding event, and this income will enter the protocol. I estimate that the long-term split will be 80% of the revenue generated by the protocol goes to the staked USDe (sUSDe), and 20% of the revenue generated goes to the Ethena protocol.
Ethena protocol annual income = total income * (1–80% * (1 — sUSDe supply / USDe supply))
If 100% of USDe is pledged, that is, sUSDe supply = USDe supply:
Ethena protocol annual income = total income* 20%
Total yield = USDe supply* (ETH pledge yield + ETH Perp swap funds)
ETH pledge yield and ETH Perp Swap funds are both variable interest rates. Recent history can guide us to future possibilities.
ETH staking yield - I assume the PA yield is 4%.
ETH Perp Swap Funding - I assume PA is 20%.
A key part of the model is that a fully diluted valuation (FDV) of revenue multiples should be used. This is always a guessing game, but I will suggest some future paths based on similar DeFi stablecoin projects.
Using these multiples as a guide, I created the following potential Ethena FDV.
Ethena’s $820 million in assets generated a 67% return this week. Assuming a 50% supply ratio of sUSDe to USDe, extrapolated one year later, Ethena’s annualized revenue would be approximately $300 million. Using an Ondo-like valuation results in an FDV of $189 billion. Does this mean Ethena's FDV will be close to $200 billion at launch? No. But it does mean the market will pay a premium for Athena's future earnings.
Summary
If you don’t remember the rest of this post, remember this:
Athena belongs to us, belongs to us, aka FUBU .
Tether is ours, created by them, aka FUBAR.
You can decide whether to go long or short USDe or the eventual Ethena governance token. I hope this article sheds some light on Ethena’s mission and why it is so important to the success of cryptocurrencies.
With that, I say goodbye because I have to concentrate on not damaging my thighs while shredding all this crusty snow.
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