Let’s look at another chart.

As we can see, the returns on US Dollar, which does not need to sit on any vulnerable smart contract, are higher than the best returns that DeFi can offer: about 4% offered on ETH, a highly volatile asset. Why would investors put their money in DeFi with all its challenges of hacks, rug pulls, and smart contract vulnerabilities when they can get higher yields in U.S. government Treasury bills?

Tether and Circle offer risks without any return

Centralized stablecoin issuers operate a straightforward business. Users hand over their USD, and in return, the companies issue an equivalent amount of stablecoins. With interest rates soaring to a 22-year high, both Tether and Circle have been investing these dollars into U.S. Treasury bills. Tether reported a profit of a whopping $1 billion in just the second quarter of 2023. Then there is Coinbase, which manages USDC alongside Circle, and has seen significantly higher interest earnings of $200 million per quarter in 2023 compared to $32.5 million from just a year ago.

Holders of USDT and USDC do not benefit from these returns, but they take on the risks associated with centralized stablecoins. They assume all the risks of the DeFi world by giving their dollars to Tether and Circle, who are the ones to receive bumper profits courtesy of Uncle Sam.

Playing games with LSTs

For those who remain hopeful in the DeFi world and can stomach the wild price action of ETH as well as the slight price differential, Liquid Staking Tokens (LSTs) have become the primary avenue to earn some on-chain “risk-free” yield. Well, “risk-free” is relative -- especially when compared to putting money in memecoins named after bald cefi founders.

During the so-called "LST summer" this year, several projects launched to help LST holders leverage their safe instruments to mint stablecoins. These stablecoins could then be leveraged further or used to access other DeFi services. Would you like to do something with your frxETH besides earning more ETH? Consider minting CrvUSD from Curve. Check out this DefiLlama crvUSD dashboard. About 18 million in FrxETH is currently being used to mint crvUSD.

The developments don’t end there. This summer saw the emergence of LST backed stablecoin projects like Lybra, Raft, and Gravita. Two of them are Liquity forks, and all of them allow an LST holder to put their precious yield-bearing derivative of ETH in a Collateralized Debt Position (CDP) to mint their own stablecoins. According to this helpful Dune Analytics dashboard by Defimochi, we’ve got about $200 million in LSTfi stablecoins in circulation.

Do you see a problem with this? That is too little value. Why haven’t users rushed to mint these new stablecoins? The problem is in the traditional CDP design used to issue these stablecoins (There is another problem too, more on that in the next paragraph). Effective collateralization in these protocols can exceed 200%.

The other problem we need to talk about is the potential size of the LSTfi market. With just over 20% of ETH staked, the total value of staked ETH is about $45 billion. Much of staked ETH is held by exchanges and independent validators, which means the market size for LSTs is actually smaller. Data from DeFiLlama tells us that the total stablecoin market cap right now is at $124 billion. The amount of stables created in the LSTfi ecosystem pales in comparison to the overall stables in circulation. This is not entirely bad, as it means there is room to grow if the amount of staked ETH increases and the price of Ethereum rises to where it should be.

Maybe these upstart stables could try what big daddy DAI has done. Bring that sweet TradFi yield on chain. Or maybe there is another way, a more shall we say, capital efficient way of minting censorship resistant stablecoins that can actually scale. And this is where Ethena comes in.

Introducing USDe

USDe is simple. As simple as USDT or USDC, and it even has a 1 to 1 exchange, although it is not entirely similar. This is how USDe works:

• The user deposits stETH worth 100 USD to Ethena.

• Ethena will short ETH worth 100 USD on an exchange.

• 100 USDe is issued to the user.

• When price of ETH increases by 1 USD, the value of the collateral will increase by 1 USD.

• On the exchange, the PnL of the short position will be -1 USD.

On Ethena you can deposit USD, ETH, or StETH to create USDe at a 1:1 collateral ratio. Unlike CDP-based LSTfi stables, Ethena allows users to fully utilize the value of their assets. How does it do this exactly? What happens behind the scenes? Ethena works with centralized exchanges (ah-oh!). Yes, really! That's how it happens. But, you might say, centralized exchanges are dirty. Remember FTX?

Here’s the solution. There will be no collateral in exchanges. They don’t need to hold it. The collateral will be held in safer venues, custodians such as copper and fireblocks. And why would the exchanges be in on this? That’s simple. The more USDe is minted, and the more ETH is shorted on their venues, the more fees they get. No wonder so many exchanges have invested.

But what about yield?

USDe has an out of the way solution for your yield needs. Well, not completely out of the way. Other projects, like UXD on Solana, have tried this before. Ethena takes your dollars, your ETH, and your StETH, and it hedges all of this collateral by shorting ETH on exchanges. It will earn funding from all this hedging activity. And this is what Ethena will earn. Take a look at this handy figure from the Ethena team:

What the USDe holders receive is (StETh yield + basis) - Ethena’s cut for the insurance pool.

Ethena has a few products lined up based on this formula.

• Floating rate bonds: These come from hedges executed via perpetual swaps

• Fixed rate bonds: Hedges executed via expiring futures

• eETH: When converting USD and ETH into LST, opportunity to pass on this flow to other providers

• Repo Finance: Provide same asset leverage on both LSTs and USDe

What about negative funding?

The excess spread estimate in the figure above does look a little rich, doesn’t it? What if funding rates are negative? If Ethena keeps paying negative funding, there goes the principal and there goes the peg.

Not quite.

This is where stETH becomes useful. It tops up the insurance pool with that yield, giving USDe an extra layer of protection. If the yield is taken up, you still have the whole insurance fund. And if that is drawn down, what happens then? Doesn’t the stable implode? (insert Luna flashback)

Not really. USDe will depeg, but slowly. Users will have enough time to exit the stable when funding is negative. This has a positive knock on effect. Existing users will lift short positions on exchanges which will boost funding rates. If the supply shrinks and shorts are lifted, funding will rise making USDe attractive enough to be minted again. If supply grows too quickly, the funding rates will decrease, slowing the growth of the stablecoin.

Then there is the history of funding rates. Take a look at the chart below. ETH Perp funding has been broadly positive since July 2021 except for that period at the end of 2022.

Not quite a rosy picture, yes. But what happens when you combine stETH yield and funding basis?

The excess spread of ETH funding after accounting for stETH yield was positive in a period when Luna collapsed, 3AC crashed and burned, FTX collapsed, and USDC depegged.

The team at Ethena is smart and they are onto something promising. With their unique approach to collateralization and risk management, Ethena could scale USDe into the billions. We don’t have any exposure but we are observing with great interest.

If you liked this post, we welcome discussions and feedback at research@108capital.ltd.