Author: Tiena Sekharan

Translation: Plain Blockchain

1. What problem does USDe attempt to solve?

In a world where the utility of most cryptocurrencies is hard to prove, stablecoins have emerged as an asset class that has found market fit:

(i) They act as a bridge between cryptocurrencies and traditional finance (TradFi).

(ii) The most liquid trading pairs on centralized exchanges (CEXes) and decentralized exchanges (DEXes) are stablecoin-denominated.

(iii) They facilitate instant peer-to-peer payments, especially cross-border transactions.

(iv) For those forced to hold weak currencies, they can serve as a store of value.

However, current stablecoin designs face some challenges:

Fiat-backed stablecoins are not decentralized.

The most widely used stablecoins are fiat-backed and controlled by centralized entities. They also have the following drawbacks:

(i) They are issued by easily scrutinized centralized entities.

(ii) The fiat supporting them is held in potentially bankrupt banks with opaque and freezable deposit accounts.

(iii) The securities backing them are held by government-regulated entities with opaque processes.

(iv) The value of these stablecoins is limited by rules and laws that may change based on the political environment.

Ironically, as the most widely used token category aimed at promoting decentralized, transparent, and censorship-resistant transactions, it is issued by centralized entities, supported by assets held in traditional financial infrastructure, susceptible to government control and revocation.

USDe aims to address these issues by providing a decentralized stablecoin solution to achieve transparency, resistance to censorship, and independence from traditional financial systems.

2. Issues USDe Aims to Solve

Cryptocurrency-backed stablecoins lack scalability.

Before receiving support from real-world assets (RWAs), MakerDAO's DAI is a relatively decentralized stablecoin that can be verified on-chain.

DAI's collateral is volatile assets like ETH. To ensure safety margins, minting DAI requires locking up 110-200% collateral, making DAI capital inefficient and less scalable.

1) Algorithmic stablecoins are unstable

Algorithmic stablecoins like Terra Luna's UST have advantages in scalability, capital efficiency, and decentralization, but as evident from their significant failures, they are unstable, leading the entire cryptocurrency market into a prolonged bear market for years.

Ethena Labs' USDe attempts to address these identified challenges. I will evaluate below whether it has achieved this goal.

2) What is USDe?

USDe is a scalable synthetic dollar supported by an incrementally neutral investment portfolio of long-term spot and short-term derivative positions, usable in DeFi protocols without relying on traditional banking infrastructure.

How does USDe maintain its peg to the dollar?

USDe's supporting assets include:

  • Long-term spot collateral: liquid equity collateral tokens (LSTs) like stETH, rETH, BTC, and USDT.
  • Short-term derivative positions: using the same collateral.

The specific workings are as follows:

In jurisdictions where KYC (Know Your Customer) has been conducted, institutions depositing LSTs, BTC, or USDT with Ethena Labs can mint USDe.

For example: Assuming 1 ETH = $3000. A whitelisted user mints 3,000 USDe by depositing 1 ETH, Ethena Labs uses the deposited ETH as collateral, opening hedging positions on perpetual contracts or futures on derivative trading platforms.

Initially, the supporting assets for 3000 USDe are:

  • 1 ETH worth $3000
  • 1 short ETH futures contract worth $0 (with an execution price of $3000) (temporarily ignoring funding rates or basis differences for short positions)

If the price of ETH rises by $1000, the supporting assets for 3000 USDe are:

  • 1 ETH now worth $4000
  • 1 short ETH futures contract now worth -$1000

If the price of ETH falls by $1000, the supporting assets for 3000 USDe are:

  • 1 ETH now worth $2000
  • 1 short ETH futures contract now worth $1000
  • The value of the investment portfolio supporting USDe remains at $3000.

3) How can USDe provide over 25% yield?

USDe has two sources of yield:

  • Collateral yield - LSTs serving as collateral will generate collateral yield in the form of (i) consensus layer inflation, (ii) execution layer transaction fees, and (iii) MEV. Now, BTC can also be used as eligible collateral to mint USDe, but it should be noted that BTC does not generate collateral yield.
  • Basis differences and funding rates - Basis trading is one of the most well-known arbitrage strategies. Futures typically trade at a premium. Therefore, buying spot and selling futures at a premium to profit from the difference (i.e., basis difference). As for perpetual contracts, when the price of the perpetual contract is higher than the underlying asset, traders holding long positions need to pay funding rates to traders holding short positions.

Not all USDe tokens can earn yield

It should be noted that not all USDe tokens default to earning yield. Only stUSDe is eligible for yield. Users in qualifying regions must stake USDe to be eligible for allocated yield. This enhances the yield as it is generated on all minted USDe but only distributed to those staking.

Assuming only 20% of USDe is staked

  • Total USDe minted: 100
  • Collateral yield rate: 4%
  • Funding rate: 3%
  • Total protocol yield: 7%
  • stUSDe yield: 7/20*100 = 35%

USDe ≠ UST

The high yield has raised suspicions of USDe's similarity to Terra Luna's UST.

I hope the above explanation can clarify that this comparison is incorrect. UST is a Ponzi scheme that distributes returns to old investors using new investors' funds. The yield generated by USDe is real and can be understood mathematically. While risks exist, we will discuss these risks below, but for those capable of managing risks, the yield is genuine.

3. Has USDe solved the stablecoin trilemma and provided scalability, decentralization, and stability?

1) Scalability

Given that USDe's support includes spot and derivatives, we need to consider the scalability of both.

Spot: Compared to DAI, USDe's advantage in scalability is that it does not require over-collateralization. However, 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 have an advantage in scalability as they are backed by the $30 trillion treasury market, whereas the market cap of BTC and ETH is relatively small.

Derivatives: If Ethena Labs were limited to decentralized exchanges (DEXes) only, scalability would be restricted. Instead, it chooses to leverage centralized exchanges (CEXes), which provide 25 times more liquidity.

USDe will have its limitations in scalability, but considering the current market cap, there is still sufficient room for growth.

2) Decentralization

Unlike stablecoins backed by fiat like USDC and USDT, USDe does not rely on closed systems of traditional banking infrastructure to custody the collateral. The LSTs, USDT, or BTC supporting USDe can be transparently observed on the blockchain.

Regarding derivative positions, if only decentralized exchanges (DEXes) are used, transparency would be higher. However, as mentioned above, E

Thena Labs has decided to use centralized exchange platforms (CEXes) for scalability after careful consideration. By using over-the-counter settlement providers, they can mitigate the centralization and counterparty risks associated with CEXes. When establishing derivative positions with centralized derivative trading platforms, the ownership of collateral does not transfer to the trading platform but is held by the over-the-counter settlement provider. This allows for more frequent settlement of unrealized gains and losses, reducing the risk exposure to the insolvency of the trading platform. Although collateral positions can be transparently observed on the blockchain, the actual value of derivatives is not as transparent. People need to rely on Ethena Labs' disclosure process to track hedging positions across multiple trading platforms. The value of derivatives can be highly volatile and often deviate from theoretical prices. For example, when the price of ETH halves, the price of short positions may rise but not enough to offset the extent of the ETH price drop. **3) Stability** Cash arbitrage strategy is a long-standing strategy used in traditional finance to capture price differentials by longing spot and shorting futures. The derivative market for top crypto assets has matured enough to support this proven strategy. However, what level of stability is sufficient? If USDe is intended to be used as a "medium of exchange," anchoring to the dollar in a 1:1 ratio for only 98% of the time is not enough. It needs to maintain anchoring even in the most volatile markets. The reason the banking system is highly trusted is because we know that one dollar with Bank A is the same as one dollar with Bank B, and the same as the physical dollar bills in your wallet, "consistent." I believe the cash arbitrage model cannot support this level of stability. To mitigate market volatility and the impact of negative funding rates, USDe has two protective measures: - Earnings from collateral as the first layer of protection, providing support for the dollar peg. - If earnings from collateral are not sufficient to cover negative funding rates, the reserve fund will serve as the second layer of protection, offering additional support for the dollar peg. If even after the reserve fund is depleted, higher negative funding rates persist, the peg may break. Historically, funding rates have been mostly positive, with an average of 6-8% over the past 3 years, including the bear market of 2022. Quoting from the Ethena website: "The longest consecutive days of negative funding rates are only 13 days. The longest consecutive days of positive funding rates are 108 days." However, this does not guarantee that funding rates will remain positive. **4) Ethena Labs is like a hedge fund** Ethena Labs operates like a hedge fund managing complex investment portfolio risks. The returns are real, but users face not only the risk of market fluctuations but also the question of whether Ethena Labs can effectively manage the technical aspects of running a delta-neutral investment portfolio. Maintaining delta-neutral positions in a portfolio holding spot and short-term derivatives is an ongoing activity. When USDe is minted, derivative positions are opened and then continuously opened and closed to realize gains and losses: - Optimizing different contract specifications and capital efficiency provided by trading platforms; - Or switching between inverse contracts collateralized with coins and linear contracts collateralized with dollars; Derivative prices often deviate from theoretical values. Each trade execution incurs transaction fees and may suffer from slippage losses. People need to trust Ethena Labs' experienced team to responsibly manage the investment portfolio. **5) The real limitation to scaling may be the lack of incentives to mint USDe** The goal of any hedge fund is to attract assets under management (AUM). For Ethena Labs, attracting AUM means attracting more people to mint USDe. I can understand why someone would want to "stake" USDe. Despite the risks, the returns are convincing. But I am unclear why someone would want to "mint" USDe. In the traditional finance (tradfi) world, when someone needs cash, they would pledge assets or stocks instead of selling them because they want to retain the potential for the price of these assets to rise. Similarly, when you mint (lend out) DAI, you know that when you burn (repay) DAI, you will receive the original collateral. However, when someone mints USDe, they do not have the right to receive back the original collateral. Instead, they receive collateral equal in value to the minted USDe. For example, if 1 ETH = $3000, and you mint 3000 units of USDe. If you decide to redeem after 6 months, and by then the value of ETH has risen to $6000, you will only receive 0.5 ETH. If the value of ETH drops to $1500, you will receive 2 ETH. This is equivalent to selling your ETH today. If the price of ETH rises, you will be able to buy less ETH in the future with the same money. If the price of ETH falls, you will need to buy more ETH in the future. The returns generated go to those who can stake USDe. The only benefit for those minting USDe is the possibility of receiving an airdrop of ENAToken. If there are no clear incentives for minting USDe, I do not understand how they attract a market value of over $2 billion. I must point out that regulatory uncertainty may be the reason for not providing returns on all minted USDe. Returns would classify USDe as a security, leading to various troubles with the U.S. Securities and Exchange Commission (SEC). **Conclusion** USDe is a viable attempt to solve the stablecoin trilemma. However, any temptation to push it as a stable token with risk-free returns to the retail market must be prevented. Before the emergence of Bitcoin, there were several attempts at digital currencies, including eCash, DigiCash, and HashCash. Although they may have failed, they made significant contributions to the study of cryptography and digital currencies, with many of their features eventually incorporated into Bitcoin. Similarly, USDe may not be perfect, but I believe its characteristics will be incorporated into a more powerful synthetic dollar that will eventually emerge.