Opinion The USDe issued by Ethena is just a bond, not a stablecoin at all.

The USDe by Ethena A Bond Masquerading as a Stablecoin

Written by: Austin Campbell, Founder and Managing Partner of Zero Knowledge Consulting, and Professor at Columbia Business School.

Translated by: Babywhale, Foresight News.

In July of this year, Ethena, inspired by Arthur Hayes’ creation of a decentralized stablecoin based on Bitcoin, secured a $6 million investment led by Dragonfly. The decentralized stablecoin launched by Ethena is called USDe. In simple terms, the protocol converts users’ collateral into Ethereum and pledges it, then hedges against the price drop of the collateral by shorting the same amount of Ethereum via perpetual contracts. (Related reading: “Ethena’s stablecoin solution: borrowing from Hayes’ proposal, stabilizing USDe by hedging with LSD”)

With this approach, the Ethereum collateral being pledged can earn staking rewards, and the short position can earn funding rate returns (in the long run, the funding rate of perpetual contracts on centralized exchanges is positive most of the time). Additionally, the hedge between the two positions can offset the loss in collateral value caused by a decrease in Ethereum’s price.

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This seems like a decent decentralized stablecoin solution, where the value of collateral is not greatly affected by price fluctuations, and users who mint USDe can also earn some returns through the mechanism. However, Austin Campbell, a scholar researching stablecoins and the Founder and Managing Partner of Zero Knowledge Consulting, as well as a professor at Columbia Business School, argues that USDe cannot be called a stablecoin and is merely a structured note:

In traditional cryptocurrency-backed stablecoins, collateral needs to exist and is used to support the value of the stablecoin. To make the stablecoin “safe,” the collateral value needs to be much higher than the stablecoin itself. The good news is that as long as there is no market crash, you can liquidate in an orderly manner (this has been effective before events like the Subprime Crisis in 2008, which was a painful lesson for TradFi). The bad news is that this method is capital inefficient because the locked capital is much higher than the capital released by using stablecoins, and it also relies on potential demand for leverage.

What sets Ethena apart? The model here attempts to eliminate the price instability of underlying cryptocurrency collateral through long positions in ETH and short positions in ETH perpetual contracts. Therefore, every price change of ETH is hedged.

As a structured financial product, I think this is a very interesting attempt. What I oppose is calling it a stablecoin and marketing it as such, or promising any degree of security. Why?

Essentially, what they are doing is replacing price risk with credit risk. In particular, Ethena now faces the following risks:

1. No matter what method is used for ETH staking. If they run their own validator, is the security and continuous operation of the validator guaranteed? If they outsource it, then the risk is borne by the supplier. If they use a liquid staking protocol, then the risk comes from the protocol, there is no free lunch here. This is not to say that risks are always present, and in most cases, there won’t be any issues. However, once a problem arises, the consequences could be unimaginable.

2. Centralized exchanges or DEX where the contract positions are held. It is obvious to diversify them over time, but the same applies here, they are not invincible, you will leave collateral behind, therefore you will face risks. In the case of CEX, it is mainly credit risk. In the case of DEX, given the frequent occurrence of hacking incidents in this field, credit risk may be smaller, but security/protocol risk is higher. In other words, what would happen if the positions were held in FTX?

3. Availability risk. Another lesson learned from 2008 is that the protocol assumes there will be enough depth for short-term trading when prices remain stable. In special periods, this is not always the case. Price gaps and liquidity will dry up, and one of the problems you will encounter is simply not having enough liquidity for short selling. Of course, this problem is related to the issues mentioned in point 2.

4. Interest rate risk. One interesting assumption is that the net value of staking rewards and perpetual contract funding rates is positive. It might not be! Unfortunately, it is common to incur losses in order to maintain hedging, but over time, this is fatal for stablecoins.

What I want to say is that these are not the reasons why I predict that this project will fail immediately.

It is indeed an interesting experiment, but I worry that, like many structurally created notes I have seen in the past, it is just an interesting experiment with no core economic purpose.

Do I expect it to be stable in the long term? Maybe, maybe not. Compared to the volatile algo stablecoins, this design definitely has fewer key flaws, but in terms of price stability, its risks are much greater than using well-designed fiat-backed stablecoins. Among the issues I mentioned, one of them will eventually arise and undermine this “stable” coin. Over a long enough period of time, this stablecoin will inevitably deviate from its anchor.

Therefore, if you know what it is, fully understand its risks, and believe it is better than using something like PYUSD, then go ahead and use it, I’m not against them doing so.

I just object to calling it a stablecoin because it’s not.

What is issued here (Ethena) are structurally created notes, which have similar risk characteristics to many notes. Are they useful? Sometimes they work, but sometimes they don’t.

Would I call them “stable” or let others price them on a trading platform based on a fixed net asset value of $1? Absolutely not. As a buyer and issuer, managing risk properly is also very complex.

Austin Campbell’s piercing evaluation

Compared to many people discussing how to keep over-collateralized stablecoins “stable,” Austin Campbell raises a more “soul-searching” question: What exactly is issued through collateralizing digital assets?

Whether it’s MakerDAO’s DAI, Curve’s crvUSD, or Aave’s GHO, regardless of the mechanism, their essence is: collateralizing assets to unlock purchasing power, and the fundamental thing is leverage. So whether the stablecoin is anchored to the US dollar or the euro, it doesn’t really matter. The protocol can define the newly issued tokens as anchored to any price-stable currency or commodity with purchasing power, because they’re not actually “stablecoins,” but structured bonds.

There are currently many decentralized over-collateralized stablecoins in the market, which increase trading depth between them and traditional stablecoins like USDT and USDC through liquidity incentives. On one hand, this allows many idle traditional stablecoins to earn higher returns; on the other hand, by increasing trading depth, users who mint over-collateralized stablecoins with their collateral can exchange them for traditional stablecoins to increase purchasing power through secondary investment.

Although the logic is sound, once external funds do not continue to enter and internal capital flow cannot support interest payments or price stability, the result in a weak market is a chain reaction. The mid-2021 chain liquidations caused by the decline in Bitcoin and Ethereum prices, as well as the large number of centralized institutions going bankrupt in the second half of 2022, are all caused by excessive leverage.

So currently, whether it’s innovative collateral preservation mechanisms like Ethena or the hotly debated issuance of stablecoins using collateralized NFTs, you can call them financial experiments, perhaps allowing some who understand the rules of the game to triumph in the existing market, or even call them “decentralized stablecoins,” but you need to understand in your mind that fundamentally, it’s just borrowing and what is being minted are “bonds.”

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