Posted April 4, 2024 at 6:41 pm EST.
Ethena’s USDe, a cryptocurrency intended to stay pegged to the U.S. dollar, has achieved phenomenal growth since first being introduced in February, primarily because of the extraordinarily high annual yield — 37.1% at press time — earned by those staking it, as well as people vying to receive an airdrop allocation of Ethena’s governance token.
But its rapid growth, with its market cap recently hitting $2 billion, outsized yield, and some aspects of how it’s structured have provoked comparisons to UST, the notorious failed stablecoin created by Do Kwon and his company Terraform Labs, both of which have been accused by the SEC of securities fraud, and left many wondering just how risky USDe is.
Before Terra’s UST blew up, DeFi protocol Anchor was offering crypto users who were willing to deposit their UST an almost 20% annual percentage yield in 2022.
Learn more: What Is Ethena’s USDe Synthetic Dollar? A Beginner’s Guide
“Since its inception, Ethena’s DeFi protocol has drawn significant attention, with comparisons to the Anchor protocol on #Terra due to its higher annual percentage yield,” wrote a crypto investor who goes by @Crypto_Rand on X. Another X user named @TaePage_, said “USDe taking the stablecoin market by storm giving UST vibes.”
But just how similar is USDe to Terra’s algorithmic stablecoin?
How They’re Alike
One major similarity between the two is that both are not fiat-backed cryptocurrencies like Tether’s USDT or Circle’s USDC, which supposedly place dollars into bank accounts or Treasury bills and then issue a corresponding token that is worth $1.
Instead, Terra’s UST maintained its peg via an algorithmic, burn-and-mint mechanism, while USDe keeps its stability through a delta-neutral strategy that includes “basis trading,” a common method used in futures markets in traditional finance, according to Gordon Scott, who is a member of Investopedia’s Financial Review Board. Essentially, USDe’s peg is simultaneously supported by Ethena’s long position in staking ETH and its short futures positions on exchanges.
To give more detail on each, UST’s peg is derived from the arbitrage users could execute when UST was trading at a discount or premium to the dollar. That’s because on the Terra blockchain, crypto users were able to mint $1 of UST by burning $1 worth of its sister token LUNA, and vice versa.
If UST traded below a dollar, people could buy the UST token, burn it to get $1 of LUNA, and sell their LUNA to profit from the depegging. The theory was that traders would do this repeatedly until UST was trading at $1 again. On the other side, if UST was trading above a dollar, traders would buy LUNA, burn it to mint UST, and sell their UST at the premium until the trade was no longer profitable.
Read More: Former Terraform Developer Testifies Against Do Kwon
“Mathematically, this is a very elegant solution, but it has an absolutely crippling problem, which is [that] this all implies that LUNA has an independent standalone value,” separate from its relationship with UST, Columbia Business School adjunct professor and Paxos’ former head of portfolio management Austin Campbell told Unchained. The collapse of UST and LUNA in 2022 highlighted how both depended on each other to be valuable and how LUNA basically didn’t have a standalone value.
Ethena’s USDe peg mechanism, on the other hand, involves simultaneously going long and short ETH. First, Ethena establishes a long position by staking ETH to earn rewards for helping secure and validate the blockchain network. Ethena then “opens a corresponding short perpetual position for the approximate same dollar value on a derivatives exchange,” as stated in Ethena’s protocol documents.
Theoretically, then, for all price movements of ETH, Ethena essentially has zero exposure. For every dollar that ETH goes down, the protocol loses $1 from its long position but makes $1 on its short position, and vice versa, according to Campbell. This keeps the USD value of the collateral relatively stable.
Where the High Yields Come From
In UST’s case, part of the high yield stemmed from staking rewards, but in reality the yields were offered primarily for marketing purposes. UST’s yield on Anchor from “the marketing incentive dwarfed the staking [component],” Campbell said.
For USDe, the yield comes from rewards from staking ETH and the funding rate earned by Ethena for opening short derivative positions. Traders holding long positions in futures derivatives markets on exchanges pay funding fees to those holding short positions like Ethena. Since traders currently have substantial leveraged long positions on futures derivatives markets, Ethena’s yield is super high, Campbell noted.
Read More: Airdrops From Wormhole and Ethena Labs Set to Inject $2.4 Billion Into Crypto Market This Week
Different Peg, Different Risks
Even though USDe’s peg mechanism is different from UST’s, it is not without risks. Campbell mentions two in particular. The first is the price of an ETH future massively dislocating from the price of spot ETH, which would upend USDe’s basis trade, though Campbell says this risk is not “major,” because the market for ETH futures is both liquid and deep.
Campbell is more concerned with credit risk stemming from the protocols and platforms Ethena is using for its futures trading. If Ethena is conducting its future trades on a protocol that gets hacked or on a centralized exchange that goes bankrupt, they’re “screwed,” says Campbell.
However, the difference between the peg mechanisms of USDe and UST is sufficient for some crypto heavyweights such as Hasu, a Lido strategic advisor, to assign less risk to USDe.
“IMO, the risk of Ethena is greatly overexaggerated…. It’s a very common and relatively low risk trade many firms employ, even more so if you can use a prime broker like Copper/Fireblocks. Pretending otherwise is either uninformed or disingenuous,” Hasu wrote on X.
Campbell also noted that USDe would be easier to unwind than UST, if Ethena ever decided to shut it down. In USDe’s case, Ethena would have the dollars to give people back their money in principle because Ethena ideally would close their short perpetual positions and in the process sell a bunch of ETH.
However, unwinding UST would mean addressing the self-referentiality problem of LUNA and UST where “somehow you’d have to demint all the UST, which causes a bunch of LUNA selling, but the value of LUNA was UST,” Campbell said. This would have caused both to collapse because they did not have independent sources of value, whereas USDe does with ETH.
Read More: Terraform Labs Files for Chapter 11 Bankruptcy in the US
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