10.04.2024
“Deploying more capital - steady lads” were the words that marked the end of Terra and dragged the entire crypto ecosystem into collapse. Ethena Labs' USDe "synthetic dollar" echoes many surface-level developments that led to the fall of the UST stablecoin.
Terra, the infamous blockchain project, aimed to develop a widely used payment system anchored by its digital currency, Luna. As the platform's native token, Luna was utilized for network security and governance purposes and was linked to its stablecoin ecosystem to provide stability. Luna was part of the Top 10 crypto by market capitalization in its prime.
UST was Terra's stablecoin, designed to maintain a steady value of $1. While real-world assets backed most stablecoins, UST uniquely relied on an algorithm involving creation and burning of the Luna token to maintain stability. UST became the fourth most capitalized stablecoin behind USDT, USDC, and BUSD, with more than $15 billion in market cap.
The image of a collapse. Source: TradingView
In May 2022, a significant sell-off of UST triggered widespread panic, causing its price to fall below $1. To restore the peg, users could exchange UST for Luna by burning UST, a mechanism designed to reduce UST's supply and help its price recover to $1. However, this process significantly increased the supply of Luna, leading to a dramatic decrease in its value. This increase in Luna supply, instead of stabilizing UST, exacerbated the situation. The rapid devaluation of Luna (meant to support UST's stability) undermined confidence in both cryptocurrencies. As UST continued to lose its pegged value, more holders panicked and sold off their UST, which, in turn, further increased the supply of Luna due to the burning mechanism. This set off a vicious cycle, with the depreciating value of both Luna and UST reinforcing each other in a downward spiral.
The Terra ecosystem collapse epitomizes the risks and potential devastation within the crypto market. Massive investor losses, rippling damage throughout crypto markets, and a devastating blow to crypto’s reputation marked immediate consequences. The fallout triggered intense regulatory scrutiny and fueled skepticism around the DeFi sector.
Ethena and USDe.
Ethena Labs, a DeFi protocol offering a synthetic US Dollar (USDe), initially sparked excitement by announcing a $14 million fundraising round backed by major investors like PayPal and Franklin Templeton. However, this announcement–a result of an error by their PR firm–proved misleading. The actual investment round was significantly smaller, casting doubt on Ethena Labs' legitimacy. This was solely a mistake, but it marked the beginning of the controversies around the project.
USDe, whose team prefers the "synthetic dollar" label to the term "stablecoin", is not backed directly by US dollars but by a basket of crypto assets and short positions. Unlike traditional stablecoins, USDe aims to achieve stability through delta-neutral hedging. This involves Ethena taking a long position on Ethereum (buying and staking ETH) and simultaneously taking a short position on ETH futures (essentially betting on its price to fall).
The profit from the short position is expected to offset any price drops in the underlying assets backing USDe, helping it maintain its $1 peg. This approach offers advantages like scalability and censorship resistance (in short: USDe, backed by a cash and carry trade, holds no US-based assets) but also comes with risks, such as the volatility of the crypto market potentially affecting the peg.
USDe has attracted crypto investors because it provides an exceptionally high yield of approximately 27-37%, similar to the collapsed Terra (UST) stablecoin, which, at its peak, offered a 20% yield on Anchor Protocol. These concerns surrounding USDe's sustainability have sparked fears of a repeat of the disastrous Terra UST depeg and its detrimental impact on the crypto ecosystem. Despite these risks, USDe has gained rapid popularity, with a market capitalization exceeding $2 billion. Additionally, it is being incorporated into various DeFi projects.
TVL, inflows, and outflows in the Ethena protocol. Source: DefiLlama
In a recent development, Ethena Labs airdropped its native token ENA, and subsequently announced the addition of Bitcoin as a backing asset for USDe. This move, intended to enhance the project's stability and credibility, has unexpectedly resulted in increased turmoil among the community members, who perceive similarities to the infamous Terra-Luna debacle.
Is there potential for a USDe collapse?
Ethena developers explain that the USDe peg mechanism is a cash-and-carry trade. In this trading operation, profit is made through mispricing a spot asset and its derivative equivalent; thus, it is an arbitrage operation that is (theoretically) risk free.
In the words of Ethena's Head of Growth. Source: MacroMate8 on X
The criticism about the USDe synthetic dollar revolves around stability and asset security. Its reliance on hedging strategies using perpetual futures contracts and spot positions introduces the risk of failure in unfavorable market conditions. With the UST and Luna connection, the collateralization mechanism only functioned effectively during bull markets. While the hedging strategy of USDe is qualitatively different, it is yet to be tested in choppier markets with futures in backwardation and more risks of liquidations, including auto deleveraging.
Moreover, the security of assets involved in the complex system could contribute negatively to under-collateralization, as any weakness in the custody of the spot value or vulnerabilities in smart contracts could lead to loss of control of the underlying asset. Analyst Willy Woo underlined the risk of such operations in a market where a due diligence process is impossible.
Source: woonomic on X
It's all about the yield.
Similar to the UST case, the yield, in this instance, serves as a magnet, tempting investors to inject liquidity into the protocol. Nevertheless, a high yield indicates the underlying risk associated with the asset it represents. In other words, the riskier the asset, the higher the yield it must offer to attract investors. This principle of risk/demand is evident in the functioning of the bond market, where riskier bonds typically command higher yields and vice-versa. The interest rate, or yield, is determined by several factors, including the creditworthiness of the issuer, the bond term, or the interest rate.
Source: DefiLlama
In the bond market, the risk-reward dynamics have been a key principle, often leading to the perception of bonds as "boring investments." While the high yields offered by decentralized finance (DeFi) protocols can be attractive, it's essential to proceed with caution, in order to avoid excessive risk. When a protocol offers extraordinarily high yields, it raises concerns and echoes past experiences: Terra Luna's collapse shattered market confidence, caused investor losses, and left the DeFi ecosystem in ruins. It's vital that the crypto market learns from past mistakes and overconfidence and exercises prudence in evaluating high-yield investment opportunities.
Ethena Labs operates differently from Terra Luna in qualitative ways that seem more sustainable: A well-executed and monitored cash and carry trade is a well-known, tested entity that does not lose the value of its principal. The fact that BTC cash and carry is added as backing for USDe in addition to the original ETH cash and carry is no cause for alarm, as it simply increases the capacity of USDe. If well executed by Ethena Labs, the main risk of a USDe holder is that it will generate negative yield at times of futures backwardation (term futures prices dropping below spot prices, perpetual funding rates turning negative for shorts) and the supply of USDe will fall, reducing the short pressure on ETH and BTC derivatives and potentially returning to contango. We must stress the "if well executed" phrase here: Most of the USDe risk lies in the execution of their gigantic "risk-free" trades. Is the yield worth trusting Ethena Labs' execution? You decide.