Ethena protocol Insights: funding rate Challenges and Strategy Optimization

Student Author| @0x0_chichi

Instructor| @CryptoScott_ETH

Start time | 2024.5.9

1. Ethena’s protocol source of income is Spot stake yield + short position funding rate yield, BTC the introduction of collateral dilutes the stake yield, the market cools down and Ethena’s large short shrinks the funding rate yield.
2. Increasing collateral is a must for Ethena’s long-term growth, but it means that interest rates may be low for a long time.
3. The insurance fund currently protocoled to the agreement is insufficient and there is a high risk.
4. Ethena has a natural advantage in the face of a bank run on a negative funding rate.
5. The total amount of open interest in the market is an important indicator Close Position to limit the amount of USDe issuance.

Ethena is a stablecoin protocol built on Ethereum Blockchain that offers a “synthetic dollar” USDe through a Delta neutral strategy.

Protocol, users deposit stETH into the protocol and minting USDe of the equivalent. Ethena utilizes an over-the-counter Settlement (OES) scheme to map stETH balances to CEXs as Margin, shorting an equal amount of ETH Perptual Futures. This portfolio achieves Delta neutrality, meaning that the value of the portfolio does not change with ETH’s price fluctuations. So in theory, USDe achieves a stable value.

Users can then stake USDe into the protocol to minting out sUSDe, and hold sUSDe to get the income generated by funding rate. At one point, this yield was as high as more than 30%, and it was one of Ethena’s main means of collecting reserves.

As of May 9, 2024, the yield of holding sUSDe is 15.3%, and the total issuance of USDe has reached $2.29 billion, accounting for about 1.43% of the total market capitalization of stablecoins, ranking fifth.

In the Ethena protocol, both stETH Collateral and ETH Perptual Futures short positions will generate gains (from funding rate), and if the combined return of both positions is negative, the insurance fund in the Ethena protocol will cover the losses.

What is the funding rate?

In traditional commodity futures contracts, the parties agree on a Delivery Date, that is, a period of physical exchange, so when the futures contract is about to reach the Delivery Date, the futures price will theoretically be equal to the Spot price. However, in Digital Currency Trading, in order to drop Delivery costs, a Perptual Futures form is widely adopted: compared with traditional contracts, the Delivery link is eliminated, resulting in the disappearance of the correlation between futures and Spot.

In order to solve this problem, the funding rate is introduced, that is: when the Perptual Futures price is higher than the Spot price (the basis is positive), the longs pay the funding rate to the shorts (the funding rate is proportional to the absolute value of the basis); When the Perptual Futures price is lower than the Spot price (with a negative basis), the shorts pay the funding rate to the longs.

Therefore, the more the Perptual Futures price deviates from the Spot price (the greater the absolute value of the basis), the greater the funding rate and the stronger the inhibition of price deviation. The funding rate becomes the correlation between futures and spot prices in Perptual Futures.

Ethena holds ETH Airdrop positions and stETH, and the income comes from funding rate and stake income, and when the comprehensive return is positive, the insurance fund will reserve a portion of the income to compensate users when the comprehensive return is negative.

In the current Bull Market, go long sentiment is significantly higher than shorting sentiment, the demand for long orders in the market is greater than the demand for short orders, and the funding rate remains high for a long time. The Delta risk of Spot collateral in the Ethena protocol is Hedging by the short position, and the short position held can earn a significant amount of funding rate income, which is why the Ethena protocol generates a risk-free high yield.

Prior to the launch of USDe, the Solana on-chain stablecoin project, UXD, was stablecoin in the same way, but UXD was Hedging in the DEX Futures Trading, which also set the stage for UXD’s failure.

From a Liquidity point of view, Centralized Exchange hold more than 95% of the un Close Position contracts, Ethena Centralized Exchange is the best option in order to scale USDe to the billion level: the price of Ethena’s short position will not cause much disruption to the market when USDe issuance large-scale rise, or in the event of a bank run.

Because Ethena’s use of Centralized Exchange hedging will inevitably create new centralized risks, Ethena has introduced a new mechanism, OES, to hand over Collateral to a third party (Copper, Fireblocks), Centralized Exchange without holding any Collateral, similar to depositing users’ Collateral in a Multi-signature Wallet to maximize drop centralized risk.

The insurance fund is an important component of Ethena’s protocol, which transfers a portion of the revenue from stETH positions and ETH short positions when the combined return is positive to release it when the comprehensive return is negative, in order to maintain coin price stability.

Figure 1: USDe floating yield simulation

The high USDe yield in the 2021 Bull Market reflects strong bullish demand, with long positions paying 40% of short funding rate per year. With the start of the Bear Market in 2022, the funding rate has often fallen below zero, but it has not remained negative, and the average has remained above 0.

In the second quarter of 2022, the collapse of Luna and 3AC had a surprisingly small impact on the funding rate, with a brief downturn that allowed the funding rate to hover around 0 for a while, but quickly returned to positive values.

In September 2022 Ethereum the switch from POW to POS triggered the largest Black Swan Event in funding rate’s history, funding rate fall to 300% at one point, due to the fact that in this conversion, users only need to hold ETH Spot to earn short rewards, resulting in a large number of users not only holding ETH Spot long positions, but also holding ETH short positions to hedge a large number of ETH Spot in order to obtain stable Airdrop returns.

The large influx of short caused the ETH Perptual Futures funding rate to big dump for a short period of time, but funding rate quickly returned to positive levels after the end of the short distribution.

The collapse of FTX in November 2022 also caused the funding rate to fall to -30%, but it did not last, and the funding rate quickly returned to positive values.

Based on historical data, the average comprehensive income of USDe has remained above 0, demonstrating the long-term viability of the USDe project. Protocol to short-term normal market shocks or black swan events that lead to a composite return of less than 0 is unsustainable, an adequate insurance fund can enable a smooth transition of the agreement.

Starting from 2024/4, users can stake BTC in the Ethena protocol for minting USDe stablecoin, and as of 5/9/2024, BTC collateral has now accounted for 41% of the total collateral.

Figure 2: Details of Ethena collateral on 5/9/2024

Figure 3: Details of the ETH short position of the Ethena protocol on April 5, 2024

On the eve of Ethena’s acceptance of BTC as collateral, Ethena’s total ETH short positions already accounted for 21.57% of the total Close Position contracts. Despite the strong Liquidity of the Centralized Exchange and the fact that Ethena holds ETH short positions in long exchange, the rapid rise of USDe issuance Centralized Exchange may not provide sufficient ETH Perptual Futures Liquidity, and Ethena is in dire need of new rise.

Compared to liquid staking Token, BTC does not have a native stake yield, and if BTC is introduced as collateral, the stake yield contributed by stETH will be diluted. However, Centralized Exchange BTC Perptual Futures of Close Position contracts exceed $20 billion, and after the introduction of BTC collateral, USDe’s capacity to scale will increase rapidly in the short term, but in the long run, the rise rate of the total number of BTC and ETH Close Position contracts is the main factor limiting USDe’s rise.

Figure 4: Average funding rate yield by year

Although the BTC collateral dilutes the stake yield of stETH, the average funding rate of BTC Perptual Futures is Bull Market below ETH and higher than ETH at Bear Market through historical data, which is also a Hedging to deal with the Bear Market funding rate downturn, improve the diversification of the portfolio, and reduce the risk of USDe de-anchoring in the Bear Market.

The current yield on sUSDe is rapidly slipping from 30%+ to around 10%+, both due to the general sentiment of the market and the impact of the large number of shorter positions brought about by the rapid expansion of USDe.

As we all know, the terrifying rise speed of USDe comes from the ultra-high funding rate payment in the Bull Market, but USDe as a stablecoin is still extremely lacking in application scenarios, and the existing trading pairs are only associated with some other stablecoin. Therefore, long the vast majority of USDe holders hold USDe for the sole purpose of reaping high APY and Airdrop activity.

Although the mechanism of the insurance fund is entered when the composite intrerest rate is negative, users who provide stETH will redeem it when the comprehensive income is lower than the stETH stake yield; Users who provide BTC will be more cautious, as the basis gradually decreases, the funding rate income continues to be low, and in the absence of ultra-high APY, a large number of redemptions may be generated after the end of the second round of airdrop activities, the reason can refer to the dilemma that Bitcoin L2 is also facing: a large number of users (especially large investors) regard BTC as the object of store of value, and the requirements for fund security are extremely demanding.

Therefore, the author believes that if before the end of Ethena’s second quarter Airdrop event, if USDe’s stablecoin application scenario has not achieved breakthrough development and the gradual reduction of the funding rate, USDe is likely to collapse.

Ethena officially made the following conclusions about the insurance fund through simulation calculations:

Figure 5: Scale of initial insurance requirements by rising scenario and insurance fund drawdown rate

In Figure 5, green, yellow, and red represent that the initial insurance fund size is less than 2 k million US dollars, between 2 k ~ 5 k million US dollars, and more than 5 k million US dollars to ensure the safety of funds.

The vertical coordinates indicate that the final amount of USDe issuance is expected to reach $1 billion, $2 billion, and $3 billion in two and a half years (2021/4~2023/10), respectively. The first three on the abscissa indicate that when the USDe issuance volume rises linearly, the withdrawal rate of the insurance fund is set to 50%, 20%, and 10% respectively. The fourth abscissa indicates that the withdrawal rate of the insurance fund is set at 20% when the USDe issuance volume remains constant after the first year is exponential rise. The fifth abscissa indicates that the withdrawal rate of the insurance fund is set at 20% when the USDe issuance volume has been at an exponential rise.

From Figure 5, a 50% withdrawal rate is very safe for a $2 k 0,000 starting insurance fund, and it keeps the insurance fund fully capitalized in almost all cases and at rise levels. If a black swan event occurs before the insurance fund has the opportunity to capitalize through forward financing, a premature index rise could pose a danger to the solvency of the insurance fund. At the same time, the late index rise is safer because it provides a more long time for the rise of the insurance fund.

But the reality is that the initial insurance fund is only $1 million, and the supply of USDe is much faster and long than the early exponential increase in the early growth case in the model. Nearly half of the current $38.2 million insurance fund (only 1.66% of USDe issuance) has increased in the last month. It can be seen that the problem caused by the rapid issuance of USDe is that the insurance fund in the early stage of the Ethena project is seriously insufficient compared to the official model estimates.

An inadequate insurance fund has two consequences:

1. Users have little confidence in the project, and if the high yield starts to decline, the TVL of the project will gradually decrease.
2. High TVL, low insurance fund, the project team must increase the withdrawal rate of the insurance fund (at least 30% or higher) to replenish the insurance fund as quickly as possible, but in the current situation of the gradual decline in the income of the funding rate, the user’s rate of return is even worse, which may exacerbate the first consequence.

Figure 6: 2023/11/23~2024/5/9 USDe issuance

Figure 7: 2024/1/11~2024/5/9 Insurance Fund Amount

Referring to the ETH Pow arbitrage event in the third quarter of 2022 in Figure 1, the funding rate has fallen significantly in a short period of time, and the annualized rate once exceeded 300%. In such a Black Swan Event, a bank run on USDe is basically inevitable, but the unique mechanism of USDe seems to have a natural advantage in dealing with the bank run.

bank run may have already occurred in the early stages of a significant decline in the funding rate, as Ethena protocol needed to pay off a large amount of Spot collateral and Close Position equal Airdrop positions due to the creation of bank run, and due to the reduction in Airdrop positions, the insurance fund could maintain its expenses for a longer period of time.

From a Liquidity point of view, when bank run happens, Ethena needs to Close Position short positions, and in a negative funding rate market, it means that long Liquidity is exceptionally adequate, and Close Position short positions are hardly bothered by Liquidity issues.

At the same time, there is a 7-day cooling-off period for sUSDe in the Ethena protocol (Collateral it cannot be liquidated within a week of stake), which can also be used as a buffer in case of sudden changes in the market.

But the premise of all this is the adequacy of the insurance fund.

The total amount of un Close Position contracts in the market (OI, open interest) is always a key factor restricting the issuance of USDe, and it is also a potential risk for USDe in the future, as of May 9, 2024, ETH OI in Ethena protocol accounts for 13.77% of the total OI, and BTC OI accounts for 4.71% of the total OI. The huge number of short positions generated by the Ethena protocol has brought some disruption to the contract market, and there will be certain Liquidity problems with the subsequent expansion of the USDe scale.

The best way to solve this problem is to increase the number of high-quality Collateral long as much as possible (funding rate greater than 0 in the long term), which not only increases the upper limit of the USDe supply, but also increases the diversification of the portfolio and reduces risk.

Protocol, the Ethena protocol demonstrates its unique stablecoin mechanism and sensitive response to market dynamics. Despite challenges such as chronic basis downturns, insufficient insurance funds, and potential bank run risks, Ethena has maintained its competitiveness in the market through innovative over-the-counter settlement mechanisms and longest collateral variety.

With the ever-changing market environment and technological innovation in the industry, Ethena must continue to optimize its strategy and enhance its Risk Management capabilities to ensure the adequacy of insurance funds and the stability of liquidity. For investors and users, it is crucial to understand how the protocol works, where it comes from, and its potential risks.