Article by: Prathik Desai

Article compiled by: Block unicorn

Stability can be an illusion. This is especially true in finance. You bet on seemingly mundane financial instruments, believing they will provide stable and reliable returns. They may indeed operate as expected until their fundamentals falter. These seemingly safe investments are often more deceptive than speculative ones. People generally expect speculative investments to be risky, but few consider that safe investments might be as risky as well.

We witnessed this happening approximately 75 years ago.

In the 1940s, following the Great Depression and World War II, dollar-denominated deposits accumulated in European banks. This allowed account holders to hold dollars in non-US banks to hedge against the risk of their currencies depreciating. The attractive yields on these deposits spurred some innovative thinking. Some account holders, such as US companies, cleverly circumvented domestic capital controls by keeping their dollars overseas.

European banks welcomed all these deposits. They accepted them and lent them out at higher interest rates. This surplus of European deposits gave rise to the Eurodollar market, a parallel dollar system not regulated by the Federal Reserve. With the outbreak of the Cold War in the late 1940s, the situation began to deteriorate. More and more people began demanding the return of their dollars, but banks did not have sufficient dollar reserves. The entire system collapsed.

We're seeing similar transactions in the stablecoin market now. However, it seems that issuers of the digital dollar have learned from history.

In today's in-depth analysis, I will explain whether Ethena's reliance on the traditional stock market can save its stablecoin reserve strategy.

Initial behavior

In early 2024, Ethena launched USDe, a unique synthetic stablecoin. USDe is issued as an asset pegged to the US dollar, but it does not actually hold dollar reserves. Instead, for every dollar of USDe issued, it holds an equivalent value of crypto assets, such as Bitcoin and Ethereum. Simultaneously, it also shorts an equivalent value of cryptocurrency futures.

These two positions balance each other out. If the price of Bitcoin rises, the short futures position will lose the gains from the rise in the spot price. Conversely, if the price falls, the short position will lose the gains. Ultimately, even if there are no actual US dollars in the bank account, USDe will always be worth $1.

But why do people hold USDe instead of existing cryptocurrencies like USDT or USDC? Because they receive returns from holding USDe.

This incentive mechanism is specifically designed to suit the way the cryptocurrency derivatives market operates. In a bull market, more traders bet on rising prices. Exchanges charge these bullish bettors a small, ongoing fee called the funding rate, which is then paid to the other party in the trade. Ethena is always on the other side of the trade. It collects these fees and returns them as profit to USDe holders.

At its peak, the yield exceeded 20% annualized. In just 18 months, the circulating supply of USDe increased sevenfold to approximately $15 billion, marking the fastest growth rate in the history of stablecoins.

I like the design, but it relies heavily on the cryptocurrency market maintaining its status quo. It works in a bull market because a small number of investors holding short positions profit while the majority hold long positions. But markets inevitably change over time. And when markets change, cracks appear. On October 11th, the day after the largest liquidation in cryptocurrency history wiped out over $19 billion, USDe briefly lost its peg to the US dollar. Athena's synthetic stablecoin briefly fell to $0.65 against the dollar on Binance.

In the five months beginning on October 10, the amount of U.S. foreign exchange reserves in circulation plummeted from approximately $15 billion to less than $6 billion.

A lesson that came too late?

More than $9 billion has been redeemed. Perpetual futures, which once accounted for almost 100% of the model's reserves, now make up only 11%. Ironically, all of this could have been avoided. Ethena should have foreseen this situation.

All indications suggest that markets are always cyclical, and cryptocurrencies are no exception. We have witnessed this over the past 16 years. Reliance on a single source of collateral (such as perpetual futures that are closely correlated with market movements) remains a ticking time bomb.

Other stablecoin issuers have also begun to adjust. As the Federal Reserve began cutting interest rates, the top two stablecoin issuers increased their issuance to supplement their reserve income. Tether diversified its reserves by increasing its gold holdings to a record high. USDC issuer Circle actively built infrastructure revenue streams through its Layer-1 network Arc and its full-stack internet payment system, Circle Payments Network.

But Ethena has been slow to react. The situation would be even worse if it did nothing at all. This isn't just my personal opinion, but rather an admission made by its founder, Guy Young, in an article published on X.

Guy also listed the measures Ethena began to take to adapt to the change of regime.

Traditional financial solutions

Ethena will expand its collateral base to include equity and commodity basis trading, overcollateralized institutional lending, prime brokerage services, and a broader range of real-world assets (RWA).

Ethena was initially conceived as a cryptocurrency-native synthetic dollar, unlike pioneers such as Tether's USDT and Circle's USDC, which backed their digital dollars by holding physical dollars or equivalent government bonds in their vaults.

For Ethena, fate seems to have come full circle. Today, it is reintegrating into the traditional financial system, continuing to generate returns for its holders. Moreover, the sources of these returns are not singular, but multiple.

This strategy, using equity basis trading, profits from the spread between buying the S&P 500 spot and simultaneously shorting its futures. This is the same strategy Ethena previously used with BTC and ETH. While the returns are small, they are predictable and unaffected by cryptocurrency market volatility.

Now imagine Ethena trading similarly across multiple asset classes: commodities such as gold, silver, wheat, and oil, indices, lending markets, and more. Each asset has price spreads, driven by market supply and demand. Ethena can trade all assets with Delta neutrality and collect spreads around the clock, regardless of retail investor sentiment towards cryptocurrencies or Bitcoin.

While this reduces reliance on the cryptocurrency market, its movements are now closely correlated with stock, commodity, or other asset markets. These strategies may fail when these markets experience significant volatility or when futures market liquidity dries up, potentially further squeezing USDe's earnings.

However, this pessimism equates to expecting a diversified portfolio of assets to fail. Of course, this can still happen, but it's extremely rare. However, this is how the financial world works: it's based on probability and mathematics. One doesn't expect to see the break-even point when the entire market is in a slump. The purpose of diversification is to reduce the likelihood and extent of losses.

For Ethena, diversifying investments across unrelated income streams achieves the same effect. This reduces the risk that returns will be completely squeezed out when one or two asset classes underperform.

Liquidity test

Ethena's diversification strategy is a reasonable solution to market cycles. Diversifying investments across stocks, commodities, credit, and cryptocurrencies enhances the stability of its yield stream. This may be its only advantage over USDT and USDC, which are backed by government bonds and do not pay any returns to holders.

However, this new strategy still faces strong resistance.

USDe's liabilities are fully liquid, meaning any holder can redeem at any time. However, the liquidity of yield-generating assets is not perfect during periods of market stress. Equity basis positions may take some time to close smoothly. Institutional loans have fixed maturities. Collateralized loan loss provisions (CLOs) are not always liquid during market volatility. This gap between highly liquid liabilities and illiquid assets can be a structural problem for any yield-generating stablecoin. Even diversified yield strategies cannot bridge this gap.

In a relatively calm market, the movements of different asset classes can reflect different signals. Inflation concerns can push up gold prices. Strong corporate earnings can boost the stock market. As we are currently seeing, geopolitical crises involving oil-producing countries could drive up oil prices. Cryptocurrency funding rates remain high due to retail investor optimism in the cryptocurrency market.

However, under extreme stress, their behavior may not follow this pattern. The correlation assumption may not hold, thus negating the advantages of diversification. What all these assets have in common is liquidity.

When the situation deteriorates significantly, everyone wants to cash out and leave.

Harry Markowitz won the Nobel Prize for demonstrating that diversification can reduce risk. However, the 2008 financial crisis, without needing a Nobel Prize, was sufficient to prove that Markowitz's Modern Portfolio Theory (MPT) has exceptions. Nassim Taleb, in his book *The Black Swan*, also raised the same point. He pointed out that the correlation between asset pairs is not constant, but a variable that changes with market conditions.

Despite these anomalies, it's important to recognize that these are unavoidable and rare black swan events. Almost no one can predict or control them. A diversified portfolio (covering multiple asset classes) can still outperform a portfolio concentrated in a single asset class. We saw this during the 2008 currency market crash.

Because of the more attractive interest rate spreads, reserve level 1 funds held short-term corporate bonds rather than government bonds. After the collapse of Lehman Brothers, these bonds became worthless overnight.

Over-collateralization is one of Ethena's measures to address this issue. Theoretically, if a borrower provides more collateral than the loan amount, losses should be absorbed before impacting USDe holders. However, the over-collateralization ratio is set based on historical volatility ranges. Stress events may exceed these ranges.

No strategy can completely eliminate risk. Ethena's mission is to inspire investor confidence, convincing them that its new diversification strategy is superior to previous models that relied on the dynamics of a single cryptocurrency market.