Who wants to buy a crypto basis-trade backed synthetic stablecoin?

The two types of stablecoin are boring and exciting. Boring is where it’s at right now. Issuers like Circle and Tether have spent the past year or two making their stablecoins sound as boring as possible, better to compete against banks and merchants whose planned stablecoins promise to be very boring indeed. 

Meanwhile, there’s this:

Ethena enables the creation and redemption of a delta-neutral synthetic dollar, USDe, crypto’s first fully-backed, onchain, scalable, and censorship-resistant form of money.

The mechanism backing USDe enables sUSDe, the first “Internet Money” offering a crypto-native, reward-accruing asset, derived from liquid asset rewards (to the extent utilized in backing) and the funding and basis spread available in perpetual and futures markets.

USDe is fully-backed (subject to the discussion in the Risks section regarding events potentially resulting in loss of backing) and free to compose throughout CeFi & DeFi.

See? Exciting!

By token value in circulation, Ethena is the world’s third-biggest stablecoin issuer. Its big idea is for a yield-bearing token that’s pegged to the dollar while avoiding any contact with TradFi-tainted “safe” assets like Treasuries. It’s a throwback to when crypto was all about breaking the shackles of fiscal oppression rather than building regulator-approved rails for payments and remittance.

Ethena has an on-site explainer that makes the mechanism look very complicated …

. . . but underneath it all has been a fairly simple trade: long spot, short futures, collect the difference.

The main ingredient of USDe is perpetual futures. Invented in 1993 by Robert Shiller, and introduced to crypto by the BitMex exchange in 2016, perpetual futures offer traders leveraged exposure to an asset via a single standardised contract without the hassles of direct ownership or contract rollovers.

Crypto has gone mad for perps. No-expiry derivatives are uniquely suited to crypto’s 24/7 volatility and its love of 100/1 leverage. They’re a huge product for Binance, were central to FTX’s business before its collapse, and are being trialled by Coinbase in the US, where they’re still classed as unregulated instruments.

A perp directly matches a buyer with a seller. There’s no need to transfer cash and no messing about with blockchains. The only upfront cost is the exchange’s margin requirement. Profit and loss will be marked to market for as long as both parties want to keep playing.

However, while the trade’s live, both sides agree to pay ongoing fees proportional to the gap between the futures price and the price of the underlying asset, which is known as basis. Whenever the basis is positive, the buyer pays the seller; when it’s negative, vice versa.

This fee, known as the funding rate, is designed to attract arbitrageurs who’ll keep spot and futures prices in check. But because crypto traders have been happy in recent years to pay exchanges a premium for long-side exposure, the funding rate has been persistently positive and the contracts have resembled a licence to print money.

The easiest trade in the world has been to buy crypto, hedge exposure by shorting the perp, and collect the funding rate. It’s a lot like an FX carry trade, but with funding replacing the interest rate differential between two countries.

This is what sits behind Ethena’s stablecoin reserves. There’s lots of stuff the website about staking yields and liquidity management but underpinning it all has been an old-fashioned basis trade. As of January, per the company, 92 per cent of protocol revenue came from “funding and basis spread earned from the delta hedging derivatives positions”.

Is this nuts? Will it crash?

According to Bryan Routledge, associate professor of finance at Carnegie Mellon University: Not necessarily; and not necessarily.

Routledge is lead author of The Crypto Carry Trade, a 2022 paper that first highlighted the arbitrage opportunity in perpetual futures. For as long as crypto’s leverage-hungry degens outnumber rentiers, there’s money to be made, he told us:

Imagine you have a bunch of people who want to be long and a bunch of people who want to be short. Usually in that setting, price would adjust so that things are balanced. A perpetual contract is designed so that the price is fixed. It is supposed to be pegged to the index of the bitcoin spot price. The way demand [and supply] are equated here is through the funding rate. It’s the thing that adjusts that makes the rate, that makes the market clear. Empirically, we observe that this funding rate tends to be positive. That means there is more demand on the long side.

It is not foolish to think that it will continue. The funding rate (empirically) is persistent. But it is not magical. We see periods where it can be negative. By way of analogy, we see this in other carry trades like in commodities or in foreign currency.  

As with all carry trades, the bigger risk is crowding. As more arbitrageurs enter the market on the short side, the funding rate will be competed away to zero.

This has already happened, to a degree, as shown by USDe’s prospective yield. This time last year it was more than 60 per cent annualised. By the turn of the year it was 27 per cent. By March it was just above 10 per cent, and has since halved again.

We should note here that it’s “yield” in the crypto sense, not the conventional sense. A person swaps their dollar for a synthetic dollar, then swaps this synthetic dollar for a virtual bottle cap. The bottle cap qualifies the holder for a cut of income, paid weekly in bottle caps. Anyone who wants their dollar back will first have to swap bottle caps into synthetic dollars, which takes seven days, then go though a redemption process that only promises to return a coin’s pro rata share of reserves up to a dollar, minus a 10 basis point fee. Redemption limits adjust “dynamically” based on market conditions and the customer’s level of KYC/AML clearance.

All this rigmarole may have looked worth it for the promise of greater than 60 per cent APY. It’s much less appealing to earn less than 5 per cent APY, which probably explains why Ethena’s recent growth has stalled:

We should note also that the above chart doesn’t feature Ethena’s USDtb, its alt-stablecoin that uses a BlackRock money-market fund for reserve backing. TradFi still has its uses, it seems.

For USDe. Ethena’s website lists seven risk factors. Perhaps the most eye-catching are the counterparty risks. The company says it protects itself against FTX-style events by using “off-exchange settlement providers” rather than exchanges, though even if that proves accurate it’s only half a solution: short positions still require margin to be posted at an exchange.

Then there’s “backing assets risk”. As well as the crypto basis trade, Ethena scrapes an income from so-called liquid staking tokens. These are virtual bottle caps representing crypto that has been locked in a box, where it qualifies for network maintenance fees.

Lock-boxes are integral to Ethereum’s proof-of-stake validation process, which replaces the environmental disaster that is bitcoin’s proof-of-work system. Bottle caps (the most popular types are called STETH and METH, in case you care) allow holders to keep trading their locked coins.

Ethena, by buying the bottle caps while shorting the underlying token, can claim the network fees without worrying about whether the ether price is going up or down. It vaguely resembles the crypto basis trade but needs active management, because there’s much less certainty that the long and short will move in lockstep. If they depeg, the hedge blows up.

Ether liquid staking tokens are just 5 per cent of reserve backing, per to Ethena’s dashboard. It may not sound much, but when basis trade returns are being whittled towards zero and the quoted capital buffer is just 1.18 per cent, it’s still quite a lot.

Talk of high yields and staking income might remind readers of Terra, whose $50bn-valued algorithmic stablecoin collapsed in three days of 2022. The comparison might not be entirely fair. Demand for leveraged crypto long bets is genuine, so by raising capital to supply the short side Ethena is adding value, says Routledge, who calls it “an interesting example of financial intermediation”.

The big risk is if market sentiment sours and flips the funding rate from positive to negative. Maintaining the carry trade would become a cost, “so the stability of the coin may not be viable if the funding is negative for a long time,” Routledge says.

And it may be worth highlighting that Ethena’s launch came after FTX’s liquidation and the crypto winter that followed. It has not yet lived through interesting times.

Arthur Hayes, co-founder of BitMex and a pre-launch adviser to Ethena, seeded the idea in March 2023 with a blog post about futures-backed synthetic stablecoins. He wrote the post while on home detention after pleading guilty to violating the US Bank Secrecy Act, having allegedly run BitMex like “a money laundering platform”.

Hayes has often used his X account to promote both the token and the developer, though he hasn’t mentioned either since January. He was reported in December to have sold nearly half of a stake tied to the Ethena protocol, a free-floating token known as ENA, for a $7.7mn profit.

The ENA token has since lost around 80 per cent of its value.

The Trump administration pardoned Hayes in March.

Whatever Ethena is, and whatever it becomes, it’s unlikely to be boring.