Liquid Stables: Dynamic Allocation

The makeup of the assets backing USDe has adapted over time based on observations and market feedback in order to mitigate risk, improve liquidity, and provide diversified revenue sources for the protocol. Additional checks and more transparent decision-making processes regarding asset allocation and overall strategy have been implemented with the Risk Committee.

The Beginning

When the initial framework of Ethena was created in April of 2023, the vision was to primarily use ETH and ETH LSTs with the delta being hedged by perpetual & dated futures contracts. The idea was borne out of Arthur Hayes’ article Dust on Crust, outlining a vision for a synthetic dollar backed by BTC. The core team felt this was an idea worth exploring, and as far as backing assets go, potentially improving on the idea with forms of staked ETH as backing to naturally increase revenue and mitigate potential negative funding risk.

At the time, the stETH yield of 6-7% provided an ample buffer for instances when funding rates dipped negative. Funding rates historically average approximately 8% annualized, and so with a spot backing anchored by stETH in a hypothetical scenario it would take almost a 2x funding rate move to the downside before the protocol was exposed to negative revenue. In theory, this was the ideal foundation upon which to build a synthetic dollar. However, as the amount of ETH staked increased, staked ETH yield fell from 6-7% to roughly 3% by the time USDe launched in February 2024. As those yields fell, staked ETH made less sense as the backbone spot asset for USDe from a risk perspective for a few reasons:

1. As a “derivative” of ETH, stETH is naturally less liquid than its underlying, exposed to risks of depegging and market discounts due to diminishing secondary market liquidity or potentially a slight delay in redeeming via a withdrawal queue. On a handful of occasions, these issues have come to a head in the market and resulted in stETH’s market price deviating from that of the underlying ETH. Since stETH yields are hovering around 3% and will likely only decline, holding a less liquid asset as a significant portion of the backing of USDe became less appealing from a risk perspective, particularly in an environment where short term US T-bills were earning close to (or in excess of) 5%.

2. As demand for USDe grew, it became clear that other assets would be needed sooner than expected to keep pace. As USDe became the fastest growing USD asset ever to reach both $2bn and $3bn in supply, it was clear that limiting Ethena to the ETH perpetual future market would eventually be a bottleneck for growth - one day having too large of an impact on ETH markets and lowering funding rates as a result, while exposing the backing to liquidity risk if Ethena-related positions constituted too great a portion of open interest. To address this, Ethena began to support BTC as a backing asset to open up an untapped futures market to hedge with.

Prioritizing Liquidity and Stability

As USDe grew to become one of the biggest USD denominated assets in the industry, minters began to show a preference to mint & redeem USDe with stable assets, such as USDT and USDC, rather than using ETH or LSTs. As a result, to facilitate on-demand 24/7 redemptions, the protocol began to maintain a balance of stable assets, such as USDT. This buffer value was initially set at ~5% of the total circulating supply of USDe with the ultimate goal of limiting downside to protocol revenue while still being able to manage large scale redemptions.

At the time Ethena launched publicly, funding rates were extremely elevated, in some weeks reaching as high as 60% annualized. As a result, Ethena generated over $8m in weekly protocol revenue on launch week. The significant levels of revenue enabled the protocol to grow the Reserve Fund by as much as $5m per week to enhance overall protocol stability, ultimately growing the Reserve Fund to over $60m today.

In April/May 2024, Ethena underwent its first stress test as it handled the first large scale redemption event in the face of a significant market open interest reduction, which reached approximately 15% in just one day (the largest single-day open interest reduction in over a year) - over 100m USDe redeemed. In the face of this extreme market event, USDe market price remained within 20bps of $1 for the vast majority of the sell off. This event was a valuable demonstration that liquidity should be a constant priority for the backing of USDe, and since that event the protocol has maintained a sufficient liquid buffer to handle mass redemption events.