Ethena Labs Divides Opinion as High Yield Stirs Memories of Terra

In the past few weeks, there’s been a lot of debate among crypto traders regarding Ethena Labs and its stablecoin USDe. Ethena Labs is a decentralized platform that focuses on yield-generating USDe tokens, which was introduced to the public by the lab in February. However, some traders have raised concerns due to resemblances between Ethena Labs and the Terra ecosystem, which experienced significant issues in 2021.

Individuals who invest USDe in the platform for a minimum of seven days currently receive an estimated annual return of approximately 37%, leading to a significant increase in Total Value Locked (TVL) from $178 million to $2.3 billion within two months. This high yield, however, comes with increased risk as Terra’s UST previously paid out nearly 20% to stakers before experiencing its downfall.

Instead of stablecoins like Tether (USDT) and USDC, which have values tied to the dollar or dollar-backed assets such as U.S. Treasury bonds, USDe classifies itself as a synthetic stablecoin. It maintains its $1 value through a financial method called the cash-and-carry trade. This trade, which includes buying an asset and selling a derivative of the same asset to collect the difference in prices (funding rate), is common in traditional finance and doesn’t involve directional risk.

Mike van Rossum, founder of Folkvang, stated in a post on X that this particular trade is widely used and safe with many having employed it for years. However, he added a cautionary note: “Though the delta risk is minimal, there are potential hazards to consider. For instance, problems may arise from the exchanges where these positions and collateral are handled. Furthermore, executing large volumes in volatile markets can pose significant challenges.”

How does Ethena work?

Users of Ethena can convert stable coins such as USDT, DAI, and USDC into USDe tokens by depositing them in the platform. After obtaining USDe tokens, with a market value of around $21.3 billion, users have the option to earn rewards by staking them.

Ethena uses various approaches to achieve that return on investment, which primarily involve cash-and-carry transactions.

In simpler terms, the fees paid on long Bitcoin and Ethereum bets (perpetual contracts) are currently more than the fees for short positions, resulting in profits for those betting against the market. However, funding rates usually become negative during downward trends in the cryptocurrency market, which could potentially reduce Ethena’s revenue source if the digital currency market enters another bearish phase.

“Ethena faces risks: the yield may disappear naturally from market fluctuations, or one of their business partners could experience financial instability, not due to any issues with the pledged collateral,” Jeff Dorman, CIO of Arca, explained in an interview.

“Ethana’s approach to basis trades, as described, is not overly complex and has been practiced in established markets for a long time,” he explained. “Individuals with sufficient funds can execute similar strategies independently. Essentially, Ethana is merely amplifying the risk involved while reducing the time commitment required for self-execution.”

Long-lasting scars

The unfortunate collapse of Terra caused several crypto companies to file for bankruptcy, and left deep marks on the industry. This happened when UST, a type of digital currency that maintains its value through algorithms, plunged into a downward spiral due to massive sell-offs and the decreasing worth of LUNA, which served as collateral for UST.

Guy Young, founder of Ethena Labs, made it clear during an interview with Laura Shin on the Unchained podcast that comparing what Ethena is doing to Luna is a shallow analysis. The fundamental distinction lies in the nature of what supports the stable asset. UST was backed by LUNA tokens, which experienced a 100% increase and a 50% decrease within a week. In contrast, Ethena’s USD is fully secured with collateral.

Regarding its dependence on a bull market, Young expressed a valid concern: “In a bull market, this strategy worked well and kept rates above U.S. Treasuries. However, I believe we would witness a significant reduction in USDe supply during a bear market.”

Young explained, “We can accept this situation. It’s a result of market conditions changing, and if there’s reduced need for borrowing to buy when interest rates decrease, we’ll scale down accordingly.”

If required, Young was open to adjusting Ethena’s yield-generation approach to one that aligns with a bear market condition.