What’s Ethena and most importantly what’s the basis trade?
Ethena is one of this cycle’s main character projects, drawing both praise and scrutiny. As the latest sensation in the stablecoin sphere it was variously hailed as a synthetic dollar, with either disastrously or ingeniously managed risk, deemed either the next UST or a novel paradigm shift. Amid a flurry of questions ranging from the absurd to the intriguing, Ethena has been catapulted over $2 billion in TVL at an unprecedented pace. The numbers speak volumes; the protocol has reshaped the landscape for yield-bearing stablecoins, setting a new benchmark that has compelled all of its rivals to seek innovative solutions to stay competitive.
We won't delve into the specifics of how USDe functions, as it has been extensively covered by others, but we will relate it to a traditional finance concept known as the "cash-and-carry trade."
What exactly does this entail?
A cash-and-carry trade is an arbitrage approach that capitalizes on the price discrepancies between an asset and its derivative, banking on the eventual convergence of this gap. It typically involves taking a long position in the asset while shorting its future or option, aiming to profit from better-than-market interest rates that arise from these positions (in our case funding rates). The basis trade, for example, is a form of cash-and-carry trade.
Ethena is a protocol automating the basis trade to their users and offering their partners (such as Morpho or Maker) the ability (or the risks) to take advantage of the leverage opportunity such a trade offers.
In order to understand the concept better, let’s take the historical example of Long Term Capital Management, one of the most infamous basis trades.
The basis trade gone wrong in TradFi
Long-Term Capital Management L.P. (LTCM) was a highly leveraged hedge fund established in 1994 by John Meriwether and composed of several Nobel laureate economists and renowned Wall Street traders. The fund was initially successful, utilizing complex strategies to exploit market inefficiencies, one of which was the "basis trade" strategy. This strategy involved taking advantage of small price differences between cash bonds and their corresponding futures or derivatives.
However, in 1998, LTCM faced catastrophic losses due to a combination of market factors that included the Russian financial crisis and the resulting global flight to liquidity. These events caused the spreads on which LTCM's basis trades relied to widen dramatically instead of converging, which was contrary to LTCM's predictions. Given the enormous leverage employed by LTCM (25x) the losses quickly escalated beyond the fund's capital base, leading to its demise.
The situation threatened to destabilize the financial system, leading to a Federal Reserve-orchestrated bailout by major banks and investment houses. Ultimately, the LTCM debacle served as a cautionary tale about the risks of high leverage and the limitations of predictive financial models based on historical data.
Now that we’ve seen the worse of such trade, let’s look close to what it has to offer at its best, the dilemma they are facing and how voting incentives could lead them to the next level.
The scale dilemma? How can Ethena scale without gobbling all the open interest?
Currently, market makers profit from the slippage they create when driving the market towards liquidity zones. However, if there are entities that consistently short sell with tens of billions of dollars, it will diminish the returns from open interest, reducing market makers' motivation to attempt market movements. Consequently, for market makers, the cost of shifting prices to reach these liquidity zones (for stop losses or liquidations) will significantly increase. This increase in cost renders such strategies unprofitable, effectively dampening the volatility that is predominantly caused by market makers and players using leverage.
So all the sUSDe yield comes from the speculative farming of funding rates but traditionally, delta hedging on such a grand scale has been avoided, as it's known to suppress yields and ultimately become ineffective. Ironically, Ethena, with their uncapped TVL (fastest “stablecoin” to get to the $2B TVL mark in history), is driving funding rates lower.
The dilemma is clear: the quicker Ethena's TVL expands without a corresponding increase in Open Interest, the more it depresses funding rates, setting the stage for its own death spiral. It could be worth the try to implement a cap on Ethena's TVL, one that scales with funding rates and OI enabling them to keep a sustainable yield for sUSDe holders and keeping them safer from a black swan event.
Introducing a monthly TVL cap that is a fixed percentage of the Open Interest might be a compelling strategy. If the TVL exceeds this percentage, the surplus could be redirected into Dai's Dai Savings Rate (DSR), for instance. This mechanism would recalibrate the system and negate the need for forcibly reducing the TVL. (This could be used also when funding rates are below DSR’s yield).
By instituting such a cap, it provides a regulatory mechanism to maintain equilibrium within the system, ensuring that the growth in TVL is in proportion to the actual market engagement as measured by OI. Redirecting excess funds into the DSR not only helps in risk mitigation by providing a stable return but also prevents the destabilization that might arise from unchecked TVL growth. This proactive measure could offer a sustainable model that aligns with the health of the broader financial ecosystem.
How could vote incentive bring value back to ENA holders and help Ethena and CEXs scale ?
Amidst the surrounding buzz, Ethena is performing exceptionally well, with outstanding metrics in TVL, yield, integrations, and most critically, revenue. Garnering over $30 million in fees in under two months is a remarkable achievement for a nascent protocol. With the introduction of the $ENA token, there is speculation that holders could potentially share in these profits. This leads to the question: What other benefits could $ENA token holders enjoy?
Holding $ENA tokens could grant holders governance power, a significant aspect of which may include the ability to direct liquidity between CEXs. This potential for governance extends beyond simple profit sharing; it positions $ENA holders as influential players bending the funding rates to their knees as the protocol scales.
For CEXs, having liquidity directed their way by $ENA holders would present a considerable opportunity. Ethena has the potential to become the most cost-effective market maker as the protocol is depositing liquidity in CEXs markets for free. Partnering exchanges stand to benefit from enhanced liquidity without the usual high costs associated with market-making activities.
The capability to steer liquidity holds strategic value. It allows $ENA holders to potentially shape the market, influence trading volumes on partner exchanges, and create synergistic relationships that could lead to further benefits, such as improved trading pairs and reduced slippage for traders. A vote incentive marketplace could be the last infinity stone for Ethena to align all the participants in its ecosystem.
Note that all of this paragraph is purely based on speculation from my end and that the Ethena team did not share any of the future utilities of the $ENA token. Furthermore, decentralizing the liquidity direction between CEXs would also need a strict risk management framework as it could lead to systemic risk for the protocol and the exchanges involved.
Conclusion
As Ethena continues to disrupt the stablecoin market with its rapid growth and innovative basis trade approach, it faces significant challenges that must be addressed to ensure sustainable development. The introduction of a TVL cap linked to Open Interest and funding rates is a strategic measure that could safeguard the protocol against the volatility and risks associated with rapid expansion.
Moreover, the potential for $ENA token holders to exert governance over liquidity directions presents a transformative opportunity not just for Ethena, but for the broader DeFi ecosystem. This governance could redefine market dynamics, offering centralized exchanges substantial liquidity benefits at minimal costs, and positioning $ENA holders as pivotal players in the market's future.
As Ethena navigates these opportunities and challenges, the careful calibration of its strategies and governance will be key to its ability to maintain leadership in the yield-bearing stablecoin market and secure a long-lasting future.