Introduction

This post walks through the history and evolution of the allocation strategy for USDe’s backing starting from launch through today. 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. In line with evolving market conditions, Ethena has made adjustments to how it approaches constructing a synthetic dollar and this post aims to highlight the thought process behind those adjustments.

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 $46m 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.

Where We Are Today

Staked ETH

In line with the above principles of prioritizing liquidity and allocations that align with risk profiles, the protocol has reduced the proportion of ETH LSTs compared to the total backing assets to less than 10%.

Liquid Stables

During the last three to four months, the return profile offered from hedging the delta of the spot digital assets on certain perpetual futures contracts has been less than the risk-free rates offered on US treasuries. Adapting to this reality, Ethena began to explore alternative means to produce a positive (or at least neutral to risk-free) return profile, reduce volatility of the return profile, as well as address potentially long term & structurally negative/poor funding rates if that were to eventuate.

In an environment when certain perpetual contracts are yielding less than US treasuries, it is naturally unappealing for the protocol to hold perpetual futures positions.  Additionally, in phases of market downturn, funding rates are at higher risk of turning negative, which could put additional pressure on the protocol.

With that in mind, Ethena started to allocate a greater portion of the USDe backing assets to stablecoins, specifically USDC on Coinbase and Sky’s USDS. Each stablecoin offers a compelling yield, with USDC on Coinbase closely tracking US treasury yields, while Sky’s USDS offers a 6.5% yield at the time of writing.

Introducing stablecoins as backing assets for USDe is expected to ease pressure on the protocol during down markets, while maintaining the flexibility to transition to perpetuals when funding improves:

1. Bull markets: perpetual future funding likely improves and more of USDe’s backing will shift towards perpetual futures, capturing the basis and the upside that funding rates have to offer. Liquid stablecoin allocations would be lower in this scenario.

2. Bear markets: funding rates lower and US treasury yields outperform. More of the backing is allocated towards liquid stablecoins, easing pressure on the protocol while potentially earning close to U.S. treasury rates on a portion.

The recent reduction in USDe supply coincided with funding rates moving significantly lower than was observed during the first quarter of 2024. As depicted in the charts below, as the spread between sUSDe APY and U.S. treasury rates compressed, USDe supply started to contract.

Ethena’s Risk Committee

As of August 2024, Ethena launched protocol governance, taking the initial step of forming and tasking a Risk Committee with identifying, evaluating and guiding risk management within the Ethena ecosystem. The Risk Committee is made up of industry leading risk and advisory firms, already advising some of the top protocols in the space (such as Maker and Aave). For the first six months, the Risk Committee members are:

• Gauntlet​

• Block Analitica​

• Steakhouse

• Blockworks Research

• LlamaRisk

• Ethena Labs Research (non-voting member)

The Risk Committee is responsible for conducting extensive research and approving new backing assets for USDe, as well as monitoring the allocation of the backing assets to ensure they stay within acceptable parameters as pertains to risk matters like exchange exposure, asset exposure and counterparty risk. By way of example, the committee recently deliberated on and approved SOL as a backing asset for USDe.

Tasking the Risk Committee with managing risk provides the Ethena community with greater visibility into the decision making process, with members posting analysis in the governance forum for each matter.

UStb

Last month, Ethena announced the impending launch of a new product in collaboration with Securitize: UStb, a stablecoin product backed by Blackrock’s USD Institutional Digital Liquidity Fund token, BUIDL. Subject to governance approval, a portion of USDe’s stable backing could be allocated to UStb once live, allowing that portion of the backing to scale up and down as necessary during varying market conditions to enhance stability.

Before UStb is launched, Ethena has implemented the below dynamic allocation approach between funding rate and stable deployments. Those allocations combined account for roughly 25% of the backing assets of USDe today. This allocation % will change in line with the below chart, depending on the performance of perpetual future funding rates.

Improving Scalability

BTC and ETH presently comprise about 70% of the backing assets of USDe. BTC open interest is $26bn today excluding CME, while ETH open interest stands at $10bn. SOL has just been approved by governance as a backing asset for USDe, unlocking a further $2bn of open interest to access.

At an end state, USDe supply might be constrained in size to roughly 30-40% of that total open interest. At its peak of $3.5bn, the BTC backing of USDe represented about 5% of BTC open interest, and the ETH backing about 15% of ETH’s. At 30% of total BTC, ETH and SOL OI, USDe would have an estimated supply cap of ~$13bn based on today’s levels of open interest across relevant venues. However, that cap assumes no further growth in market size of perpetual futures - over the last year alone BTC open interest has grown 3x in size, from $8bn to $26bn today.

Once any supply cap in perpetual and deliverable futures markets is reached, Ethena has the ability to allocate towards UStb and/or liquid stables , which can match virtually any level of demand for growth.

USDe could theoretically add ~30bn in additional liquid stables backing if perpetual future supply is exhausted, and still maintain a spread of roughly +2% to RWA rates, assuming funding stays at baseline as Ethena builds a larger position.

Summary

Ethena adopts a dynamic allocation approach, in line with feedback from members of the Risk Committee, with the aim of making USDe more stable in varying market conditions while producing protocol-level revenue. Forms of staked ETH comprise significantly less of USDe’s backing today compared to when Ethena started as the protocol prioritizes assets that aim to improve liquidity, stability and scalability.