{Introduction}:

This piece builds upon the essay by Colin Myers and Mara Schmiedt: “The Internet Bond” published in 2020, discussing how Proof of Stake ETH would enable a bond-like instrument for the decentralized economy.

To summarize their thinking behind Proof of Stake ETH as the Internet Bond:

• Similar to traditional bond structures, staking at its core represents an agreement between the bond issuer (the protocol) and the bond holder (the validator or delegator)

• The Internet bond is an entirely new asset for financial markets. It would allow anyone in the world to invest, participate, and profit off an open-sourced, decentralized digital economy

• In a matured state, the yield of the internet’s new settlement layer can become the risk free rate of a decentralized financial ecosystem and a benchmark for valuing the cost of trustless value transfer

Ethena was built with the core belief that enabling Proof of Stake ETH to transform into a globally accessible and permissionless Internet Bond was one of the most fundamentally useful products crypto can offer.

We develop the idea that staking ETH enables a digital bond with one important difference - we transform and denominate the “Internet Bond” in the world’s dominant currency: the US Dollar.

{Dollar Hegemony}:

Alarmists have forecast the death of the dollar for decades, yet there is almost no empirical evidence of this decline. 65-70% of trade volume in 2000 was conducted in US Dollars - it is more or less same today.

Foreign countries still hold a total of $7.4 trillion U.S. dollars in U.S Treasury securities as of April 2023 - the largest reserve asset on sovereign balance sheets by an order of magnitude.

Similarly, while a small group of idealists in crypto envisaged a system entirely disconnected from fiat, the reality is that 95% of all trading volume in our space is still denominated in dollars. Tether, making up c.70% of the total stablecoin market cap, owns more U.S Treasuries than countries like Australia and the UAE.

Whether you like it or not, and whether it fits your bias or not, the only ubiquitous use case of a blockchain to date has been storage, transfer, trading and settlement of digital US dollars.

While the world claims it doesn’t want to use the US dollar, their actions do not match the rhetoric.

Everyone wants access to dollars, they just don’t want dollars that can be unilaterally censored at the discretion of a single entity. We believe synthetic crypto dollars and Internet Bonds provide the solution.

{Why are Bonds so Important?}:

The size of the global bond market is $130tn compared to $120tn for global equities, $13tn for Gold and $11tn for real estate.

The $30tn US Treasury market is the single largest, most liquid, and most important financial market on earth, acting as the foundational collateral for funding financial balance sheets, the reference pricing rate for every financial asset on earth, as well as the FX reserve asset for international sovereign entities.

US Treasuries are the most important financial asset due to their unique qualities:

I. Stability

II. Liquidity

III. Yield

This allows US Treasury Bonds to act as:

I. Transactional Money

II. A Store of Value and Savings Instrument

III. Pristine Collateral

For institutional entities and sovereign balance sheets US Treasuries play a variety of important roles:

I. Banks and insurance entities look to increase the yield on their liquid cash-like assets by utilizing short-dated U.S Treasuries as liquid funding instruments in place of cash.

II. Pension funds and asset managers look to allocate towards U.S Treasuries in search of more stability, yield and liquidity for their portfolio management activities.

III. Foreign sovereign balance sheets around the world recycle dollars into the US treasury market and rely on US Treasuries as a reserve asset behind their own currencies as the largest and most liquid dollar instrument on earth.

Despite their importance, US Treasuries have two key deficiencies: they are largely inaccessible for most of the world, and they can be censored by a single entity in the US government.

{Issues with Bonds as They Exist Today}:

1/ Limited Global Accessibility

Outside of the US, retail access to US bonds are limited and usually involve higher fees than local government bonds as a result of predatory FX and ETF management fees.

Even within the U.S, retail access to bonds lags behind equities - 23% of U.S. household investable assets were held directly in stocks in June 2022, compared to just 3% in bonds.

That is not to say US cash-like instruments are not required offshore - in fact, the relative size of the Eurodollar market is direct evidence of the offshore demand for dollars. Estimates of the size of the Eurodollar market come in at $11 trillion. There are more Eurodollars than actual dollars.

At its core, demand for U.S bonds is a simple expression of demand for the most basic financial service imaginable - people want to save their hard earned wealth in a currency that doesn’t depreciate in an instrument with a yield. The rest of the world has an insatiable demand for dollar assets, but unfortunately, direct investment in this basic financial service is largely inaccessible outside of the US.

2/ An Asset Which Is Someone Else’s Liability, And Asset That is Not

The business model of the US involves importing goods and services while exporting the US dollar. Dollars received by the rest of the world need to be recycled back into US denominated instruments - and the US Treasury is the most natural home for these flows.

While they are liquid and provide a source of yield, the $30tn US Treasury market exists on a mutable database that ultimately can be censored or tampered in a keystroke. This was made most clear in February 2022, when the US unilaterally decided to confiscate ~$650bn of foreign reserves of Russia after its invasion of Ukraine. In an instant that asset was removed from existence, and the world learned the difference between an asset which is someone else’s liability, and one that is not.

While holding USD-denominated instruments are desirable for individuals seeking protection from local currency depreciation, it became evident in that moment that these bonds are susceptible to unhedgeable centralization risks.

The world has begun to recognize this risk and has begun to unwind their holdings of US Treasuries.

{How Do We Transform stETH into a USD Internet Bond?}:

Taking on decentralized collateral in the form of stETH, combined with a short ETH futures position of the same notional creates a synthetic digital dollar position with an embedded yield.

The embedded yield is sourced from staked ETH returns, alongside the funding earned from being short ETH futures - historically this has paid ~5-7% to the short side.

The net result is a stable, value-accruing, USD denominated instrument - the “Internet Bond”.

Building this asset on Ethereum enables anyone with an internet connection to access this product, enhancing accessibility, and retaining censorship resistant qualities with crypto collateral.

We view a permissionless US dollar denominated savings instrument as the largest market opportunity that crypto can provide for individuals all over the world. Even larger than a volatile store of value, or stablecoins as they currently exist.

{DeFi Problems Solved by an Internet Bond}:

1/ Over Reliance on U.S Treasuries

In the last year we’ve seen yields in DeFi compress to below ~3%, while bond yields have risen above 5% presenting DeFi with a dilemma - do you onboard US Treasuries for yield and scalability while compromising on censorship resistance. Some of the most important protocols in DeFi are now exposed to this risk including MakerDAO and FRAX as the DeFi space continues to trend towards more centralization.

Nearly 50% of the collateral backing DAI is now made up of US Treasuries (Real World Assets/RWA’s). Adding these centralized risk vectors decreases the value add of crypto-native stablecoins.

Centralized stablecoins dominate the market with over 95% market share (DAI and FRAX constitute another 4% and are exposed to the same centralized risk with USDC and US government bonds as collateral).

The simple fact is crypto runs on centralized stablecoins as of today. Centralization in the space is trending in the wrong direction thanks to rising bond yields, which has forced crypto capital into RWAs.A parallel and decentralized financial system is ultimately a pointless endeavor if the foundation is built upon centralized collateral.

With staked USDe’s yield serving as the reference yield in crypto, stablecoin issuers have another collateral option that is both crypto-native and more censorship resistant than simply holding US Treasuries or centralized stablecoins.

2/ stETH Volatility

stETH and USDT or USDC individually have desirable qualities for an Internet Bond, with stETH offering a trustless embedded yield, and USDT/C offer stability and USD denomination.

The issue with stETH as DeFi’s reserve asset is the inherent volatility and in order to appropriately lever the balance sheets of DeFi business models, a stable asset is required.

Combining the attractive qualities of stETH and USDC will enable a pristine collateral asset for reserve backing throughout DeFi.

3/ Lack of a Crypto-Native Yield Curve

Up until now, there has been no instrument that can provide crypto with a universal discount rate at both floating and fixed rates, upon which a crypto-native yield curve can be built. A yield curve is a necessary foundation on which to build a whole suite of interest rate swap products.

While the CESR index and staked ETH provide a reference rate in ETH terms, re-denominating this into USD provides a like-for-like comparison to traditional risk free rates.

A short ETH perpetual position against the same notional balance of stETH provides a floating rate reference point, while dated futures provide a fixed rate alternative over a defined maturity schedule.

The introduction of this risk free reference rate will unlock new asset categories to exchange risk from interest rate swap products.

A crypto native forward curve built upon floating and fixed yields will facilitate better hedging with an option to define a tenure, as well as a more representative discount rate at which to price future cash flows.

{Real World Problems Solved by the Internet Bond}:

1/ A Personal Savings Asset

From a savings perspective, countries and individuals, particularly in developing nations, rely on the US Dollar as a form of protection from their highly inflationary local currencies.

Avoiding volatility is the primary decision factor for individuals denominating their savings in USD, which explains part of the large demand for stablecoins as they exist today. However, stablecoins are not yield-bearing assets, and embedding a bond-like return into these assets helps not only provide stability, but a tool with which to avoid losing purchasing power to inflation.

A handful of yield bearing stablecoins have launched recently, namely sDAI and sFRAX. Both stablecoins have amassed a new influx of yield-seeking capital, attracting c.$1.2bn combined, or 1% of the global stablecoin market cap. Our expectation is that this % market share that is yield bearing will increase as users will demand a yield that matches U.S Treasuries.

2/ Global Accessibility

The global and permissionless access of Ethereum unlocks an ability to broadly distribute Internet Bonds to anyone in the world with an internet connection. This is uniquely enabled by crypto, and allows individuals and institutions who need access to the stability of the dollar the most an ability to access it with limited friction.

3/ Censorship Resistance

Foreign holders of U.S Treasuries want dollars but are beginning to wake up to the risk that the US can unilaterally zero their assets. To mitigate that inherent centralized custodial risk, decentralized collateral, or “outside money” is required.

Using staked ETH in place of US Treasuries within the crypto ecosystem to in effect replace bonds with internet bonds allows users to access a censorship resistance equivalent.

4/ Negative Correlation on Yields

Yields in crypto have naturally been uncorrelated to real yields in the past. As real rates fell from both outright Fed Fund rate reductions, or indirectly through Quantitative Easing, more speculative money flowed into crypto which saw crypto yields both in DeFi and the futures markets increase in the opposite direction.

In the last cycle during 2020/ 2021 as bond yields were approaching zero we observed a classic mismatch in the demand and supply of capital whereby not enough dollars could flow in to satisfy the demand for leverage to go long >1x the capital base of crypto.

Negatively correlated yields provide an interesting opportunity to those outside of crypto from an asset allocation perspective. While Bitcoin has evolved to show no uncorrelated characteristics to other risks assets, the yield on an Internet Bond at least historically has responded with a strong negative correlation to real yields in traditional fixed income markets. This negative correlation is appealing to institutional allocators as we sit at the top of the real rates cycle and near the bottom of the crypto rate cycle.

Below we can see the correlation between crypto yields and bond yields has been negative for a variety of regimes in the last year.

What is interesting to consider is that we are likely approaching the top of an interest cycle. Once we start cutting interest rates, real-world assets onchain will become less attractive and crypto yields may become relatively more appealing. In a lower interest rate environment, it is quite likely crypto yields increase as the negative correlation takes effect and demand picks up for riskier assets.

The last time this happened was in 2021 and we saw a huge spread between crypto yields and bond yields.

5/ Packaged Crypto Yields for DeFi

As interesting as an Internet Bond is for an individual looking for a savings asset, it is equally interesting for traditional financial institutions to have a USD-denominated, stable asset that can access the yields on offer in crypto, particularly when those yields far outweigh those on offer in traditional finance, as was the case in 2021.

However, there are plenty of barriers to entry for institutions coming to crypto like bad UX, fragmented liquidity and counterparty risk.

The Ethena Internet Bond is a solution that can access a wide range of liquidity venues, offers a straightforward staking token model and utilizes custodians to minimize counterparty risk - offering a simple packaged solution that leverages a crypto-native yield to outside investors.

That yield, capturing the basis spread on CeFi markets, can bring a yield over from CeFi to DeFi in a range of potentially tens of millions per year. Below we have given examples of the funding earned over the periods used earlier.

{Conclusion}:

An Internet Bond in the form of staked USDe satisfies all of the prerequisites of a globally accessible bond: stable, value accruing, USD denominated and permissionless.

DeFi struggles with an overreliance on centralized stablecoins and is trending towards more centralization with the rise in adoption of U.S Treasuries as the most widespread reserve asset in the system. stETH satisfies a lot of the conditions for an Internet Bond, but its volatility prohibits it from being a viable savings asset.

In the real world, both individuals and institutions need a globally accessible and permissionless version of a U.S Treasuries. If the demand for a digital dollar asset with zero return is >$120bn, we view an equivalent instrument that externalizes the return with users as an order of magnitude larger.

And Ethena is excited to //Enable the Internet Bond_ soon.