New Stablecoin Ethena - Potential Risks

Traditionally, you support the peg of a stablecoin with collateral. To guard against dips or crashes in the collateral's price, you overcollateralize. This works as long as markets don't black swan (but see maker DAO 2020) and prevent orderly liquidations. But it is capital inefficient and dependent upon an underlying demand for leverage.

To eliminate the price instability of the underlying crypto collateral, Ethena will be collateralized by a long position in staked ETH and a short position in ETH perpetuals. In short, hedging.

As a form of structure financial product, this is interesting! But it shouldn't be called a stablecoin or marketed as such or described as safer. Why?

Because they substituted credit risk for price risk. In particular, Ethena is now exposed to:

1 - Whatever method is used for the staked ETH. If they are running their own validators, the security and continual operation of those. If they are outsourcing, then risk to that person. If they are using liquid staking protocols, then risk to those protocols. There's no free lunch here. This is not to say it's critical at all times, and most of the time it won't be, but if it goes bad, it will possibly go very bad.

2 - The exchange (centralized or decentralized) where the perps reside. Obviously one should attempt to diversify this over time, but again, these things are not bulletproof and you are leaving collateral and therefore exposure to them. In the CEX case, mostly credit risk. In the DEX case, it's likely less credit risk but more security/protocol risk given the prevalence of hacks in the space. Put differently: what if some of the perps had been on FTX?

3 - Availability risk. Another lesson from 2008: this presumes there is going to be adequate depth at constant prices for the short leg. That's simply not always true in times of crisis. The prices will gap, liquidity dries up, and one of the problems that you run into is simply being able to short in adequate size at all. Critical version of this will feed into problems referenced in 2, of course.

4 - Rate risk. One of the interesting assumptions is also that the net of staking returns + perpetual funding is a positive number. It might not be! Getting into a position where you bleed to maintain your hedge is quite common, unfortunately, but would be lethal over time to a stablecoin.

Credit: Austin Campbell