Ethena: pioneering innovation or just hype?

Is $ENA a sound investment?

May 11, 2024

GM! This is Milk Road PRO, lighting up your email inbox each Saturday with a report that helps you invest successfully in crypto. 💰

This week, we're highlighting Ethena, the new synthetic-dollar protocol that has been turning heads over the past few weeks.

Ethena is blazing through records, pulling in over $2 billion in total value locked (TVL) in under 7 weeks since its February debut. 

This rapid growth makes it the fastest-growing stablecoin in history 🤯.

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Source: X

Ethena is offering yields upwards of 30% APY on its stablecoin, USDe, and has also recently launched its token, $ENA, which is valued at over $12 billion as of this writing.

Impressive growth, right? But we've seen this pattern before: huge hype, rapid TVL growth, and Twitter buzzing about it, only for it to start fading away. 

Is it the same for Ethena? Can it sustain this explosive growth and valuation? 

And what about these industry-leading yields—it’s reminiscent of the situation with Terra Luna 🫤. Can Ethena avoid a similar fate?

To answer all of these questions, in today’s report, we’ll dive into:

• What exactly is Ethena? 🤔

• How does Ethena manage to generate such high yields? 💸

• How is this yield distributed? 🔄

• How big is Ethena’s market opportunity? 🚀

• How does Ethena's valuation compare to other protocols? 📊

• What risks should we watch out for with Ethena? ⚠️

• And 4 ways to capitalize on Ethena’s growth 👀

But first… Let's establish the context for stablecoins – the market in which Ethena operates.

The stablecoin market is currently valued at $160 billion. Quite impressive, huh? 

But despite this, the existing stablecoins have their own challenges and don't provide the ideal solution.

Some stablecoins are centralized, non-transparent, and subject to censorship, while others are decentralized but not scalable. Ethena solves all that.

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Source: Ethena Labs

Before we dive into those major challenges, let's take a quick look at the distribution of this market.

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Source: DefiLlama

The stablecoin market is dominated by USDT and USDC, which hold 68% and 20% of the market, respectively. 

These stablecoins are backed by actual dollars, so each USDT or USDC corresponds to one USD in the bank. 

They are managed by central authorities (Tether & Circle), which means they are:

• Centralized

• Non-transparent

• Can be censored

• Require a lot of trust

Something we don't really like in crypto. 🤢

These organizations also make money by investing these dollars in U.S. treasury bills (short-term bonds) that currently yield about 5%. 

However, this profit isn't passed on to the users of these stablecoins. 

There are ways to access these yields:

• USDC can be staked on Coinbase 

• USDT can be staked on Tron blockchain 

But it forces users to use Coinbase or bridge the money to the Tron blockchain, which might not be that known to the majority of people. Therefore those are not ideal solutions.  

Also, if these yields drop, these organizations will have limited alternatives for investing these dollars. 

Good luck to them when central banks decide to lower the rates. 😬

Now, let's talk about DAI — the third-largest stablecoin, with 3% of the market. 

What sets DAI apart is its decentralization and the management by MakerDAO (learn more about MakerDAO in a recent report here).

This setup allows them to invest in both U.S. treasury bills and onchain, offering a notable advantage.

Yet, they'll still need to find optimal strategies for generating some juicy yield – is this where Ethena comes in? We’ll see in this report. 

For now, we've quickly covered the stablecoin market and its 3 biggest players, which hold about 93% of the total market share.

Let's now examine the features that would define the ideal stablecoin:

• Decentralized, not controlled by any central authority, and does not require much trust 

• Liquid and stable, meaning you can easily buy or sell any amount at the expected price of $1 or above if it accrues yield 

• Offers easy access to a significant yield, possibly between 10% and 30%

• Composable, meaning you can use it in various decentralized finance (DeFi) applications 

Does Ethena tick all of these boxes? Let’s explore. 👇

WHAT EXACTLY IS ETHENA? 🤔

Imagine you've developed a robust trading strategy that earns high yields – let's say 20% – and is unaffected by price changes, meaning that the strategy works well regardless of whether crypto prices go up or down.

In this scenario, if someone gives you $100, you'll be able to return the $100 at any time, plus some extra profit that you generated using your strategy. 

That's great. You have a great strategy that maintains the stable value of the initial investment ($100) and generates additional yield on top of it. 

So you start wondering: how can I gather as much capital as possible to deploy in my strategy?

Well, what if you create a stablecoin that represents the capital used in this strategy, where the value of the capital remains stable and simply accrues yield?🤯

That's a great idea, isn't it? That's exactly what Ethena has done. Here’s how it works:

For every dollar in Ethena, there is a corresponding long position (which profits when the price increases) and a simultaneous short position (which profits when the price decreases) for the selected asset (ETH or BTC). 

It is called the delta neutral strategy.

Here’s a breakdown of how Ethena works with just $100 in the system:

1/ Deposit: A user puts in $100.

2/ Conversion: The money is converted into underlying collateral assets like $ETH or $stETH.

3/ Leverage: These assets are then leveraged to open a short position on derivatives exchanges.

4/ Mint: The user gets 100 USDe, a stablecoin backed by both a long and a short position to maintain the value of the $100

That’s how Ethena works.. 

But here's the main question…

HOW DOES ETHENA GENERATE SUCH HIGH YIELD? 🤯

Ethena generates high yields through two main sources:

1/ Staking Yield from Collateral

Ethena boosts its earnings by holding staked Ethereum as part of their collateral, which currently yields about 4%. 

While Ethena currently uses only Ethereum and Bitcoin as collateral, it's important to note that staking yield is only generated from staked Ethereum. 

However, they plan to expand their portfolio by adding more assets with staking yields in the future. 

2/ Funding Rates (FR) 

These are the fees that Ethena collects for maintaining open short positions on derivatives exchanges. 

This is a well-known strategy commonly used in traditional finance. It profits from the fact that certain assets tend to trend upwards over the long term (long bias), and as a result, long positions will most of the time pay fees to the shorters. 

Ethena essentially earns these fees by maintaining open short positions, thereby acting as a counterparty to the predominantly larger group of long traders.

Is this strategy really robust and sustainable? Let’s figure it out. 👇

You can review backtests to see how Ethena's strategy would have performed in the past, as well as analyze its performance during unexpected events.

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Source: Ethena Labs

The main takeaways from this chart underscore that even in a bearish market environment, this strategy exhibited robust performance, achieving an annualized yield of around 10%.

We can also observe that in 2023 (blue window), market conditions began to improve, resulting in better performance for the strategy.

The chart ends in September 2023 so let's now examine the most recent funding rates (excluding staking yield) since February 2024.

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Source: Ethena

The funding rates, aka Perp Yields are volatile as seen on the chart above, but predominantly positive averaging around 20%. 

This allows Ethena to collect these yields and then distribute them to holders of staked USDe (sUSDe).

You can check the most recent data on the dashboards here.

Now that we have a grasp of the strategy, let's clarify the distinction between the two stablecoins used in Ethena: USDe & sUSDe.

HOW IS THIS YIELD DISTRIBUTED? 🔄

💡 USDe is a stablecoin that can be minted and redeemed on Ethena by whitelisted wallets. It doesn't accrue any yield and is designed to maintain a peg of $1. 

💡 sUSDe represents USDe that has been staked. The value of sUSDe will increase over time as it accumulates yields generated by the strategy.

To benefit from the yield generated by Ethena's strategy, you need to hold sUSDe, which represents the staked version of USDe. 

If you just hold sUSDe, you're all set – no extra steps needed. The yield grows in sUSDe value, which rises over time, currently at a rate of 10% per year.

It's interesting to see that there's $2.35 billion worth of USDe circulating, indicating that Ethena has $2.35 billion deployed in their strategy. 

However, only 13% of that USDe is staked, meaning only a fraction is earning the generated yield. 

The primary reason could be Ethena's Season 2 Sats campaign, which offers more sats (points) to USDe holders rather than sUSDe holders. 

After the campaign ends, sats can be converted into $ENA tokens –we anticipate that this staked ratio will significantly increase after that. 

Also notice that the USDe supply has barely shifted, despite $ETH falling by over $1k (25%) recently, which serves as a strong response to numerous critics of Ethena.

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Source: Dune

By the way, the yield generated by unstaked USDe (87%) is used to fund a Reserve Fund, which is intended to provide a buffer during periods when the funding rates are negative. 

The reserve fund is growing at a pace of $3M/week currently. 

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Source: Ethena

Chaos Labs, a renowned and respected risk management provider, has been selected by Ethena to provide unbiased quantitative analysis on evaluating risks associated with this strategy as well as to provide Ethena with guidance on the ideal reserve fund level to target. 

The key figure from their backtests is that the largest drawdown of this strategy was 2.9%, and 1.2% if the Merge period is excluded. The merge period (September 2022) was quite volatile for funding rates because people were reluctant to trade, and many speculated about receiving a PoW ETH airdrop for holding native ETH at the time of the merge.

It suggests that for every $1 billion in TVL, the reserve fund should contain approximately $30 to $40 million. 

However the current balance of this fund is $37 million while TVL is at $2.35 billion. So Ethena should aim to increase the reserve fund by approximately $40 million more.

Ok, now we understand the strategy and how the yield is generated… Is it possible for Ethena to get $100 billion in value locked and surpass its competitors like USDT and USDC? 

TL;DR: it’s unlikely. Here’s why…

HOW BIG IS THIS MARKET OPPORTUNITY? 📈

Ethena's capacity to deploy capital is limited by the amount of Open Interest (OI) on the available exchanges (Binance, Bybit, OKX, etc). 

Open interest refers to the total dollar value of all open trades, both long and short positions. 

Let's take a look at the actual data:

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Source: Ethena

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Source: Ethena

In total, there is $28 billion in Open Interest for $BTC and $ETH on the selected derivatives exchanges today. 

We can also see Ethena's share of the existing Open Interest. 

Note: Open Interest encompasses the dollar value of both open long and short positions, but Ethena only takes short positions. 

Therefore, Ethena's share will never reach 100%. 

We believe it's reasonable to anticipate Ethena's share to reach around 25% in the future. It offers a sizable market while also ensuring that it's not excessively large to adversely affect funding rates.

Alright, so 25% of the existing $28 billion Open Interest is $7 billion. That might not seem particularly compelling, right? 

Let's learn something about the dynamics of this market to gain a better understanding.

1/ Market Sensitivity: Open Interest (OI) fluctuates between 1.2% and 1.45% for every 1% change in market capitalization. This data can be found in this report by Chaos Labs.

2/ Market Growth Projection: If the cryptocurrency market cap doubles, the OI could more than double too, rising from $28 billion to potentially $60 billion.

3/ Market Opportunity for Ethena: With the anticipated growth in OI, the market opportunity for Ethena could surge to around $15 billion, making it significantly more attractive. 👀

4/ Impact of Market Conditions on Funding Rates:

Bear Markets: Funding rates, the fees Ethena earns, are usually around 8-10%.

Bull Markets: These rates can climb above 30%, suggesting higher profitability during market upturns.

5/ Potential for Expansion: Ethena has the opportunity to broaden its market by incorporating more collateral assets beyond just ETH and BTC.

Cool. Did this make you bullish? Are you thinking about buying? Let’s see if this is a good investing opportunity. 👇

ETHENA'S VALUATION 📊

Let's try to make some projections about where Ethena could be in 2 years from now. 

Please feel free to duplicate this Google Sheet and enter your own assumptions. Also, read the column descriptions. 

We believe that in 2 years, the crypto market cap will be above $10 trillion, which is 4x from the current levels. 

Due to the strong correlation with Open Interest (OI), we project that there could be $75 billion in Bitcoin OI and $30 billion in Ethereum OI. 

Here are some of our estimations:

1/ Ethena could capture 25% of that OI (see the charts above). 

2/ Ethena will allocate 50% of its Ethereum holdings to staking derivatives to earn staking yields. 

3/ Average funding rates to be around 20%, with a staking yield on ETH at 4%. 

4/ Close to 100% of USDe will be staked to earn the yield. There aren't many reasons to keep holding unstaked USDe since it always trades at $1.

5/ The protocol will charge a 15% fee on all generated yield.

💡 Based on these assumptions, this would mean that there would be $26.25 billion deployed by Ethena. The total yield generated would be $5.4 billion, with the protocol's revenue reaching $810 million. Not too bad!

But we need to figure out whether $ENA still has some potential to appreciate. We can try to estimate the valuation for $ENA based on the above numbers.

We will attempt a relative evaluation by comparing the valuations of similar protocols. 

We will use the ratio of Fully Diluted Value (FDV = price * total supply) to Protocol Annualized Revenue to estimate the valuation of similar projects. 

Note: Ethena is a unique protocol and doesn't precisely match any existing protocol on the market.

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Source: TokenTerminal

If we apply our revenue prediction with Ethena generating $810 million in protocol revenue, the Fully Diluted Valuation (FDV) to revenue ratio sits at 14.8.

This shows how many years it will take for the protocol to earn revenue equal to its total FDV. 

But it's not so much about the years. It's better to compare this ratio with other protocols to understand how the markets value them. 

Based on this ratio, Ethena seems undervalued, given that most of the similar protocols are trading at higher ratios. The average ratio of the selected protocols is at 38.9. 

However we suggest using our Google Sheet and adding your assumptions to forecast future revenue.

Come to join our Discord and share your assumptions or further discuss your thoughts. 

Once you have your expected revenue, combine it with the ratio you expect the protocol to be traded at to find the right price for the token. 

Here is the table where you can input your own estimates and determine the appropriate price for $ENA. The current price of $ENA is $0.80.

We envision a future where:

• Ethena generates ~800 million dollars in annual revenue.

• (s)USDe becomes the leading decentralized stablecoin in the cryptocurrency market, with more than 20 billion in circulation and more than 10% stablecoin market share.

• Ethena's strategy surpasses all other crypto venues, providing an average yield of about 20%.

• Ethena's first-mover advantage and partnerships with established derivatives exchanges help it dominate the market.

• Network effects are amplified through integrations with other DeFi ecosystems.

As the cryptocurrency market cap grows, Ethena is in the best position to benefit.

$ENA = beta for crypto market cap

With all that being said, we expect Ethena to trade at an FDV/revenue ratio of 100. 

This would mean prices around $5, which would be more than a 6x increase from the current prices.

Before we get too excited, let's look at some of the risks here.

WHAT ARE THE MAIN RISKS WITH ETHENA? ⚠️

1/ Strategy

Most concerns about Ethena are about whether it can consistently make money and sustain its approach. 

However, we believe these concerns are overstated. This strategy has a track record of success in traditional finance, and tests by Chaos Labs along with Ethena's own backtesting confirm its strength and robustness.

2/ Operations

There are some risks as Ethena uses custodians and centralized derivatives exchanges to execute their strategy. 

These custodians are institutional-level service providers, widely used by various funds and institutions in the industry and they have top-tier security practices in place. 

Therefore, the risks are heavily minimized as Ethena doesn't send funds directly to exchanges, but uses these intermediaries instead. 

The reason for choosing centralized exchanges over decentralized ones is primarily the amount of Open Interest (OI), which heavily favors centralized exchanges. 

Understanding the critical role that centralized exchanges play in their business strategy, Ethena has collaborated with most of them through partnerships to ensure alignment on objectives.

3/ Smart Contract Risks

Ethena's code for creating and removing its currency is short and straightforward, with only 600 lines. It improves safety because it only lets approved users interact with it, which lowers the chances of security issues.

A simple way to analyze the risks and strengths of this product is to look at how much other protocols want Ethena's product. 

If major players like Maker, Frax, Curve, and Aave, who have strong incentives to avoid high-risk integrations and have the resources to conduct thorough risk assessments, show significant interest, it clearly indicates reliability and acceptable risks.

All right, so how can you profit from Ethena?

4 WAYS TO CAPITALIZE ON ETHENA 💰

Ethena has quickly attracted a large amount of capital and attention. Much of this activity may be motivated by the expected airdrops for Ethena users. 

The ongoing Sat Campaign will continue until September 2nd, 2024, or until the USDe supply reaches $5 billion (currently at $2.35 billion) –whichever comes first.

But what if the primary driver is actually the superior product? We truly believe this is the case. 

A stablecoin with an embedded yield of ~****20% is currently an unparalleled product in the cryptocurrency market.

Even if you don't necessarily agree with everything written here, there are different ways to capitalize on this.

1/ Earn yield by holding $sUSDe 

By holding sUSDe, you automatically benefit from the yield generated through Ethena's delta-neutral strategy – you don't need to take any additional steps. 

You can even use sUSDe as collateral elsewhere in DeFi or provide liquidity with it, and you will still benefit from the yield generated by Ethena's strategy. 

Over time, sUSDe appreciates in value. You can check the most updated APY in the right top corner here. 

2/ Invest in $ENA as an asset with potential for future appreciation

Ethena has built something truly impressive. If you believe that the crypto market cap will grow, then Open Interest will also increase, which in turn expands the market opportunities for Ethena.

It's difficult to see a future where the global crypto market cap rises from the current $2.2 trillion to $10 trillion without Ethena significantly profiting from that growth. 

Ethena will provide superior yields and we believe that yield drives demand.

Other stablecoin issuers will need to find strategies for their capital in order to bootstrap the demand, but we think they won't be able to outperform Ethena. 

Centralized stablecoins like USDT and USDC can't use DeFi platforms, and Maker, the third largest stablecoin, has already approved a $1 billion indirect credit line to Ethena. 

Even if Maker's Endgame is successful, they will probably direct even more money into Ethena. This is why we believe Ethena has big potential to increase its stablecoin market share over time. 

Right now, $ENA is just a governance token, however, it is expected that in the future $ENA will be used somehow in the ecosystem and $ENA holders could benefit from Ethena's profits. 

If you agree with this perspective and you think that Ethena has a solid business here, then buying and holding $ENA could be a beneficial way to profit from it. 

3/ Farm $ENA by participating in the Ethena ecosystem 

If you are more conservative and prefer not to buy $ENA directly, but still want some exposure to this project, you can farm Sats (points) which will eventually be converted into $ENA tokens.

How to farm sats?

You just need to participate in the Ethena ecosystem to be eligible for the Sats Campaign. 

• For example, you can farm Sats by locking $USDe – you can earn 20x more sats

  

Explore more ways to farm sats on their website, where various options and their respective multipliers are available.

4/ Boost your Sats to earn an additional 50% in $ENA.

Lock at least 50% of the dollar value of your other Ethena positions (ie. $USDe or sUSDe) in $ENA to boost your sats rewards by 50%. 

For instance, if you have $100 $USDe, you also need to have $50 of $ENA to earn the boost.

FINAL TAKEAWAYS 💭

Regardless of how you choose to engage with Ethena, it's undoubtedly a project worth watching. 

Ethena's key selling point is clear: They provide a decentralized "stablecoin" with integrated superior yield. Just hold onto it and you're all set. 

This is an extremely compelling selling point and the reason why we are so bullish. 

Nevertheless, it's important to remember that crypto markets can be unpredictable. Keep that in mind as you position yourself. 

As for us, we're holding onto our $ENA airdrop and have no plans to sell anytime soon!

Good luck out there. ✌️

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