Author: Prathik Desai, Compiled: Block unicorn

Stability may be an illusion. This is especially common in finance. You bet on a seemingly mundane financial instrument, thinking it would deliver steady, reliable returns. It does function step by step until its fundamentals falter. These seemingly safe investments are often more deceptive than speculative investments. People inherently expect that speculative investing will be risky, but few imagine that sound investing will be as well.

We watched this happen some 75 years ago.

In the 1940s, following the Great Depression and World War II, dollar-denominated deposits accumulated in European banks. Thisallows account holders to store dollars in non-U.S. banks to hedge against the risk of currency depreciation. These deposit yields are quite attractive and have given rise to some innovative thinking. Some account holders, such as U.S. companies, cleverly store dollars overseas to circumvent capital controls at home.

European banks welcome all these deposits. They accept these deposits and lend them at higher interest rates. A glut of European deposits gave rise to the Eurodollar market, a parallel dollar system not regulated by the U.S. Federal Reserve. Things began to deteriorate with the outbreak of the Cold War in the late 1940s. More and more people are asking for their dollars back, but banks are running low on dollar reserves. The whole system collapsed.

We are now seeing similar transactions in the stablecoin market. However, digital dollar issuers seem to have learned from history.

In today's in-depth analysis, I will explain whether Ethena's reliance on traditional stock markets can save its stablecoin reserve strategy.

InitialBehavior

In early 2024, Ethena launched USDe, a synthetic stablecoin with a difference. USDe is issued as an asset pegged to the U.S. dollar but does not actually hold U.S. dollar reserves. Instead, for every dollar of USDe issued, an equal value is held in crypto-assets such as Bitcoin and Ethereum. At the same time, it also shorted the equivalent amount of cryptocurrency futures.

The two positions balance each other. If the price of Bitcoin rises, a short futures position loses the gains from rising spot prices. vice versa. Ultimately, USDe is always worth $1 even if there are no actual dollars in the bank account.

But Why would people hold USDe instead of existing cryptocurrencies like USDT or USDC? Because they are rewarded for holding USDe.

This incentive mechanism is specifically designed to fit the way the cryptocurrency derivatives market operates. In a bull market, more traders bet on rising prices. The exchange charges these bullish bettors a small ongoing fee, called a funding rate, and pays the fee to the other side of the trade. Ethena is always on the other side of the transaction. It collects these fees and returns them to USDe holders as revenue.

At its peak, returns exceeded 20% annualized. In just 18 months, USDe’s circulating supply has grown sevenfold to approximately $15 billion, marking the fastest growth ever for a stablecoin.

I like this design, but it relies heavily on the cryptocurrency market to maintain the status quo. In a bull market, it works because a small number of investors holding short positions are able to profit from it, while the majority of investors hold long positions. But the market will change over time, that's inevitable. When markets change, cracks appear. USDe briefly lost its peg to the U.S. dollar on Oct. 11, a day after the largest liquidation in cryptocurrency history wiped out more than $19 billion. Athena’s synthetic stablecoin fell as low as $0.65 against the U.S. dollar on the Binance exchange.

In the five months starting on October 10, U.S. foreign exchange reserves in circulation plummeted from about $15 billion to less than $6 billion.

A lesson too late?

More than $9 billion was redeemed. Perpetual futures, which once accounted for almost 100% of the model’s reserves, now account for just 11%. What's even more ironic is that all of this could have been avoided. Ethena should have seen this coming.

There are various signs that the market always fluctuates cyclically, and cryptocurrency is no exception. We have witnessed this over the past 16 years. Relying on a single source of collateral, such as perpetual futures that are closely tied to market movements, is always a ticking time bomb.

Other stablecoin issuers have also begun to make adjustments. As the Federal Reserve begins to cut interest rates, the top two stablecoin issuers have increased their issuance efforts to supplement their reserve income. Tether has diversified its reserves by adding a record amount of gold reserves. USDC issuer Circle is actively building infrastructure revenue sources through its Layer-1 network Arc and full-stack Internet payment system Circle Payments Network.

But Ethena was slow to react. It would be much worse if it took no action at all. This is not my personal opinion, but is something its founder Guy Young admitted in an article on X .

Guy also lists the steps Ethena began to take to adapt to the regime change.

Traditional financial solutions

Ethena will expand its collateral base to include equity and commodity basis trading, overcollateralized institutional lending, prime broker services, and a broader range of real-world assets (RWA).

Ethena started out as a cryptocurrency native to the synthetic U.S. dollar, unlike pioneers like Tether's USDT and Circle's USDC, which backed their digital dollars by holding physical dollars or equivalent Treasury bills in their vaults.

For Ethena, destiny seems to have come full circle. Today, it is being reintegrated into the traditional financial system and continues to bring benefits to holders. Moreover, there is not just one source of income, but multiple.

By stock basis trading, this strategy earns the difference between buying the S&P 500 spot and simultaneously shorting its futures. This is the same strategy Ethena used previously for BTC and ETH. This gain is small but predictable and is not affected by cryptocurrency market fluctuations.

Now imagine that Ethena conducts similar trades across multiple asset classes: commodities such as gold, silver, wheat and oil, indices, lending markets, and more. Every asset will have a price spread, which is driven by market supply and demand. Ethena enables delta-neutral trading on all assets and collects spreads around the clock, regardless of what retail investors think about cryptocurrencies or Bitcoin.

Although this has reduced reliance on the cryptocurrency market, its movements are now closely related to the stock, commodity or other asset markets. Whenever these markets become volatile and liquidity dries up in the futures market, these strategies may also fail and could further squeeze USDe's income.

But Such pessimism amounts to expecting that a portfolio that is diversified across asset classes will also fail. Of course, this can still happen, but it's very rare. However, that's how the financial world works: it's based on probability and mathematics. One wouldn't expect to see a break-even point when the entire market is bleak. The purpose of diversification is to reduce the likelihood and extent of losses.

For Ethena diversification across unrelated sources of income can achieve the same effect. This will reduce the risk that returns will be completely squeezed when one or two asset classes underperform.

Liquidity test

Ethena's diversification strategy is a reasonable plan to deal with market cycles. Diversifying investments into stocks, commodities, credit and cryptocurrencies can enhance the stability of their income streams. This is perhaps its only advantage over Treasury-backed USDT and USDC, which pay no yield to holders.

But this new strategy still faces strong resistance.

USDe's liability portion is fully liquid, meaning any holder can redeem it at any time. But income-producing assets are not perfectly liquid during times of market stress. Stock basis positions can take some time to smoothly close out. Institutional loans have a fixed term. Collateralized loan obligations (CLOs) are not always liquid when markets are volatile. This gap between liquid liabilities and illiquid assets can become a structural headache for any yield stablecoin. Even a diversified income strategy cannot bridge this gap.

In calmer markets, movements in different asset classes may reflect different signals. Inflation concerns could push gold prices higher. Good corporate earnings boost the stock market. As we are currently seeing, geopolitical crises involving oil-producing countries could push oil prices higher. As retail investors are optimistic about the cryptocurrency market, cryptocurrency financing rates have also remained high.

But under extreme pressure conditions, they don't behave that way. Correlation assumptions may not hold true, negating the benefits of diversification. What all these assets have in common is liquidity.

When things get really bad, everyone wants to cash out.

Harry MarkoWitz won the Nobel Prize for demonstrating that diversification can reduce risk. However, the 2008 financial crisis did not require a Nobel Prize to prove the exception to Harry’s Modern Portfolio Theory (MPT). Academician Nassim Taleb also made the same point in his book "Black Swan". He pointed out that the correlation between asset pairs is not constant but is a variable that changes with market conditions.

Despite these anomalies it is important to recognize that these are unavoidable and rare black swan events. Almost no one can predict or control them. A diversified portfolio (one that spans multiple asset classes) may still outperform a portfolio that is concentrated in a single asset class. We saw this during the 2008 currency market crash.

Reserve Tier 1 funds hold short-term corporate bonds rather than Treasuries because of more attractive spreads. After Lehman Brothers collapsed, those bonds became worthless overnight.

Over-collateralization is one of Ethena’s measures to deal with this problem. If a borrower posts more collateral than the amount borrowed, losses will theoretically be absorbed before reaching USDe holders. But the overcollateralization rate is set based on historical fluctuation ranges. Stressful events may fall outside these ranges.

No strategy can completely avoid risks. Ethena is on a mission to inspire confidence among investors that its new diversified strategy has advantages over previous models that relied on market dynamics in a single cryptocurrency.