Ethena Protocol Insights: Funding Rate Challenges and Strategy Optimization

1. The income sources of the Ethena protocol are spot staking yields and funding rate yields from short positions. The introduction of BTC collateral dilutes the staking yield, while market calmness and a large number of shorts reduce the funding rate yield.

2. Increasing the variety of collateral is a necessary path for Ethena's long-term development, but it may mean long-term low interest.

3. The current protocol's insurance fund is insufficient, posing a high risk.

4. Ethena has a natural advantage in facing withdrawals during negative funding rates.

5. The total open interest in the market is an important indicator that limits the issuance of USDe.

Ethena is a stablecoin protocol built on the Ethereum blockchain that provides "synthetic dollars" USDe through a Delta neutral strategy.

The working principle is as follows: users deposit stETH into the protocol to mint an equivalent amount of USDe. Ethena utilizes an off-chain settlement solution to map the stETH balance to a centralized exchange as collateral, shorting an equal amount of ETH perpetual contracts. This investment portfolio achieves Delta neutrality, stabilizing the value of USDe.

Users can stake USDe in the protocol to mint sUSDe, and holding sUSDe generates profits from the funding rate. This profit has previously reached over 30%, making it one of Ethena's main methods of attracting funds.

As of May 9, 2024, the yield for holding sUSDe is 15.3%, with a total issuance of USDe reaching 2.29 billion USD, accounting for approximately 1.43% of the total market value of stablecoins, ranking fifth.

In the Ethena protocol, stETH collateral and ETH perpetual contract short positions both generate returns. If the combined yield of the two positions is negative, the insurance fund will cover the losses.

The funding rate is a mechanism introduced to address the disconnection between futures and spot prices in perpetual contracts. When the price of the perpetual contract is higher than the spot price, longs pay the funding rate to shorts; conversely, shorts pay the funding rate to longs.

Ethena holds short positions in ETH and stETH, with earnings coming from the funding rate and staking income. When the overall yield is positive, a portion of the earnings is deposited into the insurance fund to compensate for potential future negative yields.

In the current bull market, the sentiment for going long is clearly higher than for going short, and the funding rate has remained at a high level for a long time. In the Ethena protocol, the Delta risk of spot collateral is hedged by short positions, while the short positions earn a substantial amount of funding rate income, which is the reason Ethena generates risk-free high returns.

Ethena uses centralized exchange hedging and introduces the OES mechanism to entrust collateral to a third party for custody, minimizing centralized risks.

The insurance fund is an important component of the Ethena protocol, used to maintain price stability when the overall yield is negative.

Historical data shows that the average comprehensive return of USDe has remained above 0, proving the long-term viability of the project. Short-term market fluctuations or negative returns caused by black swan events are usually unsustainable, and a sufficient insurance fund can help the protocol transition smoothly.

Starting from April 2024, users can stake BTC in the Ethena protocol to mint USDe. As of May 9, 2024, BTC collateral accounted for 41% of the total collateral.

Introducing BTC as collateral dilutes the staking yield of stETH, but increases the diversification of the portfolio and reduces the risk of USDe decoupling during bear markets. The average funding rate of BTC perpetual contracts is lower than that of ETH during bull markets and higher during bear markets, serving as a hedge against the low funding rates in bear markets.

Currently, the sUSDe yield has rapidly dropped from over 30% to around 10%, which is influenced by the overall market sentiment and also related to the impact of a large number of short positions brought about by the rapid expansion of USDe.

USDe is currently severely lacking in application scenarios, and most holders only seek to obtain high APY and participate in airdrop activities. If there is no breakthrough development in USDe's application scenarios before the second quarter airdrop activity ends, coupled with the gradually shrinking funding rate, USDe may face developmental difficulties.

The insurance fund of Ethena is currently insufficient, accounting for only 1.66% of the USDe issuance. An inadequate insurance fund may lead to a lack of user confidence and a gradual decrease in the project's TVL; at the same time, the project team must increase the withdrawal rate of the insurance fund, which may further reduce user yields.

In the black swan event where the funding rate has significantly declined, USDe may experience a run on the bank, but its unique mechanism seems to have a natural advantage in responding to such runs. When a run occurs, Ethena needs to close short positions, and in the market with negative funding rates, long liquidity is abundant, which is favorable for closing operations.

The total open interest in the market is a key factor constraining the issuance of USDe. As of May 9, 2024, ETH OI accounts for 13.77% of the total OI in the Ethena protocol, while BTC OI accounts for 4.71%. The solution is to increase the amount of high-quality collateral, raise the USDe supply ceiling, and diversify risks.

In summary, the Ethena protocol demonstrates a unique stablecoin mechanism and market sensitivity. Despite facing challenges, Ethena remains competitive through innovative over-the-counter settlement mechanisms and diversified collateral. In the future, it is necessary to continuously optimize strategies, enhance risk management capabilities, and ensure sufficient insurance funds and stable liquidity. Investors and users should fully understand the operational mechanisms of the protocol, sources of income, and potential risks.