Funding Rate Turns Negative, Can Ethena's USDe Withstand It?
The research institution CryptoQuant analyzed whether the stablecoin USDe, backed by ETH, can maintain stability. On 4/17, due to the market downturn, we saw hedging positions in Ethena showing negative annualized returns due to negative funding rates on several exchanges. This raises concerns about the potential risks in the massive $2.4 billion fund game.
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CryptoQuant Analysis of Ethena Risk
CryptoQuant has identified several risk points that could impact the stability of its synthetic dollar USDe, including funding risk, liquidation risk, custody risk, exchange failure risk, and collateral risk. This article delves into the potential dangers associated with funding risk and how Ethena manages these challenges to maintain the stability of USDe exchange rate.
— Julio Moreno (@jjcmoreno) April 16, 2024
Crisis of Funding Risk
"Funding risk is related to the possibility of sustained negative funding rates. Ethena can profit from funding rates but may also need to pay them," explained Ethena Labs. Under normal market conditions, traders in the Ethereum and Bitcoin perpetual futures markets tend to be long, leading to these traders ultimately having to pay funding rates to short holders, such as Ethena.
Crisis Point: Severe Market Adjustment
The key issue arises when a market experiences a significant downturn, where rapid price drops may cause funding rates to invert. In such a scenario, traders close their long positions, and new short sellers entering the market may push funding rates into negative territory. This inversion forces short holders like Ethena to pay funding rates to long holders, turning their expected income into expenses.
Ethena Reserve Fund: Obligation to Maintain Stability?
To protect its operations and the exchange rate stability of USDe, Ethena has established a reserve fund. This fund plays a crucial role in absorbing financial impacts when Ethena needs to cover costs of negative funding rates, ensuring USDe holders are not affected.
However, the pressing question is whether this reserve is sufficient to meet all potential obligations without jeopardizing the stability of their short positions.
Assessing Adequacy of the Reserve Fund
CryptoQuant evaluates the sustainability of Ethena's reserve fund under extreme market conditions observed during similar periods like the Ethereum merge.
Historical data from this period indicates that as long as the market value of USDe remains below $4 billion, Ethena's current reserve of $32.7 million is sufficient. However, as the market value increases, the required reserves will also increase, necessitating significant enhancements to the fund to effectively manage potential obligations at higher market values.
Risks Introduced by Exchanges
Looking at past cases, the collapse of the FTX exchange led to a sharp increase in funding risk shortly after, further complicating the situation. This event reiterated the necessity of establishing a robust and scalable reserve fund that can adapt to sudden financial pressures, safeguarding Ethena's positions and the overall health of USDe.
How to Manage Risks Effectively?
The proportion of total revenue allocated to the reserve fund, known as the retention rate, is a critical factor for Ethena.
This rate determines the growth of the reserve fund and the speed at which it strengthens its ability to buffer against adverse funding rate periods. Analysis suggests that to withstand severe market downturns experienced during prolonged bear markets, Ethena must maintain a retention rate of at least 32%.
Proactively adjusting the retention rate and allocation of the reserve fund will be key to maintaining the stability of synthetic dollars against the backdrop of an unstable cryptocurrency market.