DeFi Pioneer Andre Cronje Raises Doubts on Ethena: I Can’t Understand How It Mitigates Risks

DeFi Pioneer Andre Cronje Raises Doubts on Ethena: I Can't Understand How It Mitigates Risks

DeFi Pioneer Andre Cronje Raises Doubts on Ethena: I Can't Understand How It Mitigates Risks

In this field, we often see new things, and I often find myself in the middle of the curve (neither a beginner nor an expert). I am satisfied with this balance. However, there are some industry events that I wish I had more curiosity about, and there are also events that I completely did not anticipate.

For UST, I was very convinced from the beginning that it would fail because its mechanism did not make sense to me. However, many smart people that I thought highly of firmly believed that it would not fail, which made me start to doubt myself. As for FTX, I have to admit that I did not expect it to collapse. When people asked me if they should withdraw their funds, my default answer was “yes, why take the risk?” But I would give the same answer for any exchange. The collapse of FTX was something I did not foresee. I use this opening to express that many times, I actually do not know the answer.

Nevertheless, there is now a new infrastructure that is gaining a lot of attention. I see it being integrated into a protocol (possibly Maker) that I consider to have low risk. However, based on my (possibly incorrect) understanding, the risk of this new protocol (probably referring to Ethena) is very high. So, I don’t want to criticize it directly, but I want to ask those who are smarter than me where I misunderstood. I have read all available documents and read other people’s evaluations, but I still can’t see how the risk is mitigated.

First, let me introduce the components:

Perpetual Contract – In regular spot trading, you only buy assets (specifically, you sell one asset (short) and buy another asset (long), for example, in BTC/USD trading, you are buying (going long) BTC and selling (going short) USD. If BTC appreciates relative to USD, you make money. We call these spot trades because even if BTC/USD depreciates, you still hold the BTC asset. Perpetual trading, on the other hand, is a tool that allows similar trades without the need to own any of the assets involved. It is somewhat more like directional gambling rather than trading.

One unique mechanism of perpetual trading is that both the buyer (long) and the seller (short) have to pay a “funding rate.” If there is significantly more demand from buyers than sellers, the seller will “receive” the funding rate, and the buyer will “pay” the funding rate. This is to ensure that the price of perpetual contracts can converge towards their spot price (this mechanism is similar to borrowing rates). To maintain your position, you need to provide collateral, which is effectively used to “fund” your “funding rate debt.” If the funding rate becomes negative, it will erode your collateral until your position is liquidated.

Collateral – The next part of this mechanism is “yield-bearing collateral,” which refers to assets that appreciate in value just by holding them. In this example, it is stETH. If I have 1 stETH, I am effectively going long on stETH. So, if I open a short perpetual contract worth $1000 using stETH as collateral, I am (theoretically) “neutral.” Because even if I lose $100 on the stETH short, I earn $100 on the stETH long.

Mechanism – The theory here is that you can buy $1000 worth of stETH and use it as collateral to open a $1000 stETH short position, achieving “Delta neutrality” and benefiting from stETH yield (about 3%) and any funding rate charged.

I am not a trader, at most I execute exploratory trades to build DeFi protocols, and I am happy to admit that this is not my area of expertise. I try to compare these tools with my basic knowledge of collateral and debt. Based on my experience, eventually, you need to close your position (no longer neutral) or get liquidated. And now, the hypothetical theory I found in Ethena is that “positions can be easily closed when the market trend reverses.” But this is somewhat akin to saying “buy Bitcoin only when it goes up and sell when it goes down,” which, although it sounds intuitive, is almost impossible to achieve in practice.

So, although everything looks good now (because the market is positive, the funding rate for shorts is positive, and everyone is willing to go long), this will eventually change, the funding rate will turn negative, collateral will be liquidated, and you will be left with an asset with no underlying value.

I see the counter-argument to this issue is the “law of large numbers,” but it is almost the same as measures like UST’s $1 billion Bitcoin fund. “It is effective until it is no longer effective.”

Therefore, I would like to ask more intelligent people in the X community to help me understand where I misunderstood and what I missed.

In response to this, Ethena founder Leptokurtic commented under AC’s tweet:
“These are not Middle Curve concerns, and you correctly pointed out the risks that do exist here. I will prepare a longer-form response for you before this weekend and include some thoughts.”