Arthur Hayes: Why Ethena Will Shake Up Tether?
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Arthur Hayes: Why Ethena Will Shake Up Tether?
Ethena is the best option in the crypto ecosystem for offering a blockchain-based synthetic dollar.
Navigating Web3 tides with focused insightsAuthor: Arthur Hayes, Founder of BitMEX
Translation: Dengtong, Jinse Finance
*Originally published on March 8, 2024
Dust on the crust has returned to Hokkaido, Japan as expected. The days are bright and warm, but the nights are bitterly cold. This weather pattern creates a pitiful snow condition known as dust on the crust. Beneath the seemingly pristine, untouched powder lies ice and brittle snow. It’s nasty stuff.
As winter gives way to spring, I’d like to revisit my article from a year ago titled “Dust on the Crust.” In that piece, I proposed a method for creating a synthetically backed fiat stablecoin whose existence does not rely on the TradFi banking system. My idea was to combine long crypto hedges with short perpetual swap positions to create a synthetic fiat currency unit. I named it Nakadollar, envisioning Bitcoin and short-term XBTUSD "perpetual" swaps as the mechanism for creating synthetic dollars. At the end of the article, I pledged support to a reliable team to help turn this idea into reality to the best of my ability.
How much can change in a year. Guy is the founder of Ethena. Before joining Ethena, Guy worked at a $60 billion hedge fund investing in special situations such as credit, private equity, and real estate. He captured altcoins during the DeFi summer that began in 2020 and never looked back. After reading “Dust on the Crust,” he was inspired to launch his own synthetic dollar. But as all great entrepreneurs do, he wanted to improve upon my original idea. Instead of using Bitcoin, he created a synthetic dollar stablecoin using Ethereum.
Guy chose Ethereum because the Ethereum network offers native yield. Validators on the Ethereum network are paid small amounts of ETH directly by the protocol for each block they secure and process transactions. This is what I refer to as the ETH staking yield. Additionally, because Ethereum is now a deflationary currency, Ethereum/USD forwards, futures, and perpetual swaps trade at a persistent premium to spot—a fundamental reason. Short-term perpetual swap holders can capture this premium. Combining staked ETH with a short ETH/USD perpetual swap position creates a high-yield synthetic dollar. As of this week, staked Ethena USD (sUSDe) currently yields an annualized rate of >50%.
No matter how good an idea is, it means nothing without an executable team. Guy named his synthetic dollar Ethena and assembled a rockstar team to quickly and securely launch the protocol. Maelstrom became a founding advisor in May 2023, and in exchange, we received governance tokens. I’ve worked with many high-quality teams in the past, and the Ethena staff delivered without cutting corners. Fast forward 12 months, Ethena’s stablecoin USDe reached nearly 1 billion in circulation (TVL of $1 billion; 1 USDe = $1) just three weeks after mainnet launch.
I believe Ethena can surpass Tether to become the largest stablecoin. This prophecy may take many years to fulfill. However, I want to explain why Tether is both the best and worst stablecoin in the cryptocurrency space. It’s the best because it’s likely the most profitable financial intermediary per employee across both TradFi and crypto. It’s the worst because Tether exists solely to please its poorer TradFi bank partners. Bank envy and the problems Tether poses to the guardians of America’s peaceful financial system could lead to Tether’s immediate demise.
To all those misguided Tether FUDsters, let me be crystal clear. Tether is not financial fraud, nor has it lied about its reserves. Moreover, I hold the highest respect for Tether’s founders and operators. But frankly, Ethena will shake up Tether.
This article will be divided into two parts. First, I’ll explain why the Fed, U.S. Treasury, and politically connected large U.S. banks want to destroy Tether. Second, I’ll dive deep into Ethena. I’ll briefly outline how Ethena is built, how it maintains its peg to the dollar, and its risk factors. Finally, I’ll provide a valuation model for Ethena’s governance token.
After reading this article, you’ll understand why I believe Ethena is the best choice within the crypto ecosystem for providing a blockchain-based synthetic dollar.
Note: Fiat-backed stablecoins are tokens where issuers hold fiat currency in bank accounts—e.g., Tether, Circle, First Digital. Synthetically backed fiat stablecoins are tokens where issuers hold cryptocurrencies and hedge using short-term derivatives—e.g., Ethena.
Green with Envy
Tether (ticker: USDT) is the largest stablecoin measured by circulating tokens. 1 USDT = $1. USDT is sent between wallets across chains like Ethereum. To maintain the peg, Tether holds $1 in bank accounts for every unit of USDT in circulation.
Without a U.S. dollar bank account, Tether cannot perform the functions of issuing USDT, holding the dollars backing USDT, or redeeming USDT.
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Issuance: Without a bank account, USDT cannot be created because traders cannot send dollars.
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Dollar Custody: Without a bank account, there is no place to hold the dollars backing USDT.
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Redemption: Without a bank account, USDT cannot be redeemed because there’s no bank account to send dollars to redeemers.
Having a bank account isn’t enough to ensure success because not all banks are equal. There are thousands of banks globally that can accept USD deposits, but only certain banks have master accounts at the Federal Reserve. Any bank wishing to clear USD through the Fed to fulfill its duties as a correspondent bank must hold a master account. The Fed retains complete discretion over which banks receive master accounts.
I’ll quickly explain how correspondent banking works.
There are three banks: A, B, and C. Banks A and B are located in two non-U.S. jurisdictions. Bank C is a U.S. bank with a master account. Banks A and B want to transfer USD within the traditional financial system. Each applies to use Bank C as their correspondent bank. Bank C evaluates the customer base of each and approves them.
Bank A needs to wire $1,000 to Bank B. The flow is $1,000 moving from Bank A’s account at Bank C to Bank B’s account at Bank C.
Let’s slightly modify the example and add Bank D, another U.S. bank with a master account. Bank A uses Bank C as its correspondent, while Bank B uses Bank D. Now, when Bank A wants to send $1,000 to Bank B, what happens? The flow becomes Bank C transferring $1,000 from its Fed account to Bank D’s Fed account. Bank D then credits $1,000 to Bank B’s account.
Typically, banks outside the U.S. use correspondent banks to wire USD globally. Once dollars move across jurisdictions, they must be cleared directly through the Federal Reserve.
I’ve been in crypto since 2013, and usually, the banks used by crypto exchanges to deposit fiat aren’t registered in the U.S., meaning they depend on U.S. banks with master accounts to handle fiat deposits and withdrawals. These smaller non-U.S. banks crave deposits and crypto companies because they can charge high fees and pay nothing on deposits. Globally, banks typically desperately need cheap USD funding because the dollar is the world’s reserve currency. However, these smaller foreign banks must interact with their correspondent banks to handle USD deposits and withdrawals outside their jurisdiction. Although correspondent banks tolerate these fiat flows tied to crypto, sometimes certain crypto clients get removed from smaller banks at the correspondent bank’s request. If a smaller bank doesn’t comply, it risks losing its correspondent relationship and its ability to transfer USD internationally. A bank that loses its ability to transfer USD is effectively dead. Therefore, smaller banks always give up crypto clients if demanded by the correspondent bank.
When analyzing the strength of Tether’s bank partners, this correspondent banking dynamic is crucial.
Tether’s bank partners: Britannia Bank & Trust, Cantor Fitzgerald, Capital Union, Ansbacher, Deltec Bank and Trust.
Of the five listed banks, only Cantor Fitzgerald is registered in the U.S. However, none of these five banks have a master account at the Federal Reserve. Cantor Fitzgerald is a primary dealer helping the Fed implement open market operations such as buying and selling bonds. Tether’s ability to transfer and hold dollars depends entirely on the whims of fickle correspondent banks. Given the size of Tether’s U.S. Treasury portfolio, I believe their partnership with Cantor is critical to continued access to that market.
If the CEOs of these banking institutions didn’t negotiate equity stakes in Tether in exchange for banking services, they were fools. When I later introduce Tether’s revenue-per-employee metric, you’ll understand why.
This is why Tether’s bank partners underperform. Next, I want to explain why the Fed dislikes Tether’s business model—and fundamentally, it has nothing to do with crypto, but rather how the dollar money markets operate.
Full-Reserve Banking
From a TradFi perspective, Tether is a full-reserve bank, also known as a narrow bank. A full-reserve bank takes deposits but does not lend them out. Its only service is wiring money back and forth. Since depositors face no risk, it pays almost no interest on deposits. If all depositors simultaneously demand their funds back, the bank can immediately satisfy the request. Hence the name—full reserve. This contrasts sharply with fractional-reserve banks, which lend more than their deposit base. If all depositors simultaneously demand funds from a fractional-reserve bank, it would go bankrupt. Fractional-reserve banks pay interest to attract deposits, but depositors face risk.
Tether is essentially a full-reserve dollar bank offering dollar transaction services powered by public blockchains. No lending, no funny business.
The Fed dislikes full-reserve banks—not because of who their customers are, but because of how these banks manage deposits. To understand why the Fed hates the full-reserve bank model, I must discuss the mechanics and implications of quantitative easing (QE).
Banks collapsed during the 2008 financial crisis because they didn’t have enough reserves to cover losses from bad mortgage loans. Reserves are funds banks keep at the Federal Reserve. The Fed monitors reserve levels relative to total outstanding loans. After 2008, the Fed ensured banks would never face reserve shortages again. The Fed achieved this through quantitative easing.
Quantitative easing is the process by which the Fed buys bonds from banks and credits their reserve balances held at the Fed. The Fed conducted trillions of dollars in QE bond purchases, causing bank reserve balances to balloon. Hooray!
QE did not visibly cause inflation because bank reserves stayed at the Fed. Pandemic stimulus checks went directly to people, allowing them to spend freely. Had banks instead lent out these reserves, inflation would have spiked immediately post-2008, as that money would have gone into the hands of businesses and individuals.
Fractional-reserve banks exist to make loans; if they don’t lend, they don’t earn money. All else equal, fractional-reserve banks prefer lending out their reserves to paying customers rather than leaving them idle at the Fed. The Fed faced a problem. How could it ensure the banking system had near-infinite reserves without causing inflation? The Fed chose to bribe the banking industry not to lend.
Bribing banks required the Fed to pay interest on excess reserves held by the banking system. To calculate the bribe amount, multiply the total bank reserves held by the Fed by the Interest on Reserve Balances (IORB). IORB must hover between the lower and upper bounds of the federal funds rate.
Lending involves risk. Borrowers default. Banks would rather earn risk-free interest income from the Fed than lend to the private sector and face potential losses. Thus, as QE progressed, growth in outstanding loans across the banking system lagged far behind the expansion of the Fed’s balance sheet. But success wasn’t cheap. When the federal funds rate was 0%–0.25%, the cost of the bribe wasn’t high. Now, with the federal funds rate at 5.25%–5.50%, the IORB bribe costs the Fed billions annually.
The Fed maintains a “high” policy rate to suppress inflation; however, due to the high IORB cost, the Fed has become unprofitable. The U.S. Treasury and American public are directly funding the Fed’s bribes to banks via the IORB program. When the Fed earns profits, it remits them to the U.S. Treasury. When the Fed incurs losses, the Treasury borrows and transfers funds to the Fed to cover the shortfall.
QE solved the problem of insufficient bank reserves. Now the Fed wants to reduce bank reserves to curb inflation. Enter Quantitative Tightening (QT).
QT refers to the Fed selling bonds into the banking system and collecting payment in reserves held at the Fed. QE increases bank reserves; QT decreases them. As bank reserves decline, the IORB bribe cost falls. Clearly, the Fed wouldn’t be happy if bank reserves increased while paying high rates on IORB.
The full-reserve bank model operates counter to the Fed’s stated goals. Full-reserve banks don’t make loans, meaning 100% of deposits go straight into reserves at the Fed. If the Fed started granting full-reserve bank licenses to institutions doing business similar to Tether, it would exacerbate the central bank’s losses.
Tether is not a U.S.-authorized bank, so it cannot directly deposit at the Fed and earn IORB. But Tether can deposit cash into money market funds, which can use the Reverse Repo Program (RRP). RRP is similar to IORB—the Fed must pay a rate between the lower and upper bounds of the fed funds rate to precisely steer short-term interest rate trades. Treasury bills (T-bills), zero-coupon bonds maturing in under one year, trade at yields slightly above the RRP rate. So while Tether isn’t a bank, its deposits are invested in instruments requiring the Fed and U.S. Treasury to pay interest. Tether has invested nearly $81 billion in money market funds and Treasuries. Tether is strangling the Fed. The Fed can’t allow that.
Tether arbitrages the Fed because it pays 0% on USDT balances but earns returns close to the upper bound of the fed funds rate. This is Tether’s Net Interest Margin (NIM). As you might imagine, Tether is extremely happy about rising Fed rates—its NIM rose from nearly 0% to nearly 6% in less than 18 months (March 2022 to September 2023).
Tether isn’t the only stablecoin issuer arbitraging the Fed. Circle (USDC) and every other issuer accepting dollars and issuing tokens are doing the same thing.
If banks drop Tether for any reason, the Fed won’t lift a finger to help.
What about Yellen? Does her Treasury have issues with Tether?
Tether Is Too Big
U.S. Treasury Secretary Janet Yellen needs a well-functioning U.S. Treasury market. This allows her to borrow the necessary funds to cover annual government deficits in the trillions of dollars. Since 2008, the size of the U.S. Treasury market has ballooned alongside fiscal deficits. The bigger it grows, the more fragile it becomes.
A chart from the U.S. Government Securities Liquidity Index clearly shows declining liquidity in the U.S. Treasury market since the pandemic (higher numbers mean worse liquidity conditions). Only a small amount of selling could disrupt the market. By “disrupt,” I mean bond prices falling rapidly or yields spiking.
Tether is currently one of the 22 largest holders of U.S. Treasuries. If Tether were forced to rapidly sell holdings for any reason, it could throw global bond markets into chaos. I say global because all fiat debt instruments are priced in some way, shape, or form relative to the U.S. Treasury curve.
If Tether’s bank partners cut it off, Yellen might intervene in the following ways:
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Perhaps she would mandate a reasonable wind-down period for Tether to retain its client status, so it wouldn’t be forced to sell assets quickly to meet redemption requests.
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Perhaps she would freeze Tether’s assets, preventing it from selling anything until she deems the market able to absorb Tether’s holdings.
But Yellen certainly wouldn’t help Tether find another long-term banking partner. The growth of Tether and similar stablecoins serving the crypto market poses risks to the U.S. Treasury market.
Perhaps Yellen would side with them if Tether decided to buy unwanted bonds (i.e., long-dated bonds over 10 years maturity) instead of the short-term bills everyone wants. But why would Tether take on duration risk to earn less than shorter-dated Treasuries? That’s due to an inverted yield curve (long rates below short rates).
The most powerful departments within America’s peaceful financial institutions would rather Tether didn’t exist. And it has nothing to do with crypto.
Tether Is Too Rich
Maelstrom’s brilliant analysts created the following speculative balance sheet and income statement for Tether. They combined Tether’s public disclosures with their judgment to produce this result.
Below are eight “Too Big To Fail” (TBTF) banks within the U.S.-led peaceful economic and political system and their net profits for FY2023.
Cantor Fitzgerald isn’t a bank but a primary dealer and trading firm. There are only 23 primary dealer banks. Therefore, in the total deposits column, Cantor’s figure represents the value of assets on its balance sheet. I obtained estimates for Cantor’s net profit and total employees from Zippia.
Tether generates $62 million in revenue per employee. No other bank on the list comes close. Tether’s profitability is another example of how crypto will drive the largest wealth transfer in human civilization history.
Why don’t these TBTF banks offer competing fiat-pegged stablecoins? Tether earns more per employee than any of these banks, yet couldn’t exist without them and others like them.
Perhaps one of these banks could buy Tether instead of de-banking it. But why would they? Certainly not for technology. Due to public blockchain transparency, code to deploy a Tether smart contract clone is already online.
If I were the CEO of a U.S. bank supporting Tether, I’d immediately terminate their accounts and launch a competing product. The first U.S. bank to offer a stablecoin would quickly dominate the market. As a user, holding JPMorgan stock carries less risk than Tether. The former is a liability of a too-big-to-fail bank, essentially an empire. The latter is a liability of a private company, scorned by the entire U.S. banking system and its regulators.
I see no evidence that a U.S. bank is plotting to overthrow Tether. But doing so would be trivial. Why should Tether—a stablecoin owned by crypto puppets lounging in the Bahamas, existing 100% dependent on access to the U.S. banking system—earn more in a few trading days than Jamie Dimon?
As the crypto bull market advances, any stocks unrelated to crypto will rise. A U.S. bank seeing its share price fall due to panic over bad commercial real estate loans could boost its valuation by entering the crypto stablecoin market. This could be all the motivation needed for U.S. banks to finally compete directly with Tether, Circle, etc.
If Circle’s IPO goes smoothly, expect challenges to the banking system. Stablecoin firms like Circle and Tether should trade at low multiples to earnings because they lack competitive moats. The fact that Circle can even pursue an IPO is itself a comedy.
There’s No Mountain Higher…
I’ve just explained why it’s easier for the U.S. banking system to destroy Tether than for Caroline Ellison to beat me at the Math Olympiad. But as a crypto ecosystem, why should we create a different type of fiat-pegged stablecoin?
Thanks to Tether, we know the crypto capital market craves a fiat-pegged stablecoin. The issue is that banks provide poor service because no competition forces them to improve. With Tether, anyone with internet access can make dollar payments 24/7.
Tether has two major problems:
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Users receive no share of Tether’s NIM.
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Even if Tether follows the rules, it could be shut down overnight by the U.S. banking system.
Fairly speaking, users of any currency typically don’t share seigniorage income. Holding physical dollar bills doesn’t entitle you to a share of the Fed’s profits—but you absolutely bear its losses. So USDT holders shouldn’t expect a share of Tether’s NIM. However, one group of users that should be compensated is crypto exchanges.
Tether’s primary use case is as a funding currency for crypto trading. Tether also provides a near-instant way to move fiat between trading venues. Exchanges, as venues for crypto trading, provide utility to Tether but receive nothing in return. There’s no purchasable Tether governance token giving holders claims on NIM. Unless an exchange acquired equity in Tether early somehow, it can’t share in Tether’s success. This isn’t a sad story about why Tether should fund exchanges. Rather, it motivates exchanges to support stablecoin issuers that pass most of the NIM to holders and offer exchanges the chance to buy governance tokens at low valuations during early development.
Simply put, to surpass Tether, you must pay most of the NIM to stablecoin holders and sell cheap governance tokens to exchanges. This is how vampire squids attack physically fiat-backed stablecoins.
Ethena follows this script exactly. USDe holders can stake directly with Ethena and earn most of the NIM. Major exchanges invested in Ethena during early funding rounds. Ethena’s cap table includes Binance Labs, Bybit via Mirana, OKX Ventures, Deribit, Gemini, and Kraken as exchange-partner investors.
In terms of market share represented by these exchanges, they cover roughly 90% of ETH open interest across major exchanges.
How Ethena Works
Ethena is a synthetically backed fiat crypto-dollar.
ETH = Ether
stETH = Lido-staked ETH derivative
ETH = stETH
ETH = stETH = $10,000
ETH/USD perpetual swap contract value = $1 worth of ETH or stETH = 1 / ETH or stETH dollar value
Peg Mechanism
USDe is the stablecoin issued by Ethena, designed to maintain a 1:1 peg with the dollar.
Ethena works with various Authorized Participants (APs). APs can mint and burn USDe at a 1:1 ratio with USD.
Minting:
Currently accepts stETH Lido, Mantle mETH, Binance WBETH, and ETH. Ethena automatically sells ETH/USD perpetual swaps to lock in the dollar value of ETH or ETH LSD. The protocol then mints an equivalent amount of USDe, matching the dollar value of the short perpetual hedge.
Example:
An AP deposits 1 stETH worth $10,000.
Ethena sells 10,000 ETH/USD perps @ $1 contract value = $10,000.
The AP receives 10,000 USDe because Ethena sold 10,000 ETH/USD perps @ $1.
Burning:
To burn USDe, an AP deposits USDe into Ethena. Ethena automatically buys back part of its short ETH/USD perpetual swap position, unlocking a certain dollar value. The protocol then burns the USDe and returns a corresponding amount of ETH or ETH LSD to the AP, based on the unlocked dollar value minus execution fees.
Example:
An AP deposits 10,000 USDe.
Ethena buys back 10,000 ETH/USD perps @ $1 contract value = $10,000.
The AP receives 1 stETH = 10,000 * $1 / $10,000 stETH/USD minus execution fees.
To understand why USDe initially trades at a slight premium to the dollar on stablecoin trading platforms like Curve, I’ll explain why users want to hold USDe.
Dollar Yield
The combination of ETH staking yield and ETH/USD perpetual swap funding equals a high synthetic dollar yield. To earn this yield, USDe holders stake directly with the Ethena app. It takes less than a minute to start earning.
Because sUSDe launched with an extremely high ~30% yield, users holding lower-yielding dollar stablecoins will shift to sUSDe. This creates buying pressure and pushes up the price of USDe in Curve pools. When the premium on USDe becomes large enough, APs step in to arbitrage the spread.
Imagine: 1 USDe = 2 USDT. If an AP can create 1 USDe using ETH or stETH worth $1, they can pocket a risk-free $1 profit. Here’s the process:
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Wire dollars to an exchange.
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Sell $1 for ETH or stETH.
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Deposit ETH or stETH into the Ethena app to receive 1 USDe.
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Deposit USDe into Curve and sell it for 2 USDT.
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Sell 2 USDT for $2 on the exchange and withdraw dollars to your bank account.
If users believe Ethena is safe and the yield is real, in this hypothetical example, circulating USDT would decrease while circulating USDe increases.
UST Yield
Too many in the crypto space believe Ethena will fail like UST. UST was the stablecoin attached to the Terra/Luna ecosystem. Anchor was a decentralized money market protocol in the Terra ecosystem offering 20% APY to stakers of UST. People could deposit UST, and Anchor would lend those deposits to borrowers.
Any stablecoin issuer must convince users why they should switch from (usually Tether) to a new product. High yield is the catalyst for that shift.
UST was backed by Luna, with Bitcoin purchased by selling Luna. Luna was the ecosystem’s governance token. The foundation held most of the Luna supply. Because Luna was expensive, the foundation sold Luna for UST to fund high UST interest payments. The yield wasn’t paid in real dollars but in additional UST tokens earned. While UST maintained its 1:1 peg, the market believed holding more UST meant holding more dollars.
As the total value of UST locked in Anchor grew, so did its UST interest expenses. It became unsustainable for the foundation to keep selling Luna to subsidize Anchor’s UST rewards. The yield relied solely on the market believing Luna should be worth trillions of dollars.
When Luna’s price began to fall, the algorithmic stablecoin’s death spiral began. Because Luna was minted and burned to maintain UST’s 1:1 peg, as Luna depreciated, maintaining the peg became increasingly difficult. Once the peg broke violently, all the UST interest accumulated on Anchor became worthless.
Ethena Yield
USDe generates yield in a completely different way from UST. Ethena holds two yield-generating assets.
Staked ETH:
ETH is staked using liquid staking derivatives like Lido (stETH). stETH earns ETH staking yield. ETH is deposited into Lido. Lido runs validator nodes capitalized by ETH deposits and sends ETH paid by
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Arthur Hayes
