Author: Andre Cronje
Translator: Zombit
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 been more curious about, and there are some events that I completely did not anticipate.
Regarding UST, I was very convinced from the beginning that it would fail because its mechanism simply didn’t make sense to me. However, many people whom I consider very intelligent firmly believed that it would not fail, which made me start to question, “Am I wrong?” As for FTX, I have to admit that I did not expect it to close. 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 closure of FTX was something I did not foresee. I use this opening to express that many times I actually don’t know the answer.
However, now there is a new infrastructure that is receiving a lot of attention. I see it being integrated into a protocol (probably referring to Maker) that I consider to have low risk. But 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 name and criticize, I want to ask those who are smarter than me, where did I go wrong in my understanding? I have read all available documents and evaluations by others, but I still can’t see how the risk is being mitigated.
First, let me introduce the components:
Perpetual contracts – In regular spot trading, you simply 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 more like a directional bet rather than a trade.
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 aligns with their spot prices (this mechanism is similar to borrowing rates). In order to maintain your position, you need to provide collateral, which is essentially used to “fund” your “funding rate debt.” If the funding rate becomes negative, it will erode your collateral until your position is closed.
Collateral – The next part of this mechanism is “yield-bearing collateral,” which refers to assets that increase in value simply by holding them. In this example, it is stETH. If I have 1 stETH, I am going long on stETH. So, if I open a short perpetual contract on stETH worth $1000, I am (theoretically) “neutral.” Because even if I lose $100 on the short stETH, I gain $100 on the long stETH.
Mechanism – The theory here is that by purchasing $1000 worth of stETH and using it as collateral to open a $1000 short position on stETH, you achieve “Delta neutrality” and also benefit from stETH yields (around 3%) and any funding rates charged.
I am not a trader, at best 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 the basic knowledge I have, namely collateral and debt. Based on my experience, eventually, you need to close (no longer neutral) or get liquidated. And now the hypothetical theory I found in Ethena is that “when the market trend changes, positions can be easily closed,” but that’s a bit like saying “buy Bitcoin only when it goes up and sell when it goes down.” Although it sounds intuitive, it is almost impossible to do in practice.
So even though everything looks good now (because the market is positive and the funding rate for shorts is positive, as everyone is willing to go long), this will eventually change, and the funding rate will become negative, collateral will be liquidated, and you will have an asset with no value support.
I see the counter-argument to this issue as the “law of large numbers,” but this 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 wise people in the X community to help me understand where I went wrong and what I missed. Leptokurtic, the founder of Ethena, commented under my tweet on AC, saying, “These are not the concerns of the Middle Curve. You correctly pointed out the risks that do exist here. I will prepare a longer response with some thoughts before the end of this week.”
