Collateral Risk

Context

Given Ethena Labs uses stETH and other LSTs to margin the delta hedging derivatives positions, the integrity and confidence in those assets is paramount. "Collateral Risk" in this context refers to the fact that are collateral asset for USDe (stETH) differs to the underlying asset of the perpetual futures position (ETH).

On day one, Ethena will solely use Lido's stETH. Longer-term, Ethena is agnostic to Ethereum LSTs, however as it stands today, the stETH market share looks to be winning in a winner's take-all market. Lido stETH dominates in terms of ETH staked as well as liquidity on ETH Layer 1.

As our collateral asset, stETH, is different to the underlying asset of the hedging contracts, ETH, we need to ensure the price difference between those two assets is as small as possible. This is accomplished by supporting LST assets with the least chance of depegging and broad industry support.

We hope to onboard several different LSTs in the near future, but we need not only the quality of liquidity to improve for alternatives but also the ability to use the LST as a margin collateral asset on exchanges.

As we discussed in the liquidation risk section, we are comfortable that due to low leverage and tighter collateral haircuts, the impact of a stETH depeg is minimal to our hedged positions and the possibility of liquidation is extremely unlikely.

Overview

Therefore there are two functional risks that are front of mind:

1. Staking / Unstaking from ETH <-> LST

2. Loss of confidence in the integrity of the LST

1. Staking / Unstaking from ETH <-> LST

Users' ability to stake ETH with Lido and to receive 1:1 stETH:ETH ensures the price of the two assets do NOT typically diverge. Prices between stETH:ETH could begin to slightly diverge if there is a greater demand to stake/unstake ETH/stETH than available either via the Lido exit queue or external markets enabling swaps (Curve, Bybit, etc).

At this point in time, all protocols reliant on stETH (and any ETH LST), accept this liquidity risk profile. This means the amount of stETH that can be unstaked with Lido might be subject to delay or the user may have to accept a slight discount if required to trade immediately in external markets.

Approved users of Ethena are able to redeem USDe for stETH (or any ETH LST) at any time on-demand or request an alternate asset and tap Ethena's ability to access multiple pools of liquidity.

The stETH-ETH Curve pool is the most liquid source of liquidity for stETH with a TVL of $200m as of October 2023. Any user is able to swap stETH <-> ETH if they do not wish to wait for the Lido stETH validator exit queue.

stETH-ETH Curve Pool TVL

LST liquidity on CeFi Exchanges is low, with about $2m of stETH depth within 2% of the mid-price. Greater stETH liquidity across multiple liquidity sources would help reduce the risk related to the Lido validator exit queue delay potential.

Ethena is actively working with CeFi & DeFi exchange partners as well as Lido to support & motivate increasing liquidity to ameliorate this issue.

2. Loss of confidence in the integrity of the LST

The loss of confidence in the integrity of an LST might occur because of the discovery of a critical smart contract bug in the LST. In this event, users would all likely attempt to unstake or swap out of the LST for alternative collateral as quickly as possible. This would likely lead to long exit validator queues with protocols, such as Lido, as well as liquidity drying up on DeFi and CeFi Exchanges.

Ethena Labs actively monitors the integrity of the ecosystem as well as maintains strong relationships with CeFi & DeFi exchanges in combination with other sources of liquidity. Given capital preservation is front of mind, Ethena would proactively swap from the LST to a stable store of collateral in the extremely unlikely event an LST's smart contract is discovered to have a critical flaw that cannot be remediated by their treasury or it's backers.

While we are philosophically overweight on stETH as a collateral asset, we would note that this is a common trend throughout DeFi. Lido's stETH is now a more widely used collateral asset than ETH across many of DeFi's biggest "blue chip" protocols.

If a more serious issue were to happen to Lido stETH, the whole of DeFi would be exposed - issues would not be isolated to just Lido and Ethena, and an Ethereum hard fork might be a realistic outcome if Lido and stETH collapsed.