Ethena: The best choice for synthetic dollars in the on-chain encryption ecosystem.

As the footsteps of winter giving way to spring quicken, I want to revisit the article "Dust on the Crust" published a year ago. In this article, I proposed how to create a fiat stablecoin that exists without relying on traditional banking systems, supported by human input. My idea is to combine the long and short perpetual futures contract positions in cryptocurrency to create a synthetic fiat currency unit. I named it "Nakadollar" because I envision using Bitcoin and XBTUSD's perpetual short futures contracts as a way to create a synthetic dollar. At the end of the article, I pledged to do my best to support a credible team in bringing this idea to fruition.

The changes in a year are significant. Guy is the founder of Ethena. Before creating Ethena, Guy worked at a hedge fund with a market value of $60 billion, investing in special areas such as credit, private equity, and real estate. During the DeFi Summer that started in 2020, Guy discovered the Shitcoin problem, and from then on, it became uncontrollable. After reading the book "Dust on Crust," he had the idea of launching his own synthetic dollar. But like all great entrepreneurs, he wanted to improve on my original idea. He aimed to create a synthetic dollar stablecoin that uses ETH instead of BTC. At least that was the case at the beginning.

The reason Guy chose ETH is that the Ethereum network provides native yield. To ensure security and process transactions, Ethereum network validators directly pay a small amount of ETH for each block through the protocol. This is what I mean by ETH staking yield. Furthermore, since ETH is now a deflationary currency, there are fundamental reasons for the continuous premium in ETH/USD forwards, futures, and perpetual swaps compared to spot. Short perpetual swap holders can capture this premium. Combining physical ETH staking with short positions in ETH/USD perpetual swaps can create a high-yield synthetic dollar. As of this week, the annual yield of spot ETH in USD (sUSDe) is approximately >50%.

Without a capable team to execute, even the best ideas are just empty talk. Guy named his synthetic dollar "Ethena" and has assembled a star team to launch the protocol quickly and securely. In May 2023, Maelstrom became a founding advisor, and in exchange, we received governance tokens. In the past, I have worked with many high-quality teams, and the staff at Ethena do not take detours and excel in completing tasks. Fast forward 12 months, Ethena's stablecoin USDe officially launched, and just three weeks after going live on the mainnet, the issuance has approached 1 billion tokens (TVL is $1 billion; 1 USDe = $1).

Let me put aside my knee pads and discuss frankly the future of Ethena and stablecoins. I believe Ethena will surpass Tether to become the largest stablecoin. This prophecy will take many years to realize. However, I would like to explain why Tether is both the best and the worst business in cryptocurrency. It is considered the best because it may be the financial intermediary that earns the most for every employee in TradFi and cryptocurrency. It is considered the worst because the existence of Tether is to please its poorer traditional banking partners. The jealousy of banks and the issues that Tether brings to the guardians of the peaceful financial system in the United States could potentially spell disaster for Tether.

To all the misguided Tether FUDsters, I want to make it clear. Tether is not a financial fraud, nor has it lied about its reserves. Furthermore, I have great respect for those who founded and operate Tether. However, in my opinion, Ethena will disrupt Tether.

This article will be divided into two parts. First, I will explain why the Federal Reserve, the U.S. Department of the Treasury, and large U.S. banks with political connections want to destroy Tether. Secondly, I will delve into Ethena. I will briefly introduce how Ethena is built, how it maintains its peg to the U.S. dollar, and its risk factors. Finally, I will provide a valuation model for Ethena's governance token.

After reading this article, you will understand why I believe Ethena is the best choice for providing synthetic dollars in the cryptocurrency ecosystem on-chain.

Note: Physically backed fiat stablecoins refer to coins where the issuer holds fiat currency in a bank account, such as Tether, Circle, First Digital, etc. Synthetic backed fiat stablecoins refer to coins where the issuer hedges cryptocurrency holdings with short-term derivatives, such as Ethena.

Envy, jealousy, and hatred

Tether (code: USDT) is the largest stablecoin by token circulation. 1 USDT = 1 dollar. USDT is sent between wallets on various public chains such as Ethereum. To maintain the peg, Tether holds 1 dollar in bank accounts for each unit of USDT in circulation.

If there is no US dollar bank account, Tether will not be able to fulfill its functions of creating USDT, holding the US dollars that support USDT, and redeeming USDT.

Creation: Without a bank account, USDT cannot be created, as traders have no place to send their US dollars.

Dollar Custody: If you don't have a bank account, there is nowhere to store the USDT-supported dollars.

Redeeming USDT: Without a bank account, you cannot redeem USDT because there is no bank account to send dollars to the redeemer.

Having a bank account is not enough to ensure success, as not all banks are equal. There are thousands of banks worldwide that can accept dollar deposits, but only certain banks hold master accounts with the Federal Reserve. Any bank that wants to clear dollars through the Federal Reserve to fulfill its dollar correspondent banking obligations must hold a master account. The Federal Reserve has complete discretion over which banks can obtain a master account.

I will briefly explain how the agent bank business works.

There are three banks: Bank A and Bank B are headquartered in two non-U.S. jurisdictions. Bank C is a U.S. bank that has a master account. Banks A and B wish to transfer U.S. dollars within the fiat financial system. They each apply to use Bank C as their correspondent bank. Bank C assesses the client base of both banks and approves them.

Bank A needs to remit 1000 dollars to Bank B. The fund flow is 1000 dollars transferred from Bank A's account at Bank C to Bank B's account at Bank C.

Let's make a slight modification to the example by adding Bank D, which is also a U.S. bank with a master account. Bank A designates Bank C as its correspondent bank, while Bank B designates Bank D as its correspondent bank. Now, if Bank A wants to remit $1000 to Bank B, what will happen? The flow of funds is that Bank C transfers $1000 from its account at the Federal Reserve to Bank D's account at the Federal Reserve. Bank D ultimately deposits the $1000 into Bank B's account.

In general, banks outside the United States use correspondent banks to wire transfer US dollars globally. This is because when dollars flow between different jurisdictions, they must be settled directly through the Federal Reserve.

I started to get involved with cryptocurrency in 2013. Generally, the banks where cryptocurrency exchanges store fiat currency are not registered banks in the United States, which means they need to rely on a U.S. bank with a master account to handle fiat deposits and withdrawals. These smaller non-U.S. banks are eager for deposits and banking business from cryptocurrency companies because they can charge high fees without paying any interest on deposits. Globally, banks are typically eager to obtain cheap dollar funding since the dollar is the global reserve currency. However, these smaller foreign banks must interact with their correspondent banks to handle dollar deposits and withdrawals outside their location. While correspondent banks tolerate these fiat flows associated with cryptocurrency businesses, for whatever reason, sometimes certain cryptocurrency clients are excluded from small banks at the request of the correspondent bank. If small banks do not comply with regulations, they risk losing their correspondent relationships and their ability to transfer dollars internationally. Banks that lose dollar liquidity are like zombies. Therefore, if the correspondent bank requests, small banks will always abandon cryptocurrency clients.

When we analyze the strength of Tether's banking partners, the development of this agency banking business is crucial.

Tether's banking partners:

• Britannia Bank & Trust
• Cantor Fitzgerald
• Capital Union
• Ansbacher
• Deltec Bank and Trust

Among the five listed banks, only Cantor Fitzgerald is a bank registered in the United States. However, none of these five banks have a Federal Reserve master account. Cantor Fitzgerald is a primary dealer that helps the Federal Reserve execute open market operations, such as buying and selling bonds. Tether's ability to transfer and hold US dollars is entirely subject to the whims of the intermediary banks. Considering the size of Tether's US Treasury bond portfolio, I believe their partnership with Cantor is crucial for continuing to enter this market.

If the CEOs of these banks do not negotiate to obtain equity in Tether in exchange for banking services, then they are fools. You will understand the reason when I later introduce Tether's per capita income metrics.

This covers the reasons why Tether's banking partners have underperformed. Next, I would like to explain why the Federal Reserve dislikes Tether's business model, and fundamentally, why this is related to the operation of the dollar money market rather than to encryption.

Full Reserve Banking

From the perspective of traditional finance, Tether is a full-reserve bank, also known as a narrow bank. A full-reserve bank only accepts deposits and does not issue loans. The only service it provides is remittance. It hardly pays any interest on deposits because depositors do not face any risk. If all depositors demand to withdraw their money at the same time, the bank can immediately meet their requests. Therefore, it is referred to as "full-reserve." In contrast, the loans of fractional-reserve banks exceed their deposits. If all depositors demand a refund from a fractional-reserve bank at the same time, the bank will collapse. Fractional-reserve banks pay interest to attract deposits, but depositors face risks.

Tether is essentially a fully-backed dollar bank that offers dollar trading services powered by public chains. That's it. No loans, no funny business.

The Federal Reserve does not dislike full-reserve banks because of who their customers are, but because of how these banks handle their deposits. To understand why the Federal Reserve detests the full-reserve banking model, I must discuss the mechanisms of quantitative easing (QE) and its effects.

Banks collapsed during the 2008 financial crisis because they did not have enough reserves to cover the losses from bad mortgages. Reserves are the funds that banks hold at the Federal Reserve. The Federal Reserve monitors the level of bank reserves based on the total amount of outstanding loans. After 2008, the Federal Reserve ensured that banks would never lack reserves. The Federal Reserve achieved this goal by implementing QE.

QE is the process by which the Federal Reserve purchases bonds from banks and credits the reserves held by the Federal Reserve to the banks. The Federal Reserve's QE bond purchases amounting to trillions of dollars have led to an expansion of bank reserve balances. Great!

Quantitative easing has not caused rampant inflation in a noticeable way like the COVID stimulus checks did, because bank reserves remain at the Federal Reserve. The COVID stimulus measures were given directly to the public for discretionary use. If banks lend out these reserves, the inflation rate would immediately rise post-2008, as that money would be in the hands of businesses and individuals.

The existence of fractional reserve banks is to issue loans; if banks do not issue loans, they cannot make money. Therefore, under the same conditions, fractional reserve banks are more willing to lend reserves to paying customers rather than leaving them at the Federal Reserve. The Federal Reserve faces a problem. How can they ensure that the banking system has nearly infinite reserves while avoiding inflation?