In the aftermath of Terra's dramatic $60 billion collapse, the crypto world has been scrambling for a stablecoin design robust enough to avoid repeating history's biggest digital asset meltdown. A contender, albeit lesser known than juggernauts like USDT and USDC, is the novel "synthetic dollar" USDe from upstart Ethena Protocol - and it may just represent one of crypto's most ingenious stablecoins yet.

Chart: Constitution of the global stablecoins market
Source: DefilLama

The Fatal Flaws of Algorithmic Stablecoins

Unlike Terra's ill-fated UST stablecoin, which relied on an algorithmic peg to maintain its dollar valuation, Ethena's USDe takes an entirely different approach that avoids the pitfalls of projects like UST.

"The Ethena team learned from Terra's collapse that relying solely on smart contracts and burning/minting mechanisms isn't enough," explains Martin Dinger, who leads stablecoins research at Kryptico. "These purely algorithmic approaches proved too complex and fragile when subjected to extreme market conditions."

The risks of such overly complex algorithmic designs were laid bare when UST's peg imploded in May 2022, catalyzing a spiralling bank run that quickly drained over $60 billion in value from the Terra ecosystem. The washout event underscored the need for more robust stablecoin architectures if crypto dollars are to achieve true, lasting stability and adoption.

The Delta Hedging Engine

Ethena's solution forgoes complex algorithms entirely in favor of a synthetic approach leveraging Ethereum's deep liquidity and composability. At its core, USDe achieves its price stability by requiring all new tokens to be minted by depositing Ether (ETH) into Ethena's collateral pool. But rather than stopping there like typical overcollateralized stablecoins, Ethena layers on an elegant hedging strategy to further shield the peg.

As ETH is deposited, the protocol simultaneously takes out short positions in Ether derivatives like futures contracts. If Ethereum's price falls, these short bets become profitable - offsetting any inflation caused by the collateral pool's depreciation.

"They’re bringing the battle-tested hedging strategies of legacy finance to DeFi to create the first-ever stable synthetic dollar," says Dinger of Ethena's delta hedging engine.

This active hedging approach is a stark departure from typical passive over-collateralization. It leverages crypto's composability to enhance resiliency using classic financial risk mitigation techniques honed over decades in traditional markets.

"USDe brings the full backing of real assets while still capturing DeFi's core benefits like composability," Dinger adds.

Scaling Quickly

While dollar-backed stablecoins like USDT and UDSC continue to lead the stablecoins narrative, the combination of Ethereum collateralization and dynamic delta hedging has quickly captured investors' attention. Within months of its February 2024 launch, USDe skyrocketed to become the 5th largest stablecoin by market cap at over $2.3 billion.

Chart: Adoption speed of major USD-domiciled assets
Source: X

One driver has been major integrations bringing USDe's earning opportunities to the mainstream. In May, leading crypto derivatives exchange Bybit announced support for trading BTC and ETH perpetual futures using USDe as collateral.

The integration allows traders to simultaneously earn Ethena's 15.3% APR paid out in USDe itself. As Bybit highlighted, the move "unlock[s] greater capital efficiency" by letting users collect yield streams while trading - a compelling use case beyond just HODLing.

According to Ethena, implementations like Bybit's are just the beginning for USDe's utility. Thanks to its decentralized architecture, the synthetic dollar can be freely integrated into any DeFi application, serving as a fully functional dollar to power lending, borrowing, payments and more.

Ethena believes its protocol represents the best of both worlds: the familiarity and resilience of real-world financial strategies fused with crypto's benefits of programmability and composability.

Image source: Metaverse Post