The pathodology of ETHUSD Perpetual
Date: 03.07.2024
In this post, I explore the currently existing paradox of ETHUSD perpetual and how it is used by cryptocurrency company Ethena to obtain almost risk-free interest that exceedes the currently available bank interest rates.
ETHUSD Perpetual
We have to start with explaining what is the ETHUSD Perpetual. ETHUSD Perpetual is a futures contract on the ETHUSD, meaning that the person selling the contract (short position) agrees to give the buyer of the contract (long position) 1 ETH at the set day in a future. However, in the case of the perpetual, the date never comes. The seller will never have to give the buyer the ETH. Instead, since this is a futures contract, the seller and buyer have to keep margin accounts and transfer money to each other according to the value of the contract. If the value of 1 ETHUSD Perpetual goes from 3000\$ to 4000\$. The short position has to pay the long position 4000-3000=1000\$. If the price goes back down to 3000\$, the long has to pay to short the 1000\$ back. Natually, the price of the ETHUSD contract should equal to the price of ETH. To ensure this, the exchanges which offer the contract employ the funding rate mechanism.
Funding rate mechanism
The funding rate mechanism's main advertised goal is to ensure that the price of the perpetual follows the price of the underlying asset, in this case the Ethereum. In essence, if the price of contract exceedes the price of the ETH, the long position (holder of the contract) has to pay the short position. Consequently, this incentives the market to sell the contract and thus bring the price of the contract down, closer to ETH. If the price of the contract trails the price of ETH, the short position has to pay the long, incentivising the market to buy the contract and as a result increasing the price of the perpetual.
There is however another important goal of the funding rate mechanism that is the transfer of value to due passive income from assets/money i.e. ETH and US dollars. Since the holder of the contract obtains the value of 1ETH without actually paying it, they effectively borrow US dollars worth of ETH. Therefore, they should pay the interest on that implied loan equal to the current interest rate of US dollars. Fair enough, this is exactly the case. Binance, for example, specifies that the funding rate (percentage of value to be paid every 8 hours from shorts to longs) is
$$ \text{Funding Rate} = \text{Premium Index} - clamp(\text{Premium Index} - \text{Interest Rate}, \pm 0.05\%), $$
where Premium Index measures the difference between the price of the contract and the ETH. Thus, if the price difference is low, then the funding rate equals the interest rate. On Binance, this is true for most of the time.
Pathodology no. 1: Binance USD interest rate is very high
Binance advertises that the interest rate only includes the interest rate on dollars and sets it to 0.01%. Seemingly small, however since the interest corresponds to an 8-hour period, the 0.01% every eight hours gives annual effective rate of 11.57%! The current FED Funds rate is 5.5% which means that interest on dollars through the ETHUSD perpetuals is over twice as high.
The internet bond
Now, all is nice but shorting ETHUSD Perpetual makes the holder of the short position vulnerable to unbouded risk due to ETH volatility. These 11.57% comes at a cost, right? Cue in, the internet bond.
An internet bond is an ingenious position in which one simultaneously holds the asset and the short position on the perpetual of the asset. Since the perpetual follows the movement of the asset and thus the value of the internet bond is not affected by the fluctuations in the price of the asset.
For example, if ETH goes from 3000\$ to 4000\$, the holder has 1000\$ from the price change but at the same time has to pay 1000\$ to the long position of the ETHUSD perpetual. If ETH goes from 3000\$ to 1500\$, the holder losses 1500\$ in the value of ETH but receives the same amount from the holding the short position on the perpetual. The net change is 0.
Pathology no. 2: Perpetuals assume no passive income from ETH
The funding rate set by Binance, assumes that holding ETH provides no passive income. That was true in the past but is not now, not since ETH switched from Proof-Of-Work to Proof-Of-Stake. Currently, the holder of ETH can stake their coins to validate transactions which in turn provides them with income from the transaction costs. As of now, staking ETH can provide around 3% annual interest. Adding this to the exorbitantly high dollar interest rate, we obtain effective interest rate of 14.57%!
Ethena
Now, this is genius and Ethena is the company which does just that. It created a synthetic dollar which is essentially the internet bond based on the ETHUSD perpetual. The stability of the bond ensures the stability of the coin. Furthermore, the client can stake their Ethena dollars (USDe's) to gain passive interest from the funding rate.
It is worth noting, that non-staked USDe does not generate passive income to the holder. And while Ethena does not receive income from staking the corresponding ETH, they still do receive money from the funding rate.
Also, interestingly, Ethena is backed by all major exchanges: Binance, OKX, Bybit and Derbit which supply the ETHUSD perpetuals.
Conclusions
The ETHUSD based internet bond a very smart way to generate almost risk-free (exchange failure risk) income that greatly exceedes the interest rates available at any commercial bank. Furthermore, any individual with the right amount of ETH can recreate the position on their own without ever having to deal with a company like Ethena.
Clearly, the situation is out-of-ordinary and its profitability will at some point end. The interest rate may be offset by the price difference of the contract and the ETH - this starts to materialise as the price ETH is on average 1\$ higher than the price of the contract. Still, it is difficult to offset passive income with one-off fee to enter the bond. (Note that in this case, anyone who entered the position when the price of the contract was equal to the price of ETH can liquidate the internet bond at a profit.)
Likely, in the future the interest rate on the ETHUSD perpetual will be corrected from 11.5% to the true 2.5% i.e. the difference between dollar and staked ETH interest rate.This will be driven by the fact that the holders of the long position will no longer accept the 11% rate on the dollar and the loss of the 3% available to the holders of ETH. As the perpetual is sold off, this will drive the funding rate negative, decreasing the profit and incentivising the holders of the internet bond to close the position.