The Art of Trading: How They Profit from Arbitraging USDE Stocks

Original Title: The USDE mNAV Trade Original Author: Starkiller Capital

Editor’s Note: If a company holds $1 worth of token assets but its stock market value is only 32 cents, how can it profit from this discount?

The approach taken by the digital asset quantitative investment firm Starkiller Capital is to buy shares of StablecoinX (NASDAQ: USDE) while shorting an equivalent amount of ENA, the token held by the company. This way, even if both the stock and the token are declining, as long as the stock drops less, the profits from the short position are expected to outweigh the losses from the stock.

Starkiller has already executed this strategy once. According to their disclosure, back in August of this year, each $1 of ENA held by StablecoinX was valued at only about 18 cents. At that time, Starkiller bought the company’s stock. As the discount narrowed, the market valuation of each $1 of ENA rose to about 60 cents, and the firm sold its accumulated stock position to lock in profits. Later, the stock price fell faster than ENA, and the discount expanded again to 32 cents for every $1 of assets, prompting Starkiller to enter the market with a larger position.

In this new round of positioning, Starkiller is focused on an additional buyback path that will open up after the lockup period ends. On October 5, the lockup restrictions on ENA held by StablecoinX were lifted. The company can sell ENA to fund a stock buyback plan approved by the Ethena Foundation. At the then-current price, for every $1 of ENA sold, the company could buy back approximately $3.13 worth of token assets in stock. The company uses some of the tokens, but the number of shares decreases faster, meaning the remaining shares correspond to an increased amount of ENA.

Whether this trade can make money again depends on whether the stock can outperform ENA. The buyback may drive the discount narrower, but StablecoinX has no redemption mechanism, and shareholders cannot exit based on the value of their assets, which means the discount could persist for a long time. The upcoming third-quarter report (10-Q) will be worth watching to see if the company announces a specific buyback plan and how many shares it intends to repurchase.

Here is the original text:

Anyone who has spent a few years in the cryptocurrency market remembers GBTC. For most of 2022, you could buy Bitcoin at a significant discount through Grayscale, with discounts sometimes exceeding 40%. Those who bought in at the discount and waited until GBTC converted to an ETF made money.

Right now, a similar opportunity is emerging that is smaller in scale and has lower liquidity but potentially higher profits.

StablecoinX (stock code: USDE) is a digital asset treasury company (DAT) that holds about 20% of the total ENA supply. As of last Friday's close, the stock price was $6.43, with each share corresponding to 125.48 ENA, valued at $20.10. This means that each $1 of ENA costs only 32 cents, effectively buying a batch of tokens worth $485 million for $155 million.

Six weeks ago, Ethena granted this treasury company an exemption, lifting the lock on all these tokens. The lock was originally the main reason for the stock's discounted trading. The market had long anticipated that the exemption would be approved. Before the exemption was granted, USDE's mNAV rose from 0.15 to 0.61, and then fell sharply to 0.32.

Starkiller has held this trade since August when the mNAV was 0.18. Later, we rebalanced our position, taking profits on the accumulated USDE position at 0.60. Over the past six weeks, as the mNAV fell along with the entire crypto market, we re-entered the position, this time with a larger size. We are making this research public, clearly with our own interests in mind. We are very confident about how irrational the current market pricing is, so we are willing to speak out and hope that like-minded peers can benefit from it.

Next, we will explain the logic and risks of this trade as clearly as possible.

Some Background

StablecoinX went public in June through a merger with a special purpose acquisition company, TLGY. Ethena has positioned it as an investment vehicle for ENA in the public market, following the model of Bitcoin and Ethereum treasury companies. The company also has a small-scale infrastructure business, which is currently negligible in valuation, with revenue of $62,000 in the last two weeks of June. At the end of the second quarter, the company had about $19 million in cash and about $18 million in liabilities. Therefore, from a practical valuation perspective, this company is essentially a batch of ENA, and it can be valued accordingly.

Before proceeding, let’s be clear: we generally believe that digital asset treasury companies are poor investments and that they have little reason to exist at this point. In fact, USDE has little reason to exist as well. It has not brought actual value to the ecosystem, and the discount relative to its net asset value shows that it is generally not a good tool for holding beta exposure.

However, we will set aside these views and look at it through the lens of mNAV, which is the company’s market value divided by the market value of the ENA it holds. The stock price equals the ENA price multiplied by the number of ENA per share, multiplied by the mNAV. By hedging the price exposure of ENA, what remains is this multiple, and that is what we are trading.

The Discount Made Sense Initially, but the Situation Changed

For most of the time after going public, this stock was significantly discounted for good reason. According to the token purchase agreement, about half of the ENA must be gradually unlocked over 48 months, with full unlocking not occurring until 2029. Additionally, each sale requires approval from the Ethena Foundation. As of October 4, there were still 1.56 billion ENA locked.

The market's pricing at that time was quite rational. Measured solely by the value of unlocked ENA, from late August to early October, this stock traded around 1 times. Investors were willing to pay full price for the tokens that the company could actually utilize, while the remaining tokens were valued at zero.

Then, on September 14, Ethena and the foundation signed a letter waiving all lockup restrictions, effective October 5. Overnight, the value of the unlocked ENA per share rose from $14.82 to $30.28. The stock price rose from $14.15 to $14.96.

If the market had continued to price USDE based on the previously unlocked ENA, the stock price should have roughly doubled. The reality is that the gray line turned into the blue line, and the valuation multiple slid from 0.49 to 0.32.

Why Did the Discount Widen Instead?

Because by October, the market fell. Bitcoin dropped 7%, and ENA fell 29%. When the entire market is declining, no one is going to sit down and recalculate the net asset value of a small-cap treasury company. Investors are cutting back on their crypto asset exposure, and USDE is precisely that type of exposure.

The stock price fell harder than the token for several reasons. Many holders bought USDE to go long on ENA through their brokerage accounts. So when they wanted to exit their ENA positions, they would sell USDE. USDE is also one of the least liquid assets among these investors' holdings. The company has a market cap of only $155 million, with a daily trading volume of about 1 million shares, so once investors reduce their total exposure, the price of this position can easily gap down.

Shorts also increased their positions. The number of shorted shares increased by 78%, reaching about 2.8 million shares, accounting for about 15% of the free float.

These changes did not affect the ENA held by the company. The company still holds the 3.029 billion tokens from September, and each one can be used to fund stock buybacks. The reason for the stock price drop is unrelated to the assets supporting its value, which is precisely the kind of discount we are willing to buy.

The valuation multiple follows the beta of the crypto market, but there is another side to it. When the market warms up, the multiple often rebounds as well. In August and September, as ENA rose, the valuation multiple increased from 0.15 to 0.61, as those investors who treated USDE as a substitute for ENA bought back in. In October, the same mechanism operated in reverse. Once the market turned, those who had sold stocks to reduce their beta exposure would come back to buy.

After the token unlock, the company still needs foundation approval to sell tokens. The key is that the waiver letter pre-approved what it calls “financing sales,” and one of the explicitly listed purposes in the letter is to buy back stock according to the foundation-approved 10b5-1 plan.

How to Narrow the Discount

Buying back stock at a price below net asset value is the best way for this type of investment vehicle to increase per-share net asset value. At a valuation of 0.32, the accretion effect is particularly pronounced. For every $1 of ENA sold for buybacks, the company can cancel stock corresponding to $3.13 of ENA assets, leaving $2.13 of net asset value for the remaining shareholders. Based on last Friday's price, using one-third of the treasury assets could buy back all outstanding Class A shares.

This does not even require selling ENA in the open market. The letter grants the foundation the right to purchase any ENA the company intends to sell. Therefore, the foundation can take these tokens off-market, and the company can use the cash received to cancel shares, meaning ENA holders do not have to bear this selling pressure.

Will they do this? I believe all parties' interests point in this direction. The CFO stated in the second-quarter earnings announcement that narrowing the gap between the company’s market cap and the value of its assets is a priority. The company also changed its CEO in September. Ethena is promoting USDE to users of BlackRock's Aladdin platform, Janus Henderson, and Coinbase. If the publicly traded stock representing its own token exposure is trading at only one-third of the corresponding token value, it does not help related negotiations. The foundation was not obligated to sign a waiver letter explicitly listing the purposes of stock buybacks, but it did.

The next observation point is the third-quarter 10-Q report, which should be submitted by November 16 at the latest. This will be the first quarterly filing after the waiver letter was signed.

How to Build a Position

Go long on USDE and short ENA, with equal nominal dollar amounts on both sides. Many people make a mistake at this step. You do not need to short 125 ENA for every share bought. Under unchanged valuation multiples, the percentage changes in stock and ENA are one-to-one, so the dollar nominal amounts on both sides should be equal when hedging.

We short ENA through perpetual contracts, so funding fees need to be considered in the budget. However, since we established this trade, the funding rate for ENA perpetual contracts on Hyperliquid has remained positive, as it has for the past six weeks. USDE has a daily trading volume of about 1 million shares on NASDAQ.

If the trade develops as expected, the market value of the long position will grow faster than the nominal amount of the short position, so you will need to rebalance, or you will end up with a net long exposure to ENA. Of course, in a rising market, if you are willing to take on a bit of beta risk from the cumulative gains brought by revaluing mNAV, that could actually work in your favor. We did this from August to October and made money, but it requires timing.

If the ENA price remains unchanged, here are the approximate returns calculated based on the long nominal amount, not accounting for funding fees and trading costs. The total exposure on both long and short sides is twice the long nominal amount.

Even if the valuation does not return to 1 times, this trade can still yield considerable returns. As long as it returns to the level on the day the lock was lifted, the long side has a 56% return. We believe this stock should ultimately trade at 0.7 times mNAV. Many other treasury companies trade at this level, some even with a large amount of tokens still locked.

Several short-term catalysts have already been listed, but in reality, this is a very difficult arbitrage trade to time. Considering the valuations of comparable companies and the fact that holding this trade can yield about 5% returns, which is half of the positive funding rate earned by ENA shorts, a more reasonable approach is to hold this position continuously and wait for the catalysts to materialize.

Where Things Might Go Wrong

There is no mechanism to force the discount to narrow. The company has no redemption mechanism, and GBTC serves as a reminder in this regard. Its significant discount persisted for two years until it converted to an ETF.

The foundation controls the exit path. Selling tokens requires foundation approval, one of the three seats on the investment committee is designated by the foundation, and it also controls the voting rights of Class B shares. If the foundation never approves a buyback, the discount could remain at this level indefinitely.

The market also faces potential selling pressure. An S-1 registration statement has registered about 12.7 million shares for resale by existing shareholders, which is more than half of the total Class A shares. These shareholders can sell when the stock price rebounds.

The discount could also widen further. The mNAV at the time of the stock's listing was 0.36, and it dropped as low as 0.13 in July. In October, the company itself had no issues, yet the mNAV still fell from 0.49 to 0.32.

Warrants could cause dilution when the stock price rises. There are 11.5 million listed warrants with an exercise price of $11.50. Additionally, there are about 7.6 million warrants held by the sponsors, with exercise prices of $11.50 and $15.00, respectively. These warrants are currently out of the money but will limit the upside potential of the stock price.

The crypto market could also crash directly. At that point, investors might simply deem the ENA held by USDE worthless and believe that the value of this asset can never be realized, thus pushing the mNAV back down to its lows.

Conclusion

For three consecutive months, the market priced this stock based on the ENA that the company could actually sell. Subsequently, all ENA became sellable, and the company also had a pre-approved buyback path, allowing it to buy back stock worth $1 at 32 cents, yet the market gave a lower valuation. We have held this trade since August, and at the level of 0.32, we are more optimistic about it than when we first entered.