Hedging made easy: discover Pendle Finance

Pendle is an innovative DeFi protocol that utilizes a concept similar to bond stripping to enable people to buy assets at a discount, offer DeFi strategies for hedging interests, and even allow you to go long on an asset’s APY. Pendle supports multiple assets, has over 350 million in volume traded in PendleV1, and recently became cross-chain compatible.   

TradFi 

First, let’s focus on the problem Pendle is tackling and how this normally works in TradFi. Imagine that you deposit crypto on Aave. What is the APY you will receive? It fluctuates. And this can be problematic if you want more predictability. Hence, in TradFi, one uses derivatives to hedge against or profit from such fluctuations.  

In the yield derivative market, yield-based options are among the most essential products. Yield-based options are options contracts where the underlying asset is the yield (interest rate) of a specific fixed-income security, for example, a ten-year treasury. The holder of a yield-based option has the right, but not the obligation (since it's an option), to "trade" this yield at a predetermined strike yield before the contract's expiration date. Investors or companies use yield-based options for various purposes, mostly to speculate or hedge. 

Investors may use yield-based options to speculate on future interest rate movements, so if an investor believes that interest rates will rise or fall, they can buy call or put options to profit from their prediction potentially.  

Companies or investors exposed to interest rate risk can also use yield-based options to protect themselves against adverse interest rate movements. For example, a company with a large amount of debt may purchase put options on bond yields to hedge against the risk of rising interest rates, which could increase their borrowing costs. This is very relevant in the current macro environment as the lack of interest hedging is problematic for banks holding bonds on their ‘hold to maturity’ balances, as we have seen with Silicon Valley Bank (SVB). 

Pendle offers various products that facilitate innovative strategies for managing interest rate fluctuations. To help DeFi mature, it is crucial to provide more DeFi strategies that generate yield in creative and low-risk ways, similar to traditional financial institutions. Pendle addresses this need by tokenizing yield and offering a solution that will be further discussed.

Yield tokenization 

Pendle splits yield-containing assets into a token without yield (like zero coupon bonds in TradFi) and yields components (coupons in TradFi). It does so by utilizing ‘SY’, a token standard created by the Pendle team (EIP-5115). This token standard implements a standardized API for wrapped yield-bearing tokens. Splitting yield can be implemented with well-known tokens such as vault and lending tokens, staking tokens (for example, stETH, sJOE), and notably, LP tokens. As we will see later, splitting yield allows for innovative yield trading opportunities.  

Owners of yield-bearing tokens, like aUSDC, SLP, and gOHM, can deposit their assets into Pendle. This protocol then wraps these yield-generating assets into SY (Standardized Yield), which is, as just explained, a token standard designed to facilitate interaction with an asset’s yield-generating mechanism and consists of the principal and yield components that get created, called Principal Token (PT) and Yield Token (YT).    

It is important to note that the principal token is redeemable after maturity. So, if you strip away the yield from staked ETH and you have the PT, you can hold it to maturity and redeem the PT for staked ETH again. Naturally, this means that the YT is worthless upon maturity as it isn’t yield-bearing anymore, so there are no more coupon payments.Resulting from this, people can basically buy tokens at a discount by only purchasing the PT. The discount for buying a PT disappears in time, and the closer to the maturity date, the closer the price of the PT represents the asset would not have been split.  

By buying the PT, users who are keen to hedge against volatile yields can do so by holding the PT until maturity. The discount for this acquisition is basically your fixed-rate APY because you can redeem the PT against the yield-bearing asset at the end of maturity. As will be discussed later, the PT is an important asset that is integral to the Pendle AMM.  

A Yield Token (YT) embodies the yield aspect of an underlying asset that generates returns. By possessing YT, users gain the right to obtain the yield of the underlying asset, with its rate displayed as "Underlying APY" in the Pendle app, and it can be manually claimed at any time from the Pendle Dashboard.    

Yield tokens present a variety of opportunities for holders. For instance, they can deposit YT into Pendle's AMM to provide liquidity to the protocol and earn swap fees and other Pendle rewards. Furthermore, Pendle allows holders to sell YT in advance for cash, which lets sellers secure immediate profits. In contrast, Pendle users can acquire yield tokens directly, even without owning a yield-generating asset. 

Pendle creates a capital-efficient and effective yield market through yield tokens. Traders can amplify their yield exposure in bullish conditions and safeguard against yield risks during bearish periods. It is essential to remember, though, that YT can be traded only until its expiration, after which it becomes worthless. 

When a yield token reaches maturity, it stops yielding returns. At this point, the YT holder has the option to either redeem the principal token for the underlying asset that generates returns from Pendle or choose a new expiration date. The YT holder must also have the principal token to carry out either choice. Both the PT and YT tokens are tradeable, but since the regular AMM model (constant function market maker) doesn’t consider the time element where a yield token has an expiry date, Pendle had to create its own AMM, which will be discussed next. 

Pendle AMM 

Pendle's V2 AMM is specifically tailored for yield trading, capitalizing on the behaviors of PT and YT.  

Dynamic Curve 

The AMM curve is adapted to accommodate the yield accumulated over time, and as PT approaches maturity, the price range becomes narrower in a predictable way.  

As PT and YT prices naturally change over time and approach maturity, the AMM curve shifts to accommodate for these alterations, ensuring that only interest rate changes are traded, not the individual asset prices. 

The curve adjustment artificially drives the price of the time-depreciating token downward. A time-depreciating pricing model controls the curve shift's behavior, influenced by bond or option pricing models. The pace of price reduction typically accelerates throughout the duration of a contract period.  

These curve shifts also enhance the model's capital efficiency as maturity approaches, considering that PT trades closer to the underlying asset price (e.g. it becomes infinitely capital efficient at maturity, where PT trades 1-to-1 against the underlying asset). Although initially focusing on yield tokens, Pendle's AMM can be used to accommodate any asset exhibiting time-depreciating characteristics. Through Pendle, trading options, bonds, or any agreements with an expiration date become feasible. 

Impermanent loss, a big problem in AMMs, barely exists as there is a high correlation between the assets liquidity providers provide, namely the PT and its corresponding YT.  

Concentrated Liquidity 

Source: Pendle Finance

Yields often exhibit a cyclical pattern, swinging between high and low points like a pendulum. It is generally easier to predict the yield range for a liquid asset than its price, as the floor and ceiling of the yield can be anticipated. For instance, the annual yield for staked ETH might fluctuate within a 3-8% band. Recognizing an asset's approximate yield range allows for liquidity concentration within that specific range. Using the previous example, the V2 AMM can be tailored for the staked ETH range.

This results in a concept similar to UniV3's concentrated liquidity, where liquidity is utilized more efficiently while maintaining fungible LP tokens. Based on simulations in this yield range, Pendle V2 claims to boost capital efficiency by over 70 times, making the pool's liquidity 70 times deeper than a V1 pool of equal size. 

Pendle also allows its users to provide liquidity to Pendle pools. The liquidity providers receive swap fees and other incentives as rewards. Different Pendle pools have varying APYs (Annual Percentage Yields), calculated by trading volume and PENDLE incentives. As will be discussed next, Pendle incentives are determined by the protocol’s governance. 

vePendle 

VePENDLE, the governance token, is responsible for directing Pendle's governance. This token fosters decentralization and stability in the ecosystem while establishing a mechanism for maintaining Pendle's price. Users must stake and lock their Pendle tokens to obtain vePendle, and since there are benefits to holding vePendle, it diminishes sell pressure on the Pendle token. 

Moreover, the value of vePendle and its governance influence relies on the quantity of Pendle staked and the lock-in period's length (up to two years maximum). Over time, the vePENDLE token's value diminishes, reaching zero by the end of the lock-in period. Users can subsequently retrieve their staked Pendle. This is quite similar to most veGOVERNANCE tokens. 

So why hold vePendle? You will be entitled to a proportion of the fees generated on the PENDLE platform, consisting of swap fees and yield fees.  

Pendle's swap fees generally fluctuate based on how close it is to the maturity date. For instance, a 0.1% fee applies to swaps when there's a year left until maturity. This fee increases if the time to maturity is bigger and decreases if the time to maturity shortens. Liquidity providers receive 20% of these fees, while the rest is collected as protocol revenue and distributed among vePendle holders proportionally. 

Pendle collects a 3% yield fee on all yields obtained by YT. This fee is treated as protocol revenue and is divided among vePENDLE holders according to their individual vePENDLE value.  

Incentive channeling is one of the protocol decisions vePENDLE holders make through governance and voting. VePENDLE holders determine the distribution of incentives to different pools, providing rewards to LPs in pools they support. By voting for a pool, vePENDLE owners become eligible to receive 80% of the accumulated swap fees, which are shared proportionally among all pool voters. 

This resulted in protocols bribing for votes to improve their liquidity in Pendle pools, just like in the curve wars, or on many Solidly exchanges.  

Participating in Pendle Finance's governance offers additional advantages. For instance, the LP Reward Boost program augments user incentives (up to 250% based on vePENDLE value) when they supply liquidity and hold vePENDLE simultaneously. 

Liquid staking 

The last important point to mention here is realizing implications, for example, around liquid staking and how the Shanghai upgrade that unlocked staked ETH was one of the main driving factors of interest in Pendle.  

After the Shanghai update, the yield for ETH staking can move up or down. It can increase as stakers leave, so existing stakers get more of the existing pie. Some people bought the YT-stETH as they thought it was undervalued. Implied APY is the market consensus of the future APY of an asset. This value is calculated based on the ratio of the price of YT to PT.

Hence, the expected APY by these buyers of YT-stETH > the implied APY. Remember, you can use the YT token to earn additional swap fees on the AMM of Pendle, so that’s another reason to go long on ETH’s APY if you think it will go up. 

Yield can also move down as the possibility of unstaking results in more stakers (probably through liquid staking), so you get a smaller part of the pie as a staker. Investors in this camp locked down yield by buying the PT, and since that is redeemable at the end of maturity, it is basically a fixed yield exposure on stETH. Simultaneously, the principal token also gives you long exposure to ETH.  

Depending on your risk tolerance and the strategies you choose, this can take single-digit APY’s on assets such as stETH and supercharge them into double-digit APY’s, while possibly having little security risk since you can derisk through Pendle Pro’s yield strategies. You can read more about yield strategies here.

Conclusion 

We think Pendle is a remarkably innovative DeFi protocol that gives investors unique possibilities in trading yield that did not exist before. With more and more protocols tapping into staking and yield becoming a more established aspect in Web3 now Ethereum has successfully transitioned to Proof of Stake, Pendle has a shot to be at the forefront of interest hedging strategies. With the continuous rise in total value locked (TVL) and an ever-growing stream of new users, we will closely monitor Pendle in the future.

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