Beware of discount rate risks: mechanisms and risks of PT leveraged income flywheels from AAVE, Pendle, Ethena

Author: @Web3_Mario

I have been a little busy recently, so I have delayed the update for a while. Now I will resume the frequency of weekly updates. I would like to thank all my close friends for their support. This week, an interesting strategy in the DeFi field has attracted widespread attention and discussion, that is, using Ethena's pledge income certificate sUSDe in Pendle's fixed income certificate PT-sUSDe as the source of income, and using the AAVE lending agreement as the source of funds, interest rate arbitrage and leveraged income. Some DeFi Kols on the X platform have made relatively optimistic comments on this strategy, but the author believes that the current market seems to ignore some of the risks behind this strategy. Therefore, I have some experiences and share them with you. In general, the PT leverage mining strategy of AAVE+Pendle+Ethena is not a risk-free arbitrage strategy, where the discount rate risk of PT assets still exists, so participating users need to objectively evaluate, control the leverage ratio, and avoid overturning positions.

Analysis of the mechanism of PT leveraged income

First, let’s briefly introduce the mechanism of this income strategy. Friends who are familiar with DeFi should know that, as a decentralized financial service, the core advantage of DeFi is the so-called “interoperability” advantage brought by using smart contracts to carry core business capabilities. Most DeFi proficient people, or DeFi Degen, usually have three work contents:

1. Discover interest rate spread arbitrage opportunities between DeFi agreements;
2. Find sources of leveraged funds;
3. Explore high interest rates and low risk returns scenarios;

The PT leveraged return strategy reflects these three characteristics more comprehensively. This strategy involves three DeFi protocols, Ethena, Pendle, and AAVE. These three are popular projects in the current DeFi track, so I will only give a brief introduction here. First of all, Ethena is an income stablecoin protocol that captures short fees in the perpetual contract market in centralized exchanges with low risk through Delta Neutral's hedging strategy. In a bull market, because retail investors have extremely strong long demand, they are willing to bear higher rate costs, so the strategy has a higher rate of return, where sUSDe is its earnings certificate. Pendle is a fixed interest rate agreement. By synthesizing assets, the income certificate token of the floating rate of return is broken down into Principal Token (PT) and the income certificate (YT) with zero-interest bonds. If investors are pessimistic about future interest rate changes, they can lock in the interest rate level in the future in advance by selling YT (or buying PT). AAVE is a decentralized lending protocol, where users can use the designated cryptocurrency as collateral and lend other cryptocurrencies from AAVE to achieve the effects of increasing capital leverage, hedging or short selling.

This strategy is the integration of three protocols, namely, the fixed income certificate PT-sUSDe in Pendle, which uses Ethena's pledge income certificate sUSDe as the source of income, and uses the AAVE lending agreement as the source of funds to conduct interest rate arbitrage and obtain leveraged returns. The specific process is as follows. First, the user can obtain sUSDe at Ethena and completely exchange it for PT-sUSDe through the Pendle protocol to lock the interest rate. Next, deposit PT-sUSDe into AAVE as collateral, and lend USDe or other stablecoins through revolving loans, repeat the above strategy, and increase capital leverage. The calculation of returns is mainly determined by three factors: the basic rate of return of PT-sUSDe, the leverage multiple, and the interest rate spread in AAVE.

The market status and user participation of this strategy

The popularity of this strategy can be traced back to the recognition of PT assets as collateral by AAVE, the lending agreement with the largest amount of funds, which unleashed the financing capabilities of PT assets. In fact, before this, other DeFi protocols had already supported PT assets as collateral, such as Morpho, Fuild, etc., but AAVE can provide lower borrowing interest rates with more abundant loanable funds, amplifying the yield of this strategy, and AAVE's decisions are more iconic.

Therefore, since AAVE supports PT assets, pledged funds have increased rapidly, which also shows that this strategy has been recognized by DeFi users, especially some giant whale users. Currently, AAVE supports two types of PT assets, PT sUSDe July and PT eUSDe May, and the total supply has reached about $1B.

The maximum leverage multiple currently supported can be calculated based on the Max LTV of its E-Mode. Taking PT sUSDe July as an example, the Max LTV of this asset as collateral in E-Mode mode is 88.9%, which means that through revolving loans, the leverage ratio can theoretically be achieved about 9 times. The specific calculation process is shown in the figure below. That is to say, when the leverage is maximum, without considering the flash loan or fund exchange costs brought by Gas and revolving loans, taking the sUSDe strategy as an example, the theoretical return rate of the strategy can reach 60.79%. And this yield does not include Ethena points rewards.

Next, let’s take the PT-sUSDe fund pool on AAVE as an example. The total supply of 450M is provided by 78 investors. It can be said that giant whales account for a very high proportion and have a large leverage ratio.

Judging from the top four addresses, the leverage ratio of the first 0xc693...9814 account is 9 times, and the principal is about 10M. The leverage ratio of the second 0x5b305...8882 account is 6.6 times, the principal is about 7.25M, the leverage ratio of the third 0x523b27...2b87 account is 8.35 times, the principal is about 3.29M.

Therefore, it can be seen that most investors are willing to allocate higher capital leverage for this strategy. However, the author believes that the market may be a bit too radical and optimistic. This deviation in sentiment and risk perception will easily lead to large-scale stampede liquidation. Therefore, let’s analyze the risks of this strategy.

Discount rate risk cannot be ignored

The author sees that most DeFi analysis accounts will emphasize the low-risk characteristics of this strategy, and even claim to be a risk-free arbitrage strategy. However, this is not the case. We know that there are two main risks of leveraged mining strategies:

1. Exchange rate risk: When the exchange rate of collateral and loan subjects becomes smaller, there will be liquidation risk, which is easier to understand because the mortgage rate will become lower in this process.
2. Interest rate risk: When the borrowing interest rate rises, it may lead to a negative overall return on the strategy.

Most analyses will believe that the exchange rate risk of this strategy is extremely low, because as a more mature stablecoin protocol, USDe has experienced the market test and the risk of deaning the price is lower. Therefore, as long as the borrowing target is stablecoin type, the risk of the exchange rate is lower. Even if the deaning occurs, as long as the borrowing target is USDe, the relative exchange rate will not drop significantly.

However, this judgment ignores the particularity of PT assets. We know that the most critical function of the lending agreement is to achieve timely liquidation to avoid bad debts. However, there is a concept of a duration of PT assets. During the duration of NT, if you want to redeem the principal assets in advance, you can only conduct discount transactions through the AMM secondary market provided by Pendle. Therefore, the transaction will affect the price of PT assets, or the PT rate of return. Therefore, the price of PT assets is constantly changing with the transaction, but the general direction will gradually approach 1.

After clarifying this feature, let’s take a look at the oracle design plan for PT asset price by AAVE. In fact, before AAVE supported PT, the strategy mainly used Morpho as a source of leveraged funds. In Morpho, the price oracle for PT assets adopted a design called PendleSparkLinearDiscountOracle. Simply put, Morpho believes that during the bond period, PT assets will obtain returns at a fixed interest rate relative to native assets, and ignore the impact of market transactions on interest rates. This means that the exchange rate of PT assets relative to native assets is increasing linearly. Therefore, the redemption rate risk can naturally be ignored.

However, in the research process of the PT asset oracle scheme, AAVE believes that this is not a good choice, because the plan locks in the yield rate during the PT asset's lifetime and cannot be adjusted, which means that the model actually cannot reflect the impact of market transactions or changes in the underlying yield rate on PT price. If market sentiment is bullish on interest rate changes in the short term, or the underlying yield shows a structural upward trend (such as a sharp rise in the price of incentive tokens, new income distribution plans, etc.), it may cause the oracle price of PT assets in Morpho to be much higher than the real price, which is easy to lead to bad debts. In order to reduce this risk, Morpho usually sets a benchmark interest rate far higher than the market interest rate, which means that Morpho will actively lower the value of PT assets and set up a more abundant volatility space, which will in turn lead to the problem of low capital utilization.

In order to optimize this problem, AAVE adopted an off-chain pricing solution, which can make oracle prices follow the pace of structural changes in PT interest rates as much as possible, and can avoid short-term market manipulation risks. We will not discuss technical details here. There are discussions specifically on this issue in AAVE forum. Interested friends can also discuss it with the author on X. Here we will only present the possible price of PT Oracle in AAVE as the effect. It can be seen that in AAVE, Oracle's price performance will be similar to the segmented function, following market interest rates. This has higher capital efficiency compared to Morpho's linear pricing model, and it also better alleviates bad debt risks.

So this means that if the interest rate of PT assets is structurally adjusted, or if the market has a consistent direction for interest rate changes in the short term, AAVE Oracle will follow this change, so this introduces discount rate risk to the strategy, that is, assuming that the PT interest rate rises for some reason, the price of PT assets will decrease accordingly, and the excessive leverage ratio of this strategy may have liquidation risks. Therefore, we need to clarify the pricing mechanism of AAVE Oracle for PT assets in order to rationally adjust leverage and effectively balance risk and return. Here are some key features for everyone to think about:

1. Since in the mechanism design of Pendle AMM, liquidity will be concentrated towards the current interest rate over time, this means that the price changes brought about by market transactions will become less and less obvious, and it can be said that the slippage will become smaller and smaller. Therefore, as the expiration date approaches, the price changes brought about by market behavior will become smaller and smaller. In view of this feature, AAVE Oracle has set the concept of heartbeat to represent the frequency of price updates. The closer the expiration date, the larger the hearingbeat, the lower the update frequency, that is, the lower the discount rate risk.

2. AAVE Oracle will follow a 1% interest rate change as another adjustment factor for price updates, which will trigger price updates when market interest rates deviate by 1% from Oracle interest rates and the deviation time exceeds hearingbeat. Therefore, this mechanism also provides a time window for timely adjustment of the leverage ratio and avoiding liquidation. Therefore, for users of this strategy, try to monitor interest rate changes and adjust the leverage ratio as much as possible.