Author: @Web3_Mario
Summary: Recent work has been somewhat busy, resulting in a delay in updates for a period of time. We are now resuming the weekly update frequency, and I appreciate the support from all my dear friends. This week, I discovered an interesting strategy in the DeFi field that has received widespread attention and discussion, which is to use Ethena's staking yield certificate sUSDe as the source of income in Pendle's fixed income certificate PT-sUSDe, and leverage the AAVE lending protocol as the source of funds to conduct interest rate arbitrage and obtain leveraged returns. Some DeFi Key Opinion Leaders on platform X have made relatively optimistic evaluations of this strategy, but I believe the current market seems to overlook some risks behind this strategy. Therefore, I would like to share some insights with you all. Overall, the AAVE + Pendle + Ethena's PT leveraged mining strategy is not a risk-free arbitrage strategy, and there is still the risk of discount rate associated with PT assets. Therefore, participating users need to objectively assess and control leverage to avoid liquidation.
Analysis of the mechanism of PT leveraged returns
First, let’s briefly introduce the mechanism of this yield strategy. Friends familiar with DeFi should know that DeFi, as a form of decentralized financial service, has the core advantage of utilizing smart contracts to carry core business capabilities, offering the so-called 'interoperability' advantage compared to TradFi. Most DeFi experts, or DeFi Degens, usually have three main tasks:
1. Explore arbitrage opportunities between DeFi protocols;
2. Find sources of leveraged funds;
3. Identify high-interest low-risk yield scenarios;
The PT leveraged yield strategy comprehensively reflects these three characteristics. This strategy involves three DeFi protocols: Ethena, Pendle, and AAVE. All three are popular projects in the current DeFi track, and I will provide a brief introduction. First, Ethena is a yield-based stablecoin protocol that uses a Delta Neutral hedging strategy to capture low-risk short rates in perpetual contract markets on centralized exchanges. During bull markets, due to the extreme demand from retail investors to go long, they are willing to bear higher cost rates, resulting in higher returns for this strategy, with sUSDe being its yield certificate. Pendle is a fixed-rate protocol that, through synthetic assets, breaks down the yield certificates of floating yield rates into Principal Tokens (PT) and Yield Tokens (YT), allowing investors who are pessimistic about future interest rate changes to lock in the interest rate level for a period of time by selling YT (or buying PT). AAVE, on the other hand, is a decentralized lending protocol where users can use specified cryptocurrencies as collateral and borrow other cryptocurrencies from AAVE to achieve effects like increasing capital leverage, hedging, or shorting.
This strategy is an integration of three protocols, using Ethena's staking yield certificate sUSDe as the source of income in Pendle's fixed income certificate PT-sUSDe, and leveraging the AAVE lending protocol as the source of funds to conduct interest rate arbitrage and obtain leveraged returns. The specific process is as follows: first, users can obtain sUSDe from Ethena and fully exchange it for PT-sUSDe through the Pendle protocol to lock in the interest rate. Next, they can deposit PT-sUSDe into AAVE as collateral and borrow USDe or other stablecoins through circular lending, repeating the above strategy to increase capital leverage. The calculation of returns is mainly determined by three factors: the base yield rate of PT-sUSDe, the leverage multiple, and the interest rate spread in AAVE.
The current market status of this strategy and user participation
The popularity of this strategy can be traced back to the recognition of PT assets as collateral by AAVE, the largest lending protocol by capital volume, which released the financing capability of PT assets. In fact, before this, other DeFi protocols had already supported PT assets as collateral, such as Morpho, Fluid, etc., but AAVE, with its more abundant borrowable funds, can provide lower borrowing rates, amplifying the yield of this strategy, and AAVE's decisions are more emblematic.
Since AAVE started supporting PT assets, the amount of staked funds has rapidly increased, which also indicates that this strategy has received recognition from DeFi users, especially some whale users. Currently, AAVE supports two types of PT assets, PTsUSDe July and PTeUSDe.
Currently, the total supply has reached approximately $1B.
Currently, the maximum leverage multiple supported can be calculated based on its E-Mode Max LTV. Taking PT sUSDe July as an example, this asset has a Max LTV of 88.9% in E-Mode mode, meaning that through circular lending, the leverage ratio can theoretically reach about 9 times. The specific calculation process is shown below, indicating that when leverage is at its maximum, not considering Gas, flash loans, or costs of fund exchanges, the theoretical yield of the sUSDe strategy could reach 60.79%. Moreover, this yield does not include Ethena points rewards.
Next, let's look at the actual distribution of participants, still taking the PT-sUSDe liquidity pool on AAVE as an example. The total supply of 450M is provided by 78 investors, indicating a high proportion of whales, and the leverage ratios are not small.
Looking at the top four ranked addresses, the first address 0xc693...9814 has a leverage ratio of 9 times, with a principal amount of about 10M. The second address 0x5b305...8882 has a leverage ratio of 6.6 times, with a principal amount of about 7.25M, the third address analytico.eth has a leverage ratio of 6.5 times, with a principal amount of about 5.75M, and the fourth address 0x523b27...2b87 has a leverage ratio of 8.35 times, with a principal amount of about 3.29M.
Hence, it can be seen that investors are mostly willing to allocate higher capital leverage for this strategy. However, I believe that the market may be overly aggressive and optimistic. This emotional and risk perception deviation can easily lead to large-scale liquidation cascades. Therefore, let’s analyze the risks of this strategy next.
Discount rate risk should not be ignored
I have noticed that most DeFi analysis accounts tend to emphasize the low-risk characteristics of this strategy, even branding it as a risk-free arbitrage strategy. However, this is not the case. We know that the risks of leveraged mining strategies primarily fall into two categories:
1. Exchange rate risk: When the exchange rate between collateral and the loan object decreases, there will be liquidation risk. This is relatively easy to understand, as this process will lower the collateralization ratio.
2. Interest rate risk: When borrowing rates increase, it may lead to the overall yield rate of the strategy becoming negative.
Most analyses will argue that the exchange rate risk of this strategy is extremely low because as a relatively mature stablecoin protocol, USDe has undergone market tests, and its risk of decoupling from the price is low. Therefore, as long as the loan object is a stablecoin type, the risk of the exchange rate is low. Even if decoupling occurs, as long as the loan object is USDe, the relative exchange rate will not experience a significant decline.
However, this judgment overlooks the uniqueness of PT assets. We know that the most critical function of lending protocols is to ensure timely liquidation to avoid bad debts. However, PT assets have the concept of duration. During the duration, if one wants to redeem the principal asset early, it can only be done through discounted trading in the secondary market provided by Pendle's AMM. Therefore, trading will affect the price of PT assets, or in other words, affect PT yield. Thus, the price of PT assets is continuously changing with trades, but the general direction will gradually approach 1.
After clarifying this characteristic, let's look at AAVE's price oracle design plan for PT assets. In fact, before AAVE supported PT, this strategy primarily used Morpho as the source of leveraged funds. In Morpho, the price oracle for PT assets uses a design called PendleSparkLinearDiscountOracle. Simply put, Morpho believes that during the bond's duration, PT assets will earn returns relative to native assets at a fixed interest rate, ignoring the impact of market trading on interest rates, which means that the exchange rate of PT assets relative to native assets is continuously increasing linearly. Therefore, discount rate risk can naturally be ignored.
However, during the research process for the oracle solution targeting PT assets, AAVE believes that this is not a good choice because this plan locks the yield during the PT asset's duration and cannot be adjusted. This means that the model cannot reflect the impact of market trading or changes in the underlying yield of PT assets on PT prices. If the market sentiment is bullish regarding interest rate changes in the short term, or if the underlying yield shows a structural upward trend (for example, due to a surge in incentive token prices, new distribution schemes, etc.), it could lead to the oracle price of PT assets in Morpho being significantly higher than the actual price, easily resulting in bad debts. To reduce this risk, Morpho typically sets a benchmark interest rate much higher than the market rate, which means that Morpho actively lowers the value of PT assets and creates a wider fluctuation space, which can lead to low capital utilization issues.
To optimize this issue, AAVE adopts an off-chain pricing solution to ensure that the oracle prices can follow the structural changes in PT interest rates while avoiding short-term market manipulation risks. Here, we will not discuss technical details, as there are dedicated discussions in AAVE's forum regarding this issue. Interested friends can also discuss it with me on X. Here, I will present the possible price following effect of PT Oracle in AAVE. It can be seen that the Oracle price in AAVE will resemble a piecewise function, following market interest rates. This has higher capital efficiency compared to Morpho's linear pricing model and also alleviates bad debt risks effectively.
This means that if the interest rate of PT assets undergoes structural adjustments, or if there is a consensus direction in the market regarding interest rate changes in the short term, AAVE Oracle will follow this change. Therefore, this introduces discount rate risk for the strategy, assuming that if the PT interest rate increases for some reason, the price of PT assets will decrease accordingly. The excessively high leverage ratio of this strategy may lead to liquidation risk. Thus, we need to clearly understand AAVE Oracle's pricing mechanism for PT assets to rationally adjust leverage and effectively balance risk and return. Here, I will list some key features for everyone to consider:
1. Due to the mechanism design of Pendle AMM, liquidity will concentrate towards the current interest rate over time, which means that the price changes caused by market trading will become less and less obvious, or we can say that slippage will become smaller. Therefore, as the maturity date approaches, the price changes caused by market behavior will become smaller and smaller. To address this characteristic, AAVE Oracle has introduced the concept of heartbeat to indicate the frequency of price updates. The closer it gets to the maturity date, the larger the heartbeat, and the lower the update frequency, which means that the risk of discount rate is lower.
2. AAVE Oracle will regard a 1% change in interest rate as another adjustment factor for price updates. When the market interest rate deviates from the Oracle rate by 1% and the deviation time exceeds the heartbeat, it will trigger a price update. Thus, this mechanism also provides a time window for timely adjustment of leverage to avoid liquidation. Therefore, for users of this strategy, it is essential to monitor interest rate changes and adjust leverage accordingly.
