Abstract: Recently, I have been a bit busy, which has delayed updates for a while. I am now resuming weekly updates and I thank all dear friends for their support. This week, I discovered an interesting strategy in the DeFi field that has received widespread attention and discussion, which is to utilize Ethena's staking yield certificate sUSDe as the income source for the fixed yield certificate PT-sUSDe in Pendle, and use AAVE's lending protocol as the source of funds to conduct interest rate arbitrage and obtain leveraged returns. Some DeFi KOLs on Platform X have made optimistic evaluations of this strategy, but I believe the current market seems to overlook some of the risks behind this strategy. Therefore, I would like to share some insights and experiences with everyone. Overall, the AAVE + Pendle + Ethena PT leveraged mining strategy is not a risk-free arbitrage strategy, and the discount rate risk of PT assets still exists. Therefore, participating users need to objectively assess and control their leverage to avoid liquidation.
Analysis of the mechanism of PT leveraged returns
First, let’s briefly introduce the mechanism of this yield strategy. Friends who are familiar with DeFi should know that DeFi, as a decentralized financial service, has the core advantage of using smart contracts to carry core business capabilities, which provides the so-called 'interoperability' advantage compared to TradFi. Most DeFi experts, or DeFi Degens, generally engage in three main activities:
Discovering arbitrage opportunities between DeFi protocols;
Finding sources of leveraged funds;
Discovering high-interest low-risk yield scenarios;
The PT leveraged return 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 briefly introduce them here. First, Ethena is a yield-bearing stablecoin protocol that captures the short fee rate in the perpetual contract market of centralized exchanges through a Delta Neutral hedging strategy, with low risk. During a bull market, retail investors' demand for long positions is extremely strong, and they are willing to bear higher fee costs, resulting in higher yields, of which sUSDe is its yield certificate. Pendle is a fixed-rate protocol that decomposes the floating yield rate yield certificate token into a Principal Token (PT) similar to a zero-coupon bond and a yield certificate (YT) through synthetic assets. If investors are pessimistic about future interest rate changes, they can lock in the interest rate level for a certain period by selling YT (or buying PT). AAVE, on the other hand, is a decentralized lending protocol where users can use specified cryptocurrencies as collateral to borrow other cryptocurrencies from AAVE, thus achieving leverage, hedging, or shorting effects.
This strategy is precisely an integration of three protocols, using the staking yield certificate sUSDe from Ethena as the income source for the fixed yield certificate PT-sUSDe in Pendle, and leveraging AAVE's lending protocol as the source of funds to conduct interest rate arbitrage and gain 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 use a looping loan method to borrow USDe or other stablecoins, repeating the above strategy to increase capital leverage. The yield calculation is primarily determined by three factors: the base yield rate 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 largest lending protocol by capital volume, which released the financing capacity of PT assets. In fact, before this, other DeFi protocols had already supported PT assets as collateral, such as Morpho and Fuild, but AAVE, with its more abundant lending funds, can offer lower borrowing rates, amplifying the yield of this strategy, and AAVE's decisions are more symbolically significant.
Since AAVE supported PT assets, staking funds have rapidly increased, which also indicates that this strategy has gained recognition from DeFi users, especially some whale users. Currently, AAVE supports two types of PT assets: PT sUSDe July and PT eUSDe May, with a total supply now reaching approximately $1B.
Currently, the maximum leverage multiples supported can be calculated based on its E-Mode's Max LTV. Taking PT sUSDe July as an example, this asset's Max LTV as collateral in E-Mode is 88.9%, which means that through looping loans, the leverage ratio can theoretically reach about 9 times. The specific calculation process is shown in the diagram below. In other words, when leverage is maximized, not considering gas and the costs of looping loans or fund exchanges, using the sUSDe strategy as an example, the theoretical yield of the strategy can reach 60.79%. Moreover, this yield does not include Ethena's point rewards.
Next, let’s look at the actual distribution of participants. Taking the PT-sUSDe liquidity pool on AAVE as an example, a total supply of 450M has been provided by 78 investors, indicating a high proportion of whales and significant leverage.
Looking at the top four addresses, the first account 0xc693...9814 has a leverage ratio of 9 times, with a principal of about 10M. The second account 0x5b305...8882 has a leverage ratio of 6.6 times, with a principal of about 7.25M. The third account analytico.eth has a leverage ratio of 6.5 times, with a principal of about 5.75M. The fourth account 0x523b27...2b87 has a leverage ratio of 8.35 times, with a principal of about 3.29M.
Therefore, it can be seen that most investors are willing to allocate higher capital leverage for this strategy. However, I believe the market may be overly aggressive and optimistic. This emotional and cognitive bias regarding risk can easily lead to large-scale liquidation. So, let's analyze the risks of this strategy next.
The risk of discount rate cannot be ignored
The author has noticed that most DeFi analysis accounts 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 mainly fall into two categories:
Exchange rate risk: When the exchange rate between collateral and the borrowing target decreases, there will be liquidation risk. This is relatively easy to understand because, in this process, the collateralization ratio will decrease.
Interest rate risk: When borrowing rates rise, it may lead to an overall negative yield for the strategy.
Most analyses 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 price de-pegging risk is low. Therefore, as long as the borrowing target is of stablecoin type, the exchange rate risk is low. Even if de-pegging occurs, as long as the borrowing target is USDe, the relative exchange rate will not experience a significant decline.
However, this judgment overlooks the special nature of PT assets. We know that the most critical function of a lending protocol is to ensure timely liquidation to avoid bad debts. However, PT assets have the concept of a duration, and during this duration, if one wants to redeem the principal asset early, it can only be done through the AMM secondary market provided by Pendle for discount trading. Therefore, trading will affect the price of PT assets, or rather, the yield of PT, which means that the price of PT assets is constantly changing with trading, but the general direction will gradually approach 1.
After clarifying this characteristic, let's look at AAVE's oracle design scheme for PT asset pricing. In fact, before AAVE supported PT, this strategy mainly relied on 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's duration, PT assets will earn returns relative to the native assets at a fixed interest rate, ignoring the impact of market trading on interest rates. This means that the exchange rate of PT assets relative to native assets will continue to increase linearly. Therefore, the exchange rate risk can naturally be ignored.
However, AAVE believes that this is not a good choice during the research process for the oracle solution for PT assets, as this solution locks the yield during the life of the PT asset 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 market sentiment is bullish on interest rate changes in the short term, or if there is a structural increase in the underlying yield (e.g., a surge in incentive token prices, new yield distribution schemes, etc.), it may lead to the oracle price of PT assets in Morpho being significantly higher than the real price, which can easily result in bad debts. To mitigate this risk, Morpho usually sets a benchmark interest rate that is much higher than the market rate, which means that Morpho actively lowers the value of PT assets and sets a more generous volatility space, which in turn leads to low capital utilization.
In order to optimize this issue, AAVE adopted an off-chain pricing solution that enables the oracle prices to follow the structural changes in PT interest rates as closely as possible while avoiding short-term market manipulation risks. Here, we will not discuss the technical details. There is a dedicated discussion on this issue in AAVE's forum, and interested friends can also discuss with me on X. Here, I will present the possible price-following effects of PT Oracle in AAVE. It can be seen that in AAVE, the oracle price behaves similarly to a piecewise function, following market interest rates. This is more efficient in terms of capital compared to Morpho's linear pricing model and also better alleviates bad debt risks.
So this means that if the interest rate of PT assets undergoes structural adjustments or if market sentiment on interest rate changes is consistent in the short term, the AAVE Oracle will follow this change. Therefore, this introduces discount rate risk for the strategy. That is to say, if the PT interest rate rises for some reason, the price of PT assets will fall accordingly, and the excessively high leverage ratio of this strategy may lead to liquidation risk. Therefore, we need to clarify the pricing mechanism of the AAVE Oracle for PT assets in order to rationally adjust leverage and effectively balance risk and reward. Here are some key features listed for everyone to consider:
1. Due to the mechanism design of Pendle AMM, liquidity will concentrate towards the current interest rate over time. This means that price changes brought by market trading will become less and less noticeable, or in other words, slippage will decrease. Therefore, as the expiration date approaches, the price changes caused by market behavior will become smaller and smaller. In response to this characteristic, AAVE Oracle sets the concept of heartbeat to indicate the frequency of price updates. The closer it is to the expiration date, the larger the heartbeat, and the lower the update frequency, which means that the discount rate risk is lower.
2. The AAVE Oracle will follow a 1% interest rate change as another adjustment factor for price updates. When the market interest rate deviates from the oracle rate by 1% and the deviation exceeds the heartbeat duration, a price update will be triggered. Therefore, this mechanism also provides a time window for timely leverage adjustments to avoid liquidation. Thus, for users of this strategy, it is essential to monitor interest rate changes and adjust leverage accordingly.
#AAVE #PENDL #ethena $AAVE $PENDLE
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