Since the Shanghai upgrade, DeFi market capitalization rose more than 60% in the first half of 2023, driven by LSDs. Liquid Staking have surpassed decentralized exchanges and lending protocols as the top DeFi category by TVL. This has created a series of DeFi protocols built on LSD - LSDFi.

LSDFi protocols constantly evolve to offer users higher yields and more risk appetite options. In this article we are going to introduce you Pendle Finance, a protocol emerging from the latest LSDFi narrative.

Pendle, which went live in 2021, recently rode the LSD wave to a TVL of over $100 M. Pendle is an interest rate swap protocol based on future interest-bearing assets that allow users to execute various yield management strategies based on their risk appetite.

Yield Tokenization

Pendle splits the value of future interest-bearing assets into PT (Principal Token) and YT (Yield Token), where PT represents the principal, and YT represents the yield.

For example, if you deposit 100 DAI into the Compound protocol, you will get “credentials” of 100 cDAI. After 3 months, you can use 100 cDAI to return the principal of 100 DAI and the interest of 1 DAI and get a reward of 0.5 COMP.

With Pendle, you can split the interest-bearing asset cDAI into PT-cDAI and YT-cDAI, with PT representing the principal amount of 100 DAI and YT representing the income generated in 3 months, 1 DAI + 0.5 COMP.

PTs and YTs have an “expiration date” attribute, so the full representation of PTs and YTs should include the expiration date - for example, PT-cDAI-20240101 and YT-cDAI-20240101, with an expiration date (in this case) of January 1st, 2024.

Benefits of PT and YT

You can mint interest-bearing assets as PT and YT, with PT giving the user the right to redeem the principal before the maturity date and YT giving the user the right to earn income from the present until the maturity date. PT and YT can be traded separately to complete price discovery in the market, while PT and YT combined can redeem the principal and interest when they are not due.

Use-cases for PT

Principal token holders purchased PT at a discount compared to its value before it mature. Users buy PT at a discount, then buy futures corresponding to the principal amount: Buying 100 PT-cDAI-20240101, users purchase the equivalent of 100 DAI on January 1st, 2024.

Therefore, buying PTs at a discount is a futures-type investment. The closer users get to maturity, the lower the discount rate becomes, and the closer the price of PT is to its corresponding principal value.

Buying PT is equivalent to get a fixed interest rate.

Use-cases for YT

Holding YT allows users to have the right to earn on the corresponding principal. There are many ways to cash out the income rights of YT. If the income is settled in real-time, users can receive the fixed income at any time just by holding YT.

If the income is settled after maturity, users can only receive the income with YT after maturity, but can also sell YT halfway to realize the unsettled income. After the income corresponding to YT has been collected, YT will become invalid and will no longer have value.

YT provides users with income leverage. If there is no YT and users want to obtain staking income, they must buy a complete LSD. With YT, users can save the cost of purchasing principal and directly purchase income rights, improving the efficiency of capital use. But it’s also a double-edged sword, and YT could cost users money if the yield falls short of expectations.

Swap of PT and YT

PT offers users a fixed interest rate, while YT offers a variable interest rate.

If users are not risk oriented, they can swap YT for PT after minting PT and YT, and they will have a fixed rate. On the other hand, if their risk appetite is high, they can swap PT for YT and get a variable rate. This is the simple way to describe Pendle as an interest-rate swap protocol.

Pendle AMM

Pendle offers also an AMM (Automated Market Maker) Pool to support the buying and selling of PTs and YTs, called Pendle AMM.

Pendle only offers a dual asset pool for primary interest-bearing assets and corresponding PTs, but through this pool, trading of YT can also be completed.

For example, Pendle will provide a pool of cDAI/PT-cDAI for cDAI, through which users can swap between cDAI, PT-cDAI, and YT-cDAI anytime.

If users need to sell YT-cDAI, Pendle AMM will borrow an equal amount of PT-cDAI from the market in the form of a lightning loan, combine it with YT-cDAI to form cDAI, and then sell some of the cDAI in a swap for PT-cDAI to repay the lightning loan.

If users, on the other hand, need to use cDAI to buy YT-cDAI, Pendle AMM will borrow more cDAI through lightning loans and then mint all cDAI into PT-cDAI and YT-cDAI and sell PT-cDAI to cDAI to repay the lightning loan.

In short, Pendle allows the dual asset pool of PT-cDAI and cDAI to support the swap between cDAI, PT-cDAI, and YT-cDAI assets through a clever design.

If you want to understand better the whole Pendle AMM mechanism, you can see the official documentation HERE.

Liquidity Incentives

Pendle AMM liquidity providers will receive a swap fee incentive and a $PENDLE incentive. This depends on how much Pendle incentive each pool gets from the pool’s voting weight in the Gauge vote. This model is pretty similar to the ones applied by Curve or Balancer, as they use this approach to drive liquidity.

For a more thorough understanding, you can refer to how Balancer’s Gauge voting works, which we explain in this Article.

Pendle AMM also offers a Zap In feature, which allows users to provide liquidity to Pendle AMM with one click as long as they have ETH, WETH, or ETH LSD (such as vETH), eliminating the need for extra swap operations.

Summary

Pendle provides users with various viable income management strategies through creative design. By splitting interest-bearing assets into PT, YT and supporting swaps between PT, YT, and the original interest-bearing assets, Pendle gives users a variety of options to

• Hold PT for a fixed interest rate
• Hold YT for a variable interest rate
• Buy YT for yield leverage
• Trade and arbitrage PT and YT based on interest rate expectations

Bifrost, as one of the leading LSD protocol, with its strong focus on vToken integration, will soon be launching a partnership with Pendle to offer users the opportunity to earn a five-fold return in LSDFi.

Stay tuned!