Beware of discount rate risks: the mechanisms and risks of the PT leverage yield flywheel of AAVE, Pendle, and Ethena.

The PT leveraged mining strategy of AAVE+Pendle+Ethena 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 the leverage ratio to avoid getting liquidated.

**Written by: **@Web3_Mario

Summary: Recently, the work has been a little busy, so the update has been delayed for a period of time, and now the frequency of weekly updates is resumed, and I thank you for your support. This week, I found an interesting strategy in the DeFi space that has received a lot of attention and discussion, that is, using Ethena's staking yield certificate sUSDe in Pendle's fixed income certificate PT-sUSDe as the source of income, and using the AAVE lending protocol as the source of funds to carry out interest rate arbitrage and obtain leveraged income. Some DeFi KOLs on the X platform have made more optimistic comments about this strategy, but the author believes that the current market seems to ignore some of the risks behind this strategy. Therefore, I have some experience to share with you. In general, AAVE+Pendle+Ethena's PT leveraged mining strategy is not a risk-free arbitrage strategy, in which the discount rate risk of PT assets still exists, so participating users need to evaluate objectively, control the leverage ratio, and avoid liquidation.

Analysis of the Mechanism of PT Leverage Profits

First, let me briefly introduce the mechanism of this yield strategy. Friends familiar with DeFi should know that DeFi, as a decentralized financial service, has a core advantage over TradFi, which is the so-called "interoperability" advantage brought by leveraging smart contracts to carry core business capabilities. Most DeFi experts, or what we call DeFi Degens, usually have three main areas of work:

1. Explore arbitrage opportunities between DeFi protocols;
2. Find sources of leveraged funds;
3. Explore high-yield, low-risk income scenarios;

The PT leveraged income strategy reflects these three characteristics more comprehensively. The strategy involves three DeFi protocols, Ethena, Pendle, and AAVE. All three of them are popular projects in the current DeFi track, and we will only briefly introduce them here. First of all, Ethena is a yield-based stablecoin protocol that captures short positions in the perpetual contract market on centralized exchanges with low risk through Delta Neutral's hedging strategy. In a bull market, the strategy has a higher yield due to the extremely strong long demand of retail investors and their willingness to incur higher fee costs, with sUSDe being its income certificate. Pendle is a fixed-rate protocol that decomposes the floating yield certificate token into Principal Token (PT) and Income Certificate (YT) with a zero-coupon bond similar to a zero-coupon bond by synthesizing assets. AAVE, on the other hand, is a decentralized lending protocol that allows users to use specified cryptocurrencies as collateral and lend other cryptocurrencies from AAVE to achieve effects such as increasing capital leverage, hedging, or shorting.

This strategy is an integration of three protocols, namely using Ethena's staking yield certificate sUSDe as the source of income through 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 acquire sUSDe from Ethena and fully convert it into the PT-sUSDe fixed rate through the Pendle protocol. Next, they deposit PT-sUSDe into AAVE as collateral and, through a loop lending method, borrow USDe or other stablecoins, 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 multiplier, and the interest spread in AAVE.

Market Status and User Participation of This Strategy

The popularity of this strategy can be traced back to AAVE, the largest lending protocol by capital, recognizing PT assets as collateral, which released the financing capability of PT assets. In fact, prior to this, other DeFi protocols had already supported PT assets as collateral, such as Morpho, Fuild, etc., but AAVE, with its more abundant lending funds, could offer lower borrowing rates, amplifying the returns of this strategy, and AAVE's decision carries more symbolic significance.

Since AAVE started supporting PT assets, the staked funds have quickly increased, which indicates that this strategy has received recognition from DeFi users, especially some whale users. Currently, AAVE supports two types of PT assets: PT sUSDe July and PT eUSDe May, and the total supply has reached approximately $1B.

The maximum leverage supported currently 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 under E-Mode is 88.9%, which means that theoretically, through loop lending, the leverage can reach about 9 times. The specific calculation process is shown in the figure below. This means that when leverage is at its maximum, not considering the costs from Gas, flash loans, or fund exchanges brought by loop lending, using the sUSDe strategy as an example, the theoretical yield of the strategy can reach 60.79%. Moreover, this yield does not include Ethena point rewards.

Next, let's take a look at the distribution of actual participants, still using 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 a significant leverage ratio.

Looking at the top four addresses, the first 0xc693... The leverage of the 9814 account is 9x, and the principal amount is about 10M. The second place of the 0x5b305... The leverage of the 8882 account is 6.6 times, with a principal of about 7.25M, the third place analytico.eth has a leverage of 6.5 times, and the principal is about 5.75M, and the fourth place is 0x523b27... The 2b87 account has a leverage of 8.35x and a principal of about 3.29M.

Therefore, it can be seen that most investors are willing to allocate a higher financial leverage for this strategy. However, I believe the market may be a bit too aggressive and optimistic. This deviation in sentiment and risk perception may easily lead to large-scale liquidation events. Therefore, let's analyze the risks of this strategy.

Discount Rate Risk Should Not Be Ignored

The author has observed 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 mainly include two types:

1. Exchange rate risk: When the exchange rate of the collateral decreases relative to the borrowing object, there will be liquidation risk, which is relatively easy to understand, because in this process, the collateralization ratio will decrease.
2. Interest Rate Risk: When borrowing rates increase, it may lead to an overall negative return on the strategy.

Most analyses would believe that the exchange rate risk of this strategy is extremely low, as USDe, being a more mature stablecoin protocol, has undergone market tests, and its risk of decoupling is low. Therefore, as long as the borrowing target is a stablecoin type, the exchange rate risk is low. Even if decoupling occurs, as long as the borrowing target is USDe, the relative exchange rate will not experience a significant decline.

However, this judgment ignores the specificity 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 a duration period. During this duration period, if one wishes to redeem the principal assets early, it can only be done through the discount trading in the AMM secondary market provided by Pendle. Therefore, the trading will affect the price of PT assets, or in other words, affect PT's yield. Consequently, the price of PT assets is constantly changing with transactions, but the general direction will gradually approach 1.

After clarifying this feature, let's look at the oracle design plan for PT asset prices by AAVE. In fact, before AAVE supported PT, this strategy mainly utilized 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 is continuously increasing linearly. Therefore, the exchange rate risk can be naturally ignored.

However, in the process of researching the oracle scheme of PT assets, AAVE believes that this is not a good choice, because the scheme locks in the yield and is not adjustable during the duration of PT assets, which means that the model cannot actually reflect the impact of market transactions or changes in the underlying yield of PT assets on the PT price, and if the market sentiment is bullish on the change in interest rates in the short term, or the underlying yield has a structural upward trend (such as a sharp rise in the price of incentive tokens, new revenue distribution schemes, etc.), which may cause the oracle price of PT assets in Morpho to be much higher than the real price, which can easily lead to bad debts. In order to reduce this risk, Morpho usually sets a benchmark interest rate that is much higher than the market interest rate, which means that Morpho will actively reduce the value of PT assets and set up a more ample room for volatility, which in turn will lead to the problem of low capital utilization.

In order to optimize this problem, AAVE adopts an off-chain pricing solution, which can enable the oracle price to follow the pace of structural changes in PT interest rates as much as possible, and avoid the risk of market manipulation in the short term. We will not discuss the technical details here, there is a special discussion on this issue in the AAVE forum, and interested partners can also discuss with the author in X. Here is only a summary of the possible price following effect of PT Oracle in AAVE. It can be seen that in AAVE, Oracle's price performance will be similar to the piecewise function, which follows the market interest rate, which is more capital efficient than Morpho's linear pricing model, and also better mitigates the risk of bad debts.

So this means that if the interest rates of PT assets undergo a structural adjustment, 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, meaning that if the PT interest rates increase for some reason, the prices of PT assets will decrease accordingly. The excessively high leverage of this strategy may pose 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 listed for everyone's consideration:

1. Due to the mechanism design of the Pendle AMM, over time, liquidity will concentrate around the current interest rates, which means that the price changes brought about by market trading will become less and less noticeable, or it can be said that the slippage is getting smaller. 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 has set up the concept of heartbeat to indicate the frequency of price updates. The closer it gets to the expiration date, the larger the heartbeat, and the lower the update frequency, which means the discount rate risk is lower.

The 2 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 time exceeds the heartbeat, a price update will be triggered. Therefore, this mechanism also provides a time window for timely adjustment of leverage to avoid liquidation. Thus, for users of this strategy, it is essential to monitor interest rate changes and adjust leverage accordingly.