Original Title: "Beware of Discount Rate Risks: The Mechanisms and Risks of the PT Leverage Yield Flywheel of AAVE, Pendle, and Ethena"

Original author: @Web3_Mario

Abstract: 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 would like to thank you for your support. This week, we found that there is 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 and PT-sUSDe, a fixed income certificate in Pendle, 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 Leveraged Earnings

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

· Explore arbitrage opportunities between DeFi protocols;

· Looking for sources of leverage funding;

· 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 interest rates 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 the integration of the three protocols, that is, using Ethena's staking income certificate sUSDe and the fixed income certificate PT-sUSDe in Pendle 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. The specific process is as follows: first, users can obtain sUSDe at Ethena and fully convert it to PT-sUSDe through the Pendle protocol to lock in the interest rate, and then deposit PT-sUSDe into AAVE as collateral, and lend USDe or other stablecoins through revolving loans, repeating the above strategy to increase capital leverage. The calculation of the return is mainly determined by three factors, the base yield of PT-sUSDe, the leverage multiplier, and the spread in AAVE.

Current 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 unlocked the financing potential of PT assets. In fact, prior to 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 offer lower borrowing rates, amplifying the yields of this strategy, and AAVE's decisions carry more symbolic significance.

Since AAVE started supporting PT assets, the staked funds have rapidly increased, indicating that this strategy has gained recognition among 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 of approximately $1B.

The maximum leverage supported at present 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 theoretically, through loop lending, the leverage can be approximately 9 times. The specific calculation process is shown in the figure below, which means that when the leverage is at its maximum, not considering Gas, flash loans or currency conversion costs 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 points rewards.

Next, let's take a look at the distribution of actual participants, still taking the PT-sUSDe liquidity pool on AAVE as an example. A total supply of 450M is contributed by 78 investors, indicating a high proportion of whales and a significant leverage ratio.

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

Therefore, it can be seen that most investors are willing to allocate a higher financial leverage for this strategy. However, I believe that the market may be a bit too aggressive and optimistic. This deviation in sentiment and risk perception could easily lead to large-scale liquidations. 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 touting it as a risk-free arbitrage strategy. However, this is not the case; we know that the risks of leveraged mining strategies mainly come in two forms:

Exchange rate risk: When the exchange rate between the collateral and the loan target decreases, there is a liquidation risk. This is relatively easy to understand, as the collateralization ratio will decrease during this process.

Interest Rate Risk: When borrowing rates increase, it may lead to an overall negative return on the strategy.

Most analyses would suggest that the exchange rate risk of this strategy is very low, because as a more mature stablecoin protocol, USDe has undergone market testing, and its risk of de-pegging is low. Therefore, as long as the borrowing target is of the 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 see a significant decline.

However, this judgment overlooks the uniqueness of PT assets. We know that the most critical function of lending protocols is to achieve timely liquidation to avoid bad debts. However, PT assets have the concept of a duration period. Within this duration, if one wants to redeem the principal asset early, it can only be done through the discount trading in the secondary market provided by Pendle's AMM. Therefore, trading will affect the price of PT assets, or in other words, affect the yield of PT. As a result, the price of PT assets is constantly changing with transactions, but the general trend will gradually approach 1.

After clarifying this feature, let's take a look at the oracle design scheme 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 named PendleSparkLinearDiscountOracle. Simply put, Morpho believes that during the bond's duration, PT assets will earn returns at a fixed interest rate relative to native assets, ignoring the impact of market trading on interest rates. This implies that the exchange rate of PT assets relative to native assets will continuously increase linearly. Therefore, it is natural to ignore the exchange rate risk.

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 issue, AAVE has adopted an off-chain pricing solution that allows oracle prices to follow the structural changes in PT interest rates as closely as possible while avoiding the risks of market manipulation in the short term. We will not discuss the technical details here; there is a dedicated discussion on this issue in the AAVE forum, and interested friends can also discuss it with me on X. Here, we only present the possible price-following effects of PT Oracle in AAVE. It can be seen that in AAVE, the performance of Oracle prices will resemble a piecewise function, following market interest rates. This has higher capital efficiency compared to Morpho's linear pricing model, while also better alleviating bad debt risks.

So this means that if there is a structural adjustment in the interest rate of PT assets, or if the market has a consistent direction regarding interest rate changes in the short term, AAVE Oracle will follow this change. Therefore, this introduces discount rate risk into the strategy, which means that if the PT interest rate rises for some reason, the price of PT assets will consequently decrease. The high leverage of this strategy may pose liquidation risks. Hence, 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 Pendle AMM, over time, liquidity will concentrate around the current interest rate, 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 resulting from market behavior will become smaller, and in response to this characteristic, AAVE Oracle has set up the concept of heartbeat to represent 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 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 by 1% from the Oracle rate 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 advisable to monitor interest rate changes and adjust leverage accordingly.

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