Abstract: Recently, work has been a bit busy, which delayed updates for a while. Now we are resuming weekly updates, and I would like to thank all the dear friends for their support. This week, I discovered an interesting strategy in the DeFi space that has garnered widespread attention and discussion, which is to use Ethena’s staking yield certificate sUSDe as the source of income in Pendle’s fixed yield 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 KOLs on platform X have made relatively optimistic comments about this strategy, but I believe the current market seems to overlook some risks behind this strategy. Therefore, I would like to share some insights. In summary, 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 liquidation.

Analysis of the Mechanism of PT Leverage Earnings

First, let me introduce the mechanism of this yield strategy briefly. Friends who are 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 using smart contracts to carry core business capabilities. Most DeFi experts, or DeFi Degens, usually have three main tasks:

• Explore arbitrage opportunities through interest rate differentials between DeFi protocols;
• Find sources of leveraged funding;
• Explore high-interest, low-risk return scenarios;

The PT leverage 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 space, and a brief introduction is provided here. First, Ethena is a yield-bearing stablecoin protocol that captures low-risk short fees in the perpetual contract market of centralized exchanges through a Delta Neutral hedging strategy. During a bull market, retail investors are extremely eager to go long, therefore willing to bear higher fee costs, resulting in a higher yield for this strategy, with sUSDe being its yield certificate. Pendle is a fixed-rate protocol that decomposes the yield-bearing token of floating yield into Principal Tokens (PT) similar to zero-coupon bonds and Yield Tokens (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 is a decentralized lending protocol where users can use specified cryptocurrencies as collateral and borrow other cryptocurrencies from AAVE to achieve effects such as increasing capital leverage, hedging, or shorting.

This strategy is an integration of three protocols, utilizing Ethena’s staking yield certificate sUSDe as the source of returns through Pendle’s fixed income certificate PT-sUSDe, and leveraging the AAVE lending protocol as the source of funds to carry out interest rate arbitrage and obtain leveraged returns. The specific process is as follows: first, users can acquire sUSDe from Ethena and fully exchange it for PT-sUSDe through the Pendle protocol to lock in the interest rate. 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 multiple, and the interest spread in AAVE.

The current market status of the strategy and user participation.

The popularity of this strategy can be traced back to the recognition of PT assets as collateral by AAVE, the lending protocol with the largest amount of capital, which unlocked the financing capacity 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 available funds for lending, 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, which 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 of approximately $1B.

The maximum leverage currently supported 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 the E-Mode is 88.9%, which means that theoretically, the leverage can reach about 9 times through a loop loan. The specific calculation process is shown in the figure below. In other words, when the leverage is at its maximum, without considering the costs of Gas, flash loans resulting from loop loans, or currency exchange costs, taking 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 taking the PT-sUSDe liquidity pool on AAVE as an example. A total supply of 450M is provided by 78 investors, which indicates a high proportion of whales and considerable leverage.

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

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

The risk of discount rate should not be underestimated.

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 fall into two categories:

• Exchange rate risk: When the exchange rate between the collateral and the loan target decreases, there will be liquidation risk, which is relatively easy to understand because the collateralization ratio will decrease during this process.
• Interest rate risk: When borrowing rates increase, it may lead to an overall negative yield for the strategy.

Most analyses 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 has a lower risk of price decoupling. Therefore, as long as the loan collateral is a stablecoin type, the exchange rate risk is low. Even if a decoupling occurs, as long as the loan collateral 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 a duration period. During this duration period, if one wants to redeem the principal assets in advance, it can only be done through the discount trading in the AMM secondary market provided by Pendle. 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 trading, but the general direction will gradually approach 1.

After clarifying this feature, let’s take a look at the oracle design plan for PT asset prices by AAVE. 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 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 the interest rate. This means that the exchange rate of PT assets relative to native assets continuously increases linearly. Therefore, the exchange rate risk can be naturally ignored.

However, AAVE believes that the oracle solution for PT assets is not a good choice during its research process, as this solution locks in the yield and is non-adjustable during the life of the PT assets. This effectively means that the model cannot reflect the impact of market trading or changes in the underlying yield of PT assets on PT prices. If, in the short term, market sentiment is bullish on interest rate changes, or if there is a structural upward trend in the underlying yield (such as a significant increase in incentive token prices or new yield distribution plans), it may lead to the oracle price of PT assets in Morpho being far higher than the real price, which can easily result in bad debts. To reduce this risk, Morpho typically sets a benchmark interest rate that is significantly higher than the market interest rate, which means that Morpho actively suppresses the value of PT assets and sets a more flexible volatility space, which in turn can lead to the issue of low capital utilization.

In order to optimize this issue, AAVE has adopted an off-chain pricing solution, which can make the oracle prices follow the structural changes of the PT interest rate as closely as possible, while avoiding the risk of market manipulation in the short term. Here, we will not discuss the technical details; there is a dedicated discussion on this topic in the AAVE forum, and interested friends can also discuss it with the author on X. Here, we only present the possible price-following effect of the PT Oracle in AAVE. It can be seen that in AAVE, the oracle price performance will resemble a piecewise function, following the market interest rates. Compared to Morpho’s linear pricing model, this has higher capital efficiency and also better alleviates bad debt risks.

So this means that if there is a structural adjustment in the interest rates of PT assets, or if the market has a consistent direction for interest rate changes in the short term, the AAVE Oracle will follow this change. Therefore, this introduces discount rate risk to the strategy. That is to say, if the PT interest rates increase for some reason, the price of PT assets will decrease accordingly. The excessively high leverage of the strategy may pose liquidation risks. Thus, 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 return. Here are some key features listed for your consideration:

1. Due to the mechanism design of Pendle AMM, liquidity will concentrate towards the current interest rate over time, which means that price changes resulting from market transactions will become less and less significant, 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 has set 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.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 important to monitor interest rate changes and adjust leverage accordingly.

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