Pendle: Full Swing in Leading Interest Rate Swaps
June 9th, 2022

We continue our analysis of the latest DeFi fixed-income solutions with Pendle. Founded in late 2020 by TN Lee, Pendle is a DeFi yield trading protocol with a native automated market maker (AMM) where users can obtain fixed yield or compounded yield exposure on yield-bearing instruments (Pendle Finance, 2022). We at Decent can relate to TN’s founding story; he began as an early member of Kyber Network before starting a Layer 1 development shop. This development experience bolstered TN’s confidence in DeFi and led to fixed-income yield trading solutions. Fixed-income solutions were largely unexplored and underdeveloped until Pendle’s launch on mainnet in June 2021. Since then, the vertical has seen several fixed-income protocols launch and compete for users and liquidity. Pendle’s goal from the start has been to realize this opportunity through education and a friendly, permissionless application experience.

What is a fixed-income solution in DeFi? TN believes it's a stable and more predictable flow of earnings from an investment over a period of time. The majority of yield in DeFi is generated via lending, liquidity provision, or both. Yield volatility can be challenging for investors, but fixed-income solutions offer an attractive, capital-efficient alternative (Choi, 2021). TN breaks down DeFi’s fixed-income market into three categories: securitization and tranching, fixed-rate lending, and interest rate swaps, the last being Pendle’s market. Interest rate swaps, which are typically executed by sophisticated market participants, expand the interest market in DeFi by increasing the amount of optionality, speculation, and hedging opportunities against DeFi rate exposure. Pendle specializes in trading yield that allows buyers and sellers to interact without having to hold any of the underlying assets (Choi, 2021). Interest rate trading is complex, which is why Pendle’s majority of users are hedge funds and sophisticated DeFi traders. Long term, this is where Pendle’s mission of education and seamless user experience makes an impact. Trustless, permissionless systems are open to all users anywhere.

The relationship of the underlying asset is critical to understanding the financial mechanics of Pendle’s on-chain yield trading. Yield-generating tokens have two components: the ownership of the underlying (OT, ownership token) and the yield of the underlying (YT, yield token), i.e, the right to future yield streams (Choi, 2021). The expiry of YT is critical to the economics of the assets and how Pendle evaluates the yield products they are offering. The expiry is the desired expiration date of the yield contract in epoch time. Multiple yield contracts of different expiries can be created, making different YT/OT smart contracts. Before yield tokenization can occur, the yield contracts must exist for the intended underlying yield-bearing asset and expiry (Pendle Finance, 2022).

Pendle is developing towards flexibility for investors, allowing them to withdraw their capital without lock-up restrictions (GoodWill Yunting, 2021). The redemption call function enables YT holders of a particular underlying yield token and expiry to receive the due interests and underlying yield-bearing asset at any time (Pendle Finance, 2022). After expiration, only OT is needed to withdraw the underlying. Pendle introduced an expiry mechanism as a way to promote trustless trading. If minting OT and YT had no expiry, there would be no reason to sell YT back to the original minter; and if the original minter wanted to redeem the underlying, they’d have to purchase it back on the open market. Pendle feels the expiry function creates a consistent refreshing of the token, allowing better yield pricing with the time frame in mind (Choi, 2021).

Let’s review Pendle’s simple user journey and its competitive advantage:

  1. A user deposits funds into Aave to generate yield-bearing assets like aUSDC (Aave’s yield token).
  2. The user deposits aUSDC into Pendle and Pendle mints OT and YT tokens.
    1. YT is structured based on the expiry of the markets, covering the yield the underlying protocol will be paying out (GoodWill Yunting, 2021).
  3. Now that OT and YT are minted, the user can do two actions:
    1. Sell YT on Pendle’s AMM to collect payment, which they call fixing the yield, allowing users to receive payment upfront by selling the yield exposure.
    2. Use YT to provide liquidity on Pendle’s AMM to earn trading fees and incentives.
  4. Before the expiry takes place, if a user wants to withdraw or redeem the underlying, they will have to surrender OT and YT in order to redeem aUSDC. After expiry, only the OT is available, as YT is valueless. This is because YT serves as a certificate entitling the holder to the interest of the underlying protocol, and with every passing day, the expected yield declines (GoodWill Yunting, 2021).

While comparable to protocols like Element, Pendle differentiates through its focus on the yield component as opposed to Element’s focus on utilizing the fiscal component of the underlying ownership asset. Most of Pendle’s development centers around innovating the yield component and its corresponding AMM. Pendle’s AMM is designed for yield assets that are time-dependent, giving users optionality and control. Long term, Pendle wants to generalize its AMM to support all yield-bearing assets and not be confined to lending and borrowing platforms (Jiang, 2021).

In April, Pendle announced to their Discord community that they’ve been researching and planning the next stages of development given the information and data it’s collected since launch. Their goal is permissionless support for every yield-bearing asset. Pendle’s V2 goal, titled “Project Permissionless,” is to become the Uniswap of the yield market where tokens can be listed permissionlessly and seamlessly, optimizing liquidity provision and boosting capital flows overall. Its plans are as follows:

  • Allow anyone to create a new pool with any asset and provide liquidity without impermanent loss.
    • Easy and predictable yield.
  • Improve the order routing system for an improved user experience.
  • Enhance LPs benefits by maximizing value accrual.
  • Enable traders to trade with their preferred base token.
    • Ethereum, not Avalanche, will remain the primary chain due to its deeper liquidity and receptivity to derivatives markets.
  • Introduce a new standard that simplifies pool creation and lowers barriers to entry.
    • Create a universal adapter that reads yield tokens from a larger variety of other protocols (Pendle Team, 2022a).

More recently, Pendle announced its publication of EIP-5115, the SCY token standard. SCY enables seamless token integrations and functions as the universal composability gateway for projects building on top of interest-bearing tokens (Pendle Team, 2022b). Pendle can automatically integrate new yield-bearing tokens as any SCY tokens can be plugged into Pendle V2 and work instantly. In addition, Pendle states that the governance component of its system is coming soon. Lastly, Pendle’s latest tweet states that its smart contracts are currently under audit. With round 1 complete and round 2 around the corner, Pendle feels V2 is progressing smoothly towards their Q3 target deadline.

Pendle is heads-down building. They are maintaining a progressive long-term development approach with the goal of simplifying a traditionally complex financial strategy. They are creatively innovating more financial options in the DeFi landscape. Education and user experience are their top priorities—they aim to abstract as much complexity away from the user as possible, which is paramount to the success of permissionless and decentralized protocols. As they further develop their contracts and generalize their AMM, Pendle wants to allow all users a decent opportunity at optimizing their yield in a market that was once solely privy to sophisticated players.


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