Introduction:

Pendle Finance is a protocol deployed on Ethereum and Arbitrum that facilitates the tokenization of yield on assets through a fixed-rate lending market. Users can deposit yield-bearing assets into the platform, and the smart contract separates the principal and interest by minting principal tokens and yield tokens. The protocol also incorporates an automated market maker (AMM) algorithm for trading these tokens. Recently, Pendle Finance has experienced significant growth in total value locked and increased market demand, thanks to the increased market interest in the Liquidity Staking Derivatives (LSD) section and its integration with protocols like Lido and Frax.

Foreword

The DeFi lending market can be classified into a floating-yield lending market and a fixed-rate lending market, based on the volatility of the interest rates. The floating-yield lending market has matured, with projects like Maker, Compound, and Aave serving as major platforms attracting substantial funds. These projects continue to expand their ecosystem and diversify their offerings, demonstrating a robust development trajectory. In contrast, the fixed-rate lending market started relatively later, with most projects emerging in the latter half of 2020. Currently, it has not yet reached a significant market size. Many protocols rely on leading floating-yield lending projects to attract users, which may not necessarily bring in genuine existing users. Additionally, they sustain their user base through liquidity mining incentives, but once these incentives decrease, users may exit quickly. Despite being in the early stages of development, the fixed-rate lending market still remains a market demand, especially among institutional investors seeking products with deterministic and predictable yields to manage their assets.

Currently, fixed-rate lending projects in the market can be classified into the following four categories based on the different ways fixed rates are implemented:

1. Zero-coupon bonds: These protocols issue tradable zero-coupon bond tokens with a specific maturity date, allowing users to pay off the debt with predetermined interest and redeem their collateral upon maturity. They are fundamental underlying protocols in the fixed-rate lending market. Examples of such protocols include Yield, Notional, etc.
2. Yield tokenization: This is similar to the separation of coupons in traditional bonds. The key concept is to split user deposits into principal and yield components, which are then bundled into assets with fixed terms and fixed yields. Examples of such protocols include Pendle, Elenment, etc.
3. Risk tranching: The core idea here is to divide the yield into senior and junior tranches. Senior tranches offer lower yields and lower risk, while junior tranches provide higher yields but typically require collateralization with funds from the senior tranche. BarnBridge is a notable example of a project implementing this strategy.
4. Interest rate swaps: This involves the exchange of a floating rate for a fixed rate, or vice versa, based on the same amount of principal. A typical example of this is Horizen.

Pendle Finance is a protocol that falls into the category of yield tokenization in the fixed-rate space.

With the recent surge in market interest, Pendle Finance has witnessed a significant influx of users and funds. In this article, we will provide a comprehensive introduction to how Pendle Finance operates, including a detailed exploration of the mechanism for separating principal and interest, as well as the design of the AMM algorithm. We will also provide an overview of Pendle Finance’s tokenomics and share the latest updates regarding its development.

Introduction to Pendle Finance

Pendle Finance was initially launched on the Ethereum mainnet on June 21, 2022, and has recently been deployed on Arbitrum. The founder, TN Lee, previously served as Head of Business at Kyber Network, while information about other team members remains undisclosed. Pendle has continued to iterate and evolve its product, reaching Version 2 (V2) currently. Its core functionality involves the separation of yield-bearing assets to achieve fixed interest rates, and providing users with AMM pools for trading principal tokens.

Following the Shanghai upgrade, users are allowed to withdraw Ethereum, and the Liquidity Staking Derivatives (LSD) have become more effective in maintaining the pegged price. This development allows users to improve their yield strategies through the utilization of Pendle Finance. Notably, Pendle Finance has gained support from protocols such as Lido, Frax, Aura Finance, GMX, and Stargate, demonstrating increased attention from the market.

Principal and Interest Separation Mechanism

When users deposit funds into protocols like Aave, Compound, and Lido, they receive corresponding yield-bearing assets (i.e. aTokens, cTokens, stETH, etc). These assets can then be deposited into the Pendle protocol, where users have the option to select a maturity date. The Pendle minting contract automatically splits the yield-bearing asset into principal tokens (PT) and yield tokens (YT) on a 1:1 ratio.

PT represents the principal of the underlying yield-bearing asset, while YT represents an entitlement to all the yield of the asset. The price of the underlying asset = PT price + YT price.

The value of PT will appreciate over time. Upon maturity, PT can be redeemed at a 1:1 ratio for the underlying asset.

On the other hand, the value of YT will depreciate over time. YT holders can claim the yield accrued at any time from the Pendle Dashboard; that is to say that the yield generated from the principal is stored in the Dashboard rather than within the YTs themselves. The calculation of YT yield follows the yield calculation method of the underlying protocol. For example, if a user deposits aUSDC, the yield earned will be calculated based on the USDC yield rate in Aave. By holding YT, users are entitled to receive the yield of the underlying asset continuously. As the maturity date approaches, the accrued yield in the Dashboard increases, and the yield in YT gradually decreases until it eventually reaches zero.

Source: https://docs.pendle.finance/

Let’s consider a scenario where a user deposits some amount of cDAI (worth 100 DAI) into Pendle Finance for 3 months. The contract will mint 100 PT cDAI and 100 YT cDAI tokens. At this time, the price of PT will be discounted, let’s say to 99.5 DAI, and the 100 PT cDAI held by the user can be redeemed and converted into 100 cDAI after the 3-month period. The price of YT will be 0.5 DAI (calculated as 100 DAI - 99.5 DAI), and holding 100 YT cDAI will provide access to the floating interest cash flow of cDAI in Compound during the 3-month period.

Source: https://app.pendle.finance/pro/learn?level=1

YT holders can engage in trading in the AMM pool provided by Pendle. The trading decision is made based on users’ estimation of future yields. Here are two scenarios:

1. If the user anticipates that the interest rate may drop in the future, they can choose to sell ​​YT to receive upfront cash flows and secure future yields.
2. Conversely, if they expect that the interest rate may rise in the future, they can buy YT from the AMM pool to potentially obtain higher returns.

In practice, selling YT allows users to secure a fixed yield, while buying YT exposes them to the volatility risk associated with the yields of the underlying protocol. Therefore, trading YT has a higher threshold as it relies on users’ ability to estimate future yield rates, which necessitates a deep understanding of the DeFi lending market. Additionally, users’ returns depend on the fluctuation of deposit rates, which are relatively small. Compared to investing in other ERC-20 tokens, the earnings from buying YT tokens are limited.

Pendle AMM

Users have the freedom to trade PT and YT before the expiration date, and the Pendle team has established corresponding AMMs to facilitate these transactions. In Pendle V1, the team improved the YieldSpace algorithm, considering the impact of time decay. But in V2, the team integrated the AMM algorithm from the Notional fixed-rate protocol to determine the price curve of YT and introduced the Logit function to ensure that PT can be traded at a fixed rate. The trading price of YT is then determined based on the constant relationship between PT and YT prices and the underlying asset.

The core of the Pendle AMM algorithm is that the liquidity of PT changes with the maturity time (t). As the expiration time (t) increases, the liquidity becomes more dispersed, resulting in minimal slippage in interest rates. Conversely, as the expiration time (t) decreases, liquidity becomes more concentrated.

During trading activities, when the proportion of PT fluctuates within a specific range, the interest rate will fluctuate between 0 and the anchor rate. We know that as the expiration date approaches, the liquidity curve experiences larger fluctuations in interest rates, resulting in a steeper curve. Even if no trades occur in the pool at that moment, the interest rate can still undergo significant changes. To mitigate the impact of the expiration date on interest rate fluctuations, the team using this AMM algorithm will reset the anchor rate for every trade. This ensures that the current rate aligns with the updated rate after each trade, rather than changing gradually over time.

Source: Pendle Finance Whitepaper

Tokenomics

PENDLE is the governance token of the Pendle Finance protocol, which adopts a hybrid inflation model. To incentivize liquidity, a specific number of tokens are released monthly. Regarding its token allocation plan, tokens allocated to the team are locked until April 2023. In addition, any increase in circulating supply will be contributed by incentives and ecosystem building.

Source: https://www.tokenomicshub.xyz/posts/pendle

According to the token information provided by the team, as of October 2022, the number of PENDLE unlocked every week is 667,705. Over time, the weekly unlocking amount will decrease by 1.1% until April 2026.

Source: https://www.tokenomicshub.xyz/posts/pendle

In order to further empower decentralized governance, the team also launched veToken. Specifically, vePENDLE provides new use cases for the unlocking of PENDLE tokens. Users can stake PENDLE to obtain vePENDLE, and the amount received is proportional to the amount and duration staked, with a maximum staking period of 2 years.

Source: https://www.tokenomicshub.xyz/posts/pendle

Users holding vePENDLE can vote to decide on parameters related to liquidity incentives. If vePENDLE holders also act as liquidity providers (LPs), they can earn higher returns. The vePENDLE token captures the value of the protocol through the following two aspects:

1. The protocol allocates 0.1% (this ratio will fluctuate over time) of the trading fees from PT and YT transactions in the AMM liquidity pool to token holders, where 80% goes to vePENDLE holders and 20% goes to liquidity providers.
2. 3% of YT yield fees is allocated to vePENDLE holders.

The Development of Pendle Finance

The Pendle Finance protocol was previously deployed on Ethereum. Last year, the project team launched a liquidity incentive program, which attracted a certain amount of funds and users. However, due to the high gas fee on Ethereum, it becomes challenging for the project to retain users and funds. To address this issue, the project team recently launched the protocol on the Arbitrum ecosystem. Besides, benefiting from the growing popularity of LSD, Pendle Finance has witnessed a rapid surge in Total Value Locked (TVL), surpassing $60 million. The reported trading volume has also exceeded $350 million.

Source: https://defillama.com/protocol/pendle

The Pendle website provides two UI modes: Simple UI and Pro UI. Both modes run on the same set of smart contracts, but the Pro version offers the full suite of functions, allowing users to buy and sell PT and YT. Currently, the Pro version has introduced 9 products with different underlying assets and maturity dates, resulting in varying interest rates. To enhance convenience and efficiency, the website also provides a “Calculator” feature, allowing users to calculate the potential yield of PT and YT for different underlying assets and maturity dates.

Source: https://app.pendle.finance/pro/markets?utm_source=landing&utm_medium=landing

Is Pendle (PENDLE) a good investment?

As with any investment, the decision of whether or not Pendle is a good investment ultimately depends on an individual’s risk tolerance and investment goals. However, from a fundamental perspective, Pendle’s innovative approach to decentralized options trading and yield farming has the potential to revolutionize the DeFi space. By allowing users to trade and farm options on a variety of assets in a decentralized and user-friendly manner, Pendle is bringing new functionality to the blockchain ecosystem that was previously unavailable.

Moreover, Pendle’s focus on multi-collateral pools and risk management also sets it apart from many other DeFi platforms. These features allow users to more effectively manage their risk exposure and hedge against potential losses, which can help to mitigate some of the volatility and risk inherent in the DeFi space. Overall, while the success of any investment is never guaranteed, Pendle’s innovative approach and focus on risk management make it a potentially attractive option for those looking to invest in the DeFi space.

How to own PENDLE?

One way to own PENDLE is to go through a centralized crypto exchange, so the first step is to create a Gate.io account and complete the KYC process. Once you have added funds to your account, check out the steps to buy PENDLE on the spot or derivatives market.

Take Action on PENDLE

Check out PENDLE price today and start trading your favorite currency pairs:

• PENDLE_USDT

Conclusion

The core of Pendle Finance is to split the yield-bearing assets into a principal token (PT) and a yield token (YT) at a ratio of 1:1. PT holders can redeem their underlying asset upon maturity, while YT holders can benefit from the floating interest yield provided by the underlying protocol. The protocol introduced Pendle AMM, inspired by Notional’s algorithm, and considered the impact of time decay on interest rates to determine token prices. The entire system requires users to have an understanding of DeFi lending. However, due to the small fluctuations in interest rates of the underlying protocol, the potential returns for users are limited.

The fixed-rate lending market is still in its early stages, but Pendle Finance has successfully achieved the tokenization of yield by separating principal and interest, demonstrating the efficiency of its well-designed mechanism. Additionally, the protocol has benefited from the market demand for LSD and has integrated with other protocols such as Lido, Frax, and Aura Finance, leading to a significant increase in liquidity. The team has adopted liquidity incentives to attract users, resulting in positive business performance. Overall, the protocol shows promising potential for further development and growth.