May 21, 2021

5 min read

Pendle Finance: A New DeFi Primitive

Maybe you heard about Pendle weeks ago when Twitter shut down their account for “reasons”. Perhaps you read about, or participated in, their LDB token launch that beat the bots. For all I know you could just be coming across this project for the first time. Regardless of how we got here, this affable group of meme loving degens has excited investors across DeFi.

Before you ape, it’s important to learn about what Pendle is, how it works, and what kind of value the protocol adds to the ever expanding DeFi ecosystem. While I can’t guarantee that reading one article constitutes DYOR, I can assure you that its not not DYOR.

Swap Meet

Swaps are an incredibly important financial instrument that are foundational to effective markets. At their core swaps are just derivatives that allow for the trade of cash flow over some time horizon. Typically these instruments consist of fixed and variable components, with the most common example being interest rate swaps. In TradFi markets these are mostly done over the counter (OTC) rather than on exchanges.

The Pendle protocol has abstracted this via Ownership Tokens (OT), the fixed component, and Future Yield Tokens (XYT), the variable component. A user with 10k DAI deposited in Aave (aDAI), for example, could use Pendle to split that aDAI into the OT token representing the 10k DAI principle and an XYT token representing the deposit interest rate on the principle.

Why does this matter? By splitting the principle from the yield, Pendle is able to give lenders the ability to swap variable interest rates into fixed ones by selling the XYT token over a specified timeframe. On the other side of this transaction borrowers have the option to hedge their own exposure when rates are low. Additionally, Pendle offers traders the ability to purchase assets at a discount by leveraging the variability in interest rates. To understand how the protocol accomplishes all this in a capital efficient way we can examine Pendle’s secret sauce: their AMM.

Time Is The Fire That Burns Us All

The UniSwap AMM model uses a constant product formula for determining the price of assets in a given pool. This is a tried and true approach that works great for trading most assets. However, with time aware assets the constant product formula guarantees significant impermanent loss. But ser, IL is always a risk! While this is true, the nature of time aware assets magnifies this effect to the extreme.

To illustrate this let’s say there are two assets in a UniSwap constant product AMM: $DECAY, a fictional time aware asset with a starting price of $1 that decreases by $0.01 every day for 100 days, and $USDC, the stablecoin pegged to $1. $DECAY will inherently decrease in value relative to $USDC as time passes, changing the value ratio of $DECAY:$USDC. On day one our pool would have an value ratio of 1:1. On day 50 the pool would be at 2:1, and so on and so forth. When maturity is reached the pool should be entirely drained of $DECAY and any liquidity provider would have faced extreme impermanent loss that is made certain by the time-decay property of the $DECAY asset.

To solve this issue Pendle’s AMM breaks the hard coded link between the value of the pool and its base tokens by accounting for time as a variable. This is achieved by shifting the equilibrium point of the curve to account for time decay as maturity approaches. In our example the pool would not inherently lose value as $DECAY approaches maturity, thus eliminating the time-dependent IL a traditional AMM would guarantee. It’s worth noting that liquidity providers can still face impermanent loss as the relative price of assets change in the pool. However that IL will not be due to time decay.

Pendle AMM curve shift governed by time-decaying pricing model similar to bonds & options.

To get further in the weeds on the math that makes this possible check out Pendle’s in-depth exploration of their AMM on Medium or see their extensive documentation.

Moar Legos

In traditional finance the interest rate swap market alone is worth trillions of dollars. By bringing these tools to DeFi with their novel AMM, Pendle has created an opportunity to capture immense value as the crypto market continues to grow and mature.

Additionally, it’s easy to see how protocols like Yearn could leverage Pendle in a strategy around trading future yield to buy assets at a discount or how massive holders of Dai like OlympusDAO or Alchemix could use Pendle to lock in interest rates and de-risk from the typical volatility DeFi interest rate markets.

The protocol will launch soon with support for Aave and Compound yield bearing tokens, creating a capital efficient swap market for lending yield on Ethereum. Down the line the Pendle AMM facilitates the creation of markets for any kind of yield bearing token — even high yield farming tokens— positioning Pendle as a new primitive in an expanding DeFi ecosystem.

Disclaimer: As always, do your own research and understand your own investment goal. Aping into complex protocols like Pendle might not be for everyone.