Pendle Finance Explained: Introducing Yield Trading in DeFi

Introduction

The Fixed Income market stands among the largest financial markets globally, surpassing the Stock Market by more than three times, according to the CFA Institute. While it may not grab the same attention from everyday investors as other markets do, it holds substantial significance in comprehending the potential progress of a country's economy through a concept known as the Yield Curve.

This article takes a closer look at Pendle Finance, a DeFi project that aims to introduce familiar traditional Yield Strategies to the crypto market. With Pendle Finance, users gain the opportunity to diversify their investment portfolios by utilizing fixed-income strategies, paving the way for fresh possibilities in the crypto industry.

Currently, the US yield curve is inverted, which indicates that short-term bonds are providing higher interest rates compared to long-term bonds. This goes against the natural order of things since holding a bond for a longer duration typically entails greater risk, which should correspond to a higher return.

Historically, instances like these have served as a signal for potential economic recessions. This highlights the significance of having access to yield curve information, demonstrating its importance in understanding and predicting market conditions.

What is Pendle Finance?

Pendle Finance is a DeFi project which was first developed on Ethereum that introduces fixed-income opportunities to the crypto market. To better understand its significance, let's explore how the DeFi market operates without Pendle.

Without Pendle, if a user wishes to earn a yield on his USDC, he can lend his assets to AAVE or other similar protocols. However, a significant challenge arises in this scenario: the user faces uncertainty regarding the precise amount he will earn over time. The yield is subject to fluctuations, varying between values such as 1%, 3%, 5%, or any other figure based on market demand.

With Pendle, users gain the ability to lock in a specific yield and accurately determine their earnings during the specified period. Furthermore, they can adopt various strategies and even trade yields. For instance, during a bullish market, yields tend to be higher. If a user locks in for example an 8% yield but the market value drops to 2%, they experience a significant advantage, akin to profiting from a yield "short."

These strategies, commonly practiced in Traditional Financial Markets, can now be implemented on the blockchain, thanks to Pendle Finance.

- As of now, Pendle is available on Ethereum, Arbitrum, and BNB Chain.

How Does Pendle Finance Work?

Pendle is a Yield-Trading DeFi protocol, but how does it manage to enable users to yield trade? Let’s explore:

Yield Tokenization

To grasp the concept of Pendle, it's important to understand how tokens are traded, which is facilitated through Yield Tokenization.

• Standardized Yield Tokens (SY): Pendle automatically converts Yield-Bearing Assets like stETH, cDAI, and rETH into standardized tokens known as SY tokens. For example, stETH becomes SY-stETH on the platform.

SY Tokens are further divided into two types of tokens: Principal Tokens (PT) and Yield Tokens (YT).

• Principal Token (PT): PT represents the principal portion of the underlying yield-bearing asset. At the Maturity date, PT can be redeemed at a 1:1 ratio for the underlying asset. Essentially, this means that users can purchase assets at a discounted rate, which can later be redeemed at their full value.
• Yield Token (YT): As the name implies, YT represents the yield component of the underlying yield-bearing asset. For instance, owning 10 YT-stETH entitles you to receive the equivalent yield generated from staking 10 ETH on Lido Finance.

Yield Strategies

In order to make it easier for readers who are not familiar with the Fixed Income Market and its jargon, let's provide a clearer understanding of Pendle. In this section, we will present some yield strategies that users can implement using YT and PT on the Pendle platform.

YT: If you believe that DeFi yields will be higher in the future, you can buy YT which is equivalent to “longing yield”, meaning that your earnings will be higher if the yield goes up.

PT: Principal Tokens allow you to engage in fixed-rate strategies within DeFi, similar to trading fixed-rate bonds. With PT, you have two options: you can acquire PT and hold it until maturity to redeem the complete asset value, or you can trade PT tokens. By trading PT, you can profit when the price of PT increases. This typically happens in the fixed-income market when the market yield falls below the interest rate value you previously fixed.

Basically, these tokens allow traders to engage in different types of strategies. For instance, during bull markets, yields tend to be higher. If a user wishes to protect his portfolio against a market correction or the beginning of a bear market, he can purchase PT at a high fixed rate. When the correction occurs, he can sell his PT, profiting from the situation. This is essentially a “Yield Short Strategy”.

If the user's prediction is incorrect and the market continues to rise, his losses are relatively minimal if he holds the PT until maturity. In this case, he can redeem the asset he bought at a discounted rate in a 1:1 ratio at maturity. The worst-case scenario would be earning less than if he had simply held onto a complete stETH position. This is known as “opportunity risk”.

Pendle Finance Tokenomics

The native token of Pendle Finance's ecosystem is PENDLE, which can be locked by holders for a period of up to 2 years to obtain vePENDLE. vePENDLE offers the following advantages to its holders:

• Governance Power: Holders of vePENDLE have the ability to participate in governance decisions. They can vote on the allocation of rewards, determining which pools will receive incentives. As a result, vePENDLE voters earn swap fees from the pools they voted for.
• Protocol Fees: Holders of vePENDLE receive a portion of the protocol fees. Currently, Pendle collects 3% of fees generated from YT tokens, and 100% of this amount is distributed to vePENDLE holders.
• Enhanced Incentives: LPs (Liquidity Providers) who hold vePENDLE enjoy boosted incentives and rewards within the Pendle Finance ecosystem. This provides additional benefits and incentives for LPs to participate in the platform.

Token Distribution

The PENDLE tokens are distributed in the following manner:

•  All categories of tokens were fully vested by April 2023.
• Pendle Finance is transitioning to a perpetual emission model. Currently, the platform has weekly emissions of approximately 460,000 tokens.
• In a gradual approach, the weekly emissions will reduce by 1.10% every week until April 2026. At this stage, the tokenomics of Pendle Finance allow for a terminal inflation rate of 2.00% per year, which will be utilized for incentives.

Pendle Partnerships

Pendle Finance has achieved significant milestones through partnerships that enhance the user experience and offer a wider range of products for traders to explore different strategies. Here are some of the notable collaborations:

• LSDFi sector integrations: Pendle has joined forces with popular DeFi platforms like Lido Finance, Rocket Pool, FRAX, and Ankr. These partnerships enable Pendle users to access and benefit from the yields provided by these platforms.
• Perpetual Derivatives: Pendle has partnered with GMX and Gains Network. This collaboration allows Pendle users to trade the yields from GLP and gDAI.
• DEX Liquidity: Pendle has created a yield market for LPs on Balancer, Aura Finance, Stargate, and Camelot.

Conclusion

Pendle Finance brings a significant feature to the DeFi ecosystem, making it more advanced and compatible with traditional markets. Despite being in its early stages, Pendle has the potential to create new markets and attract both institutional and regular users to engage in yield trading within DeFi.

Pendle's partnerships with popular DeFi platforms further exemplify its dedication to expanding product offerings and providing diverse opportunities for users to explore different strategies. These collaborations strengthen Pendle's position in the market and contribute to its growth.

In summary, Pendle Finance serves as an essential element in the DeFi landscape, blending the sophistication and adaptability of traditional financial markets with the innovative possibilities of decentralized finance. With its growth potential, Pendle is poised to attract more users and emerge as a leading platform for yield trading in the DeFi space.