Pendle Me Softly: Unraveling the Complexities of Yield Tokenization

15 min readJun 27, 2024

No other recent project has achieved product-market fit in a storm like Pendle, appealing to a wide range of customers from point-hunting degens to institutional investors. Paradoxically, only a few users truly understand its mechanics. In this article, as a Product person, I aim to explain Pendle’s mechanics in a structured way with use cases, detailed calculations, and accompanying diagrams.

Retrospective / Preface

The DeFi landscape has evolved significantly since the yield farming frenzy of 2020–2021. While those days were characterized by unsustainable triple-digit APYs and subsequent market crashes, today’s yield mechanisms are more sophisticated and diverse. Pendle emerges in this new era, offering innovative solutions for yield management that address the lessons learned from past experiences.

Yield-Generating Assets

To understand Pendle’s innovative approach, we first need to explore the foundation of its ecosystem: yield-generating assets.

Every asset that provides additional perks while owned is defined as a yield-generating (or yield-bearing) asset. Sometimes, protocol holders can earn additional perks by performing specific actions like locking more tokens at specific times, sharing their email, joining a Discord server, inviting friends, or just clicking on icons for a few days in a row.

During the previous era of staking, the decision on which asset to stake mainly involved three factors:

The APR/APY
The actual asset price
The code quality and audits (since many staking smart contracts were exploited, leading to losses)

Nowadays, yield comes in various forms. Examples include:

stETH: Staking ETH in Lido generates approximately 3% annual growth.
DAI: Staking in Compound yields around 5.5% in DAI and 1% in COMP annually.
ETH: Restaking in Ether.Fi offers various perks like ETH, ETHFI tokens, EigenLayer points, AVS rewards, and Ether.Fi points, with new game rules frequently introduced. Simple actions like daily check-ins can earn more points and multipliers.

Yield Tokenization

With a clear understanding of yield-generating assets, we can now delve into how Pendle revolutionizes its management through yield tokenization.

The main idea behind yield tokenization is to separate the original asset (a.k.a. principal asset, the one being staked or locked) from its yield (generated by the locking protocol). This approach introduces new capital management strategies, especially in bullish market conditions and in the context of the EigenLayer ecosystem. If EigenLayer does not sound too familiar read my article here. It covers in-depth the protocol mechanics with diagrams and representative usage scenarios.

Yield-representing tokens are priced significantly lower than the original asset because they represent only the market’s expectation regarding the future yield of the underlying protocol, not the actual asset value. Therefore, if the market expects the yield to stay above 5%, the yield token price might be around 5% (or higher, depending on market expectations) of the original asset’s price. This allows investors to gain exposure to yield potential with less capital.

Example: Suppose you expect the APY on a specific asset (e.g., DAI) to increase from 5% to 10%. Instead of buying more DAI, you can buy yield-representing tokens, which are much cheaper. If the market expectation is 5% of the underlying asset, the yield token price will be around 100%/5% = 20 times cheaper than the asset price. This roughly equates to 20x leverage trading of the original asset.

Pendle Tokenization Mechanism

Let’s examine the core of Pendle’s innovation: its unique tokenization mechanism that separates yield from principal. We’ll start with the two main use cases insightfully identified by Pendle.

Alice, the Conservative Institutional Investor

Alice hopes that the principal stable token (USDe) will not de-peg keeping its price until maturity. Alice prefers a guaranteed return, protecting her investments from yield volatility. In Pendle terms, Alice buys a PT (Principal Token), so that:

Represents the right to redeem the full principal at maturity. The token is initially sold at a discount. Therefore, the yield upon maturity is guaranteed by code when the token reaches its original price.
The PT token is tradeable at all times vs the principal token so that if USDe drops or raises dramatically in price, Alice can abandon her PT token or take the revenue ahead of time.

Example: Alice buys 100 PT-USDe at $94.5, and receives $100 at PT maturity.

Bob, the Degen Yield Optimizer

Bob has just discovered the EigenLayer ecosystem and is bullish on the potential to boost rewards from Renzo Protocol, EigenLayer, and Actively Validated Services (AVSs) altogether. Bob buys YT-ezETH tokens to maximize his exposure to these potential yield increases.

The token allows Bob to receive all the actual yield generated by staked ETH until maturity, starting from the time of purchase.
While PT holders enjoy a guaranteed interest upon maturity, YT holders like Bob can claim the accrued staking rewards in real time, thanks to the integration with the underlying ezETH protocol.
The YT token is tradeable, allowing Bob to speculate on yield expectations. However, the YT value typically decreases over time and goes to zero upon PT maturity.

Example:

Initial conditions:

1 ezETH is worth $3,500
The expected APY is 5%
Token maturity: 1 year

Step 1: Bob buys YT-ezETH for 1 ezETH

Expected yield for 1 year: 5% of $3,500 = $175
YT-ezETH price for 1 ezETH: $175
Bob buys YT-ezETH for the worth of 1 ezETH, exposing his investment to x20 leverage factor: $3,500 / $175 = 20x

Step 2: APY jumps to 20%

New expected yield for 1 year: 20% of $3,500 = $700
New theoretical YT-ezETH price: $700

Step 3: YT price reaction

Let’s assume the YT-ezETH price doesn’t fully reflect the new yield immediately
New YT-ezETH price: $500 (reflecting increased yield expectations but with some lag)

Step 4: Bob’s position

Initial investment: $175
Current YT-ezETH value: $500
Unrealized profit: $500 — $175 = $325
Return on investment: ($325 / $175) * 100 = 185.7% in addition to all EigenLayer and Renzo Protocol rewards such as AVSs points, REZ token, and EigenLayer points.

Sidenote: In the EigenLayer days multiple rewards and points were promised for every LST/LRT token locked. Pendle protocol enabled multipliers and perks, facilitating armies of degens to increase their exposure to YT tokens. Having said that, the high hopes of getting massive rewards had passed quite a few disappointments recently, when the actual rewards turned out to be way less than expected (as there is no magic “give me the money” button).

Biting the “Zero-Sum” Game

Every market needs a zero-sum game, enabled by pairs of assets that balance each other against a well-defined invariant. Pendle documentation refers to the formula:

PT + YT = Underlying asset price

The principal price is incorporated in the Principal Tokens (PTs), while the yield aspect is revealed in both Principal Tokens (PTs) and Yield Tokens (YTs).

Let’s explore the initial discount on the PT, which enables a guaranteed revenue upon maturity. That “bite” from the actual PT price at the market launch time, becomes the initial price of the YT, enabling the yield-generating token.

Example: with a 100 DAI asset yielding 6% annually and 1-year maturity:

PT might be priced at 94.5 DAI
YT would be initially priced at 5.5 DAI

The initial ‘bite’ or discount is crucial to Pendle’s mechanism. Thanks to the talks in the Pendle discord, I’ve learned that it’s calculated based on current market conditions and historical data. Specifically, the smart contract looks at:

Past market consensus of implied yield from previous pools, if available.
The last 7-day average underlying yield as an alternative. This approach ensures the initial pricing reflects both market expectations and recent yield performance, creating a fair starting point for both PT and YT holders.

Keeping the Equilibrium

Understanding the zero-sum nature of Pendle’s system, we can now explore how this equilibrium is maintained in practice. Let’s explain how the market stays efficient based on the arbitrage use case:

Charlie, the Arbitrageur

Observes: PT at 0.93 DAI, YT at 0.06 DAI. Action: Spends 1 DAI to buy 1 PT and 1 YT.
At maturity: PT redeems for 1 DAI, YT yields additional profit (let’s say 0.04 DAI)
Total return: 1 DAI (from PT) + 0.04 DAI (from YT) = 1.04 DAI
Profit: 1.04 DAI — 1 DAI initial investment = 0.04 DAI

This risk-free profit incentivizes arbitrageurs to maintain the PT + YT = Underlying asset price equilibrium.

Pendle’s AMM Structure

Pendle’s innovative tokenization wouldn’t be complete without a robust trading mechanism. This is where Pendle’s unique AMM structure comes into play. The key components of this structure are:

A single liquidity pool type: PT/SY (Principal Token / Standardized Yield)
Support for both PT vs Principal and YT vs Principal trades (YT vs Principal trades are enabled via a flash swap mechanism using the same PT/SY pool)

SY (Standardized Yield) is a token standard (EIP-5115) developed by the Pendle team that:

Wraps any yield-bearing token
Provides a standardized interface for interacting with various yield-generating mechanisms
Acts as a building block for future DeFi applications
Is a purely technical component, e.g. users don’t interact with it directly

This structure offers several advantages:

Efficient Price Discovery: The PT/SY pool allows for an intuitive valuation of both PT and YT against the standardized yield-bearing asset.
Liquidity Optimization: Using a single pool type (PT/SY) allows for more efficient utilization of liquidity.
Capital Efficiency: Liquidity Providers (LPs) earn fees from both PT and YT swaps from a single liquidity provision.

It’s important to note that while PT + YT = Underlying asset value maintains as an equilibrium, the individual prices of PT and YT are subject to market forces. At maturity, PT will always be redeemed 1:1 to the underlying asset, while YT decays to 0.

Pendle’s AMM design also significantly mitigates the risk of impermanent loss (IL) for liquidity providers. Unlike traditional AMMs where IL can be substantial due to price divergence between paired assets, Pendle’s system ensures that PT generally follows the price of the original asset (wrapped as SY) closely, becoming 1:1 at maturity. This design feature makes liquidity provision in Pendle’s AMM a more predictable and potentially profitable endeavor, with negligible IL risk.

By combining efficient trading mechanisms, optimized liquidity utilization, and minimal impermanent loss, Pendle’s AMM structure offers a robust and attractive platform for both traders and liquidity providers.

Lifecycle of a Pendle Token

To truly grasp how all these components work together, I have tried to play with the numbers creating a set of examples with a hypothetical yield-bearing asset called yUSD, which represents a yield-bearing USD stablecoin. We’ll examine its behavior over 1 year with the following initial conditions:

Underlying yUSD price: $100
Expected annual yield: 10%
Maturity: 1 year from now

Sidenote: To avoid redundant zeros in our calculations, I am using $100 as the base price for yUSD instead of $1.

Let’s break this down into quarters:

The YT price typically decreases over time as the remaining yield potential diminishes, approaching zero at maturity. Conversely, the PT price increases, converging towards the full principal amount at maturity. This reflects the changing time value and risk profile of each token as the maturity date approaches.

Now, let’s examine some edge cases:

Edge Case 1: Unexpected Yield Increase

This scenario demonstrates how Pendle’s system adapts to sudden changes in yield expectations. When the expected yield doubles at Day 180, the system adapts through market forces and arbitrage:

Initial state (Day 90): PT = $97.50, YT = $5.00, Total = $102.50
Yield expectation doubles (Day 180):
YT price should increase to reflect higher future yield
PT price should decrease as more value is attributed to yield
Market reaction: YT price jumps to $8.75, PT drops to $96.25, Total = $105.00

Arbitrage mechanism: If the market overreacts, creating a mismatch (e.g., YT = $9.00, PT = $96.25, Total = $105.25):

Arbitrageurs sell 1 YT for $9.00
They buy 1 underlying yUSD for $100
They split this yUSD into 1 PT and 1 YT
They sell the newly created PT for $96.25
Net profit: $9.00 + $96.25 — $100 = $5.25 (minus fees and slippage)

This process continues until PT + YT = yUSD ($100). This arbitrage ensures the system maintains equilibrium despite the shock in yield expectations.

This scenario demonstrates Pendle’s ability to adapt to sudden yield changes while maintaining overall equilibrium through market forces and arbitrage.

Edge Case 2: Underlying Asset Value Decrease

When yUSD drops 10% at Day 180, PT and YT prices adjust to maintain the equilibrium.

This adjustment maintains the equilibrium PT + YT = yUSD price in the face of underlying asset volatility, demonstrating Pendle’s resilience to significant market movements while preserving the yield tokenization structure.

This case illustrates Pendle’s resilience to underlying asset volatility, showing how the system adjusts to maintain the fundamental PT + YT relationship.

Edge Case 3: High Yield Uncertainty Near Maturity

This scenario showcases the impact of yield uncertainty as the token approaches maturity:

Initial expectation: 10% annual yield
Actual yield by Day 365: 12% (higher than expected)

What happens:

YT price becomes more volatile due to uncertainty (e.g., fluctuating between $7.50 and $8.75)
PT price remains relatively stable, approaching $100 (full principal)

YT price volatility increases near maturity because:

Less time for yield generation means each yield change has a larger relative impact
Market participants have differing short-term yield expectations
Any new information about potential yield has a more immediate effect

User benefit:

Initial YT price (Day 0): $5.00 (expecting 10% yield)
Final yield payout: $12.00 (12% of $100)

YT holders benefit because they receive the actual yield, which exceeds expectations. They paid for an expected 10% yield but received a 12% yield, resulting in a 20% higher return on their investment (($12 — $10) / $10 = 20% increase).

This example highlights how Pendle handles yield uncertainty near maturity, benefiting YT holders when yields exceed expectations while maintaining PT stability.

Risks and Limitations

As with any complex financial system, Pendle comes with its own set of challenges. Let’s examine the potential risks and limitations users should be aware of:

Smart Contract Risk: Despite rigorous audits, Pendle’s smart contracts may contain unforeseen vulnerabilities. For example, a bug in the yield calculation mechanism could lead to incorrect token pricing. Pendle mitigates this through regular audits and bug bounty programs.
Market Volatility: Extreme market conditions could cause significant price discrepancies between PT, YT, and the underlying asset. A sudden drop in ETH price, for instance, could lead to unexpected losses for YT holders. Users can hedge their positions by combining PT and YT from different assets.
Liquidity Risk: During periods of low liquidity, users might struggle to enter or exit positions at desired prices. This could be particularly problematic near maturity dates when many users may want to close positions simultaneously. Pendle incentivizes liquidity provision to maintain deep pools.
Complexity: The system’s sophistication might confuse less experienced users. For example, a user might inadvertently sell their YT, thinking they’re only trading excess yield, and miss out on future yield appreciation.
Regulatory Uncertainty: Evolving DeFi regulations could impact Pendle’s operations or token classifications. Securities regulators might, for instance, classify YTs as derivatives, potentially limiting their accessibility.
Underlying Asset Risk: Issues with yield-generating assets could affect both PT and YT values. A de-pegging event in a stablecoin used as an underlying asset would impact all associated Pendle tokens.
Oracle Dependence: Accurate pricing and yield calculations rely on oracles, which could be manipulated or fail. An oracle reporting inflated yield data could lead to mispricing of YTs.
Maturity Mismatch: Users must be aware of token maturity dates to avoid unexpected value changes or expirations. Holding a YT past its maturity date, for example, would result in holding a worthless token.

Composability

Despite these challenges, Pendle’s design opens up a world of possibilities through its high degree of composability with other DeFi protocols. By separating principal and yield into tradable tokens, Pendle offers versatile building blocks for complex financial strategies:

Collateralized Borrowing: Use PTs as collateral on lending platforms like Aave to borrow stablecoins, while retaining YTs for yield exposure. This allows users to leverage their principal while still benefiting from yield appreciation. Example: Alice deposits 100 DAI PT on Aave, borrows 70 USDC, and uses it to buy more YT, amplifying her yield exposure.
Cross-chain Yield Strategies: Bridge Ethereum-based PTs to other networks like Polygon or Arbitrum, using them in those ecosystems’ DeFi protocols. This enables users to capitalize on yield opportunities across multiple chains. Example: Bob bridges 100 USDT PT from Ethereum to Polygon, and uses it as collateral in a Polygon DeFi protocol, earning additional yield.
Yield Tranching: Combine high-yield, high-risk YTs (e.g., from newer, more volatile protocols) with low-yield, low-risk PTs from established assets. This creates customized risk-return profiles catering to different investor appetites.
Options on Yield: Develop option contracts on ETH staking YTs, allowing users to speculate on or hedge against future changes in staking rewards. This adds a new dimension to yield management and risk mitigation.
Yield-boosted Savings Accounts: Create stablecoin savings products backed by DAI PTs, using YTs to boost the offered APY. This provides users with stable principal protection while offering competitive yields.

These examples showcase how Pendle’s tokenized yield becomes a versatile component in the DeFi ecosystem, enabling innovative financial products and strategies previously unattainable in traditional finance or early DeFi systems.

Future Developments

With a solid understanding of Pendle’s current mechanics and potential, let’s look ahead to the exciting developments on the horizon. Pendle continues to evolve with the upcoming Pendle V3, set to launch in 2024. This new version promises the following significant advancements:

Native Cross-margin Engine

Allows users to manage multiple positions across different assets and maturities within a single margin account.
Reduces capital inefficiencies by netting out positions and sharing collateral across trades.

Example: A user can now use their ETH-based PT as collateral for trading USDC-based YTs without needing separate deposits.

The native cross-margin engine could allow users to more efficiently leverage their positions across multiple assets, potentially increasing overall capital efficiency in the Pendle ecosystem.

Introduces a new order type where users specify their desired outcome rather than exact execution parameters.
The system automatically finds the best execution path, potentially across multiple liquidity pools.

Example: Instead of placing a specific swap order, users can input “I want to maximize my YT exposure for 1000 USDC,” and the system will determine the optimal execution across available markets.

These innovative developments offer more sophisticated, efficient, and flexible tools for yield management and trading.

The intents-based execution might lead to more complex yield optimization strategies, as users can more easily express complex trading goals.

The native cross-margin engine could allow users to more efficiently leverage their positions across multiple assets, potentially increasing overall capital efficiency in the Pendle ecosystem. The intents-based execution might lead to more complex yield optimization strategies, as users can more easily express complex trading goals.

Conclusion

In this deep dive into Pendle’s mechanics, we’ve covered many concepts, from the basics of yield-generating assets to the intricacies of Pendle’s tokenization mechanism. We’ve explored how Pendle separates yield from the principal, creating a flexible system that caters to various investor needs — from conservative principal-seekers to yield optimizers and even yield shorters.
Through detailed examples and edge cases, we’ve illustrated how Pendle maintains its core equilibrium of PT + YT = Underlying asset price across various market conditions. We’ve seen how the system handles unexpected yield increases, underlying asset volatility, and even extreme market optimism, showcasing the robustness of Pendle’s design.
As DeFi continues to mature, protocols like Pendle demonstrate the sophisticated financial instruments that can be created on-chain. By tokenizing yield and creating liquid markets for future yield expectations, Pendle opens up new strategies for capital efficiency and risk management in the digital asset space.

Sources

Acknowledgments

It’s worth noting that the depth of understanding displayed in this article owes much to the Pendle community, particularly the knowledgeable members of the Pendle Discord. Unlike many crypto communities where discussions rarely venture beyond token prices and redemption processes, the Pendle community stands out for its technical depth and willingness to engage with complex protocol mechanics. Their insights and patience in explaining intricate details have been invaluable in crafting this comprehensive overview.

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