Principal and Interest Separation Protocols
In this section, we delve into the realm of fixed interest rate protocols, focusing on Principal and Interest Separation Protocols, which are distinct from the fundamental fixed-rate lending protocols discussed previously （https://medium.com/@scapital/fixed-interest-rates-protocols-in-defi-1-b2d67f1120b2）. These innovative protocols are designed to work atop existing DeFi platforms, such as AAVE, Compound, and Yearn Finance, and are structured to enable fixed-rate deposits while omitting fixed-rate borrowing.
Principal and Interest Separation Protocols revolutionize the DeFi landscape by providing users with the ability to deposit their assets into lending protocols or yield aggregators. Within these protocols, users tokenize both their principal and future interest, enabling the separation of two key financial components. While interest tokens are priced based on market expectations of future interest rates before maturity, principal tokens assume a role similar to zero-coupon bonds, redeemable at face value upon maturity. Much like zero-coupon bonds, interest tokens assume a time value in the market as the maturity date approaches. This ingenious mechanism empowers the creation of fixed interest rates and facilitates leveraged long positions in the interest rate market.
1. Element Finance
Element Finance embraces a structure where all funds are stored within the Yearn Finance yield aggregator and subsequently divided into Principal Tokens (PT) and Yield Tokens (YT). Principal Tokens are minted and issued to depositors who opt for term lockups, and they are redeemable at the end of the term for the same value as the initial deposit. Conversely, Yield Tokens are minted and issued to depositors choosing term lockups, representing the variable interest accrued within the underlying yield protocol (Yearn) during the term. This separation mirrors the concept of bond stripping in traditional finance, distinguishing PT as akin to zero-coupon bonds and YT representing the isolated coupon component. This framework offers flexibility for more intricate use cases, including fixed income deposits, interest rate trading, and serves as essential infrastructure for re-collateralization with fixed terms.
Basic Mechanism
Users can achieve fixed interest rates in two ways. First, they can mint PT and YT using the underlying assets. Since YT represents a variable interest position, selling YT while holding PT can provide a fixed interest position. The second method involves purchasing Principal Tokens (PT) at a discount through the support of Automated Market Makers (AMMs). Fixed interest rates depend on the discount rate of the assets at the time of purchase. Buyers of Principal Tokens, which have not yet matured, trade them at a discount based on the discount of the respective representative asset. The farther the maturity date, the higher the discount. At maturity, users can choose to redeem their Principal Tokens at a 1:1 value. If users wish to withdraw and redeem fixed interest earnings before the maturity date, they can also sell them to AMMs to earn fixed interest rates determined by secondary market pricing up to that point.
Element’s Principal Tokens and Yield Tokens can be traded in a customized Balancer AMM. A typical liquidity pool holds Principal Tokens paired with their underlying assets (eP:yETH and ETH). Each term has its own liquidity pool corresponding to the maturity date of Principal Tokens.
Liquidity Provider
Being a liquidity provider involves providing liquidity to Automated Market Makers (AMMs) by offering pairs of assets. Element allows users to become liquidity providers for Principal Tokens. The incentive for liquidity providers is to earn trading fees on the assets they provide. Users who mint Principal Tokens and provide liquidity with them will earn variable interest income (from holding Yield Tokens) in addition to AMM fees.
Advanced Trading Strategies for Both Principal Token and Yield Token
Selling PT, Holding YT
Users can split the underlying assets in Element Finance into PT and YT through the Mint & LP interface. They can then sell PT in the corresponding pool, but at a discount. The discount rate depends on the proximity of the maturity date and market supply and demand. At this point, the seller retains variable interest in the underlying assets (YT), while the principal is released.
Buying and Selling Yield Tokens
Buying Yield Tokens directly is essentially a long position on interest rates. If users believe that future interest rates will decrease, they can also sell Yield Tokens at the current exchange rate to lock in profits, which is equivalent to taking a short position on interest rates.
Increasing Exposure to Variable Interest (Sell PT and Accumulating YT)
Users who sell their Principal Tokens at a discount can choose to reinvest the assets they receive into Element, thereby increasing their overall exposure to variable interest. This is referred to as “Yield Token Compounding,” allowing users to gain this increased exposure without the risk of liquidation. In other words, it’s a way to leverage long positions on interest rates and increase the exposure to Yield Tokens. However, it’s important to note that the Discount Rate is not fixed, and the APY for YT can change at any time.
Element AMM
Principal Tokens and interest tokens are different in nature, so Element establishes separate liquidity pools for them. Similar to zero-coupon bonds, Element’s Principal Tokens use the YieldSpace AMM curve for their Principal Token liquidity pool, effectively mitigating the loss faced by liquidity providers. Interest tokens can be redeemed at maturity in exchange for the accrued interest during that period. However, since future interest is uncertain, it may lead to significant price fluctuations due to changes in market supply and demand. Therefore, x×y=k is chosen as the pricing curve for interest tokens, which is relatively straightforward and helps with price discovery.
2. Pendle Finance
Pendle is a DeFi yield trading protocol built on the Ethereum blockchain, allowing users to execute various yield management strategies. Its basic mechanism is highly similar to Element, so we won’t go into extensive detail.
Basic Mechanism
Pendle Finance packages interest-bearing tokens into SY (Standardized Yield tokens). SY is then split into its principal and yield portions, PT (Principal Token) and YT (Yield Token), which can be traded using a custom V2 AMM. Unlike Element, Pendle standardizes the yield generation mechanisms by first converting interest-bearing tokens into SY, such as stETH, cDAI, and yvUSDC, which are packaged into SY-stETH, SY-cDAI, and SY-yvUSDC. This makes their yield generation mechanisms standardized on Pendle. The process happens automatically in the background, so users interact directly with their interest-bearing tokens without manually handling SY to yield tokens conversion. Another difference is in how yield tokens operate. Pendle’s YT represents the right to receive deposit interest, with longer holding periods yielding more interest. As the maturity date approaches, the value decreases to zero. In contrast, Element’s yield accumulates on the value of YT tokens until the maturity date when they can be redeemed.
Users can achieve fixed interest rates by splitting Yield-Bearing Tokens (e.g., aUSDC) into Principal Tokens and Yield Tokens, enabling them to buy at a price lower than the market rate. Before the fixed maturity date, the principal of interest-bearing tokens is represented by PT, while the right to yield during this period is represented by YT. Therefore, the monetary value of YT can allow the principal assets to be sold at a better price. Once the maturity date is reached, the relevant interest-bearing tokens can be claimed in PT. However, even with a fixed maturity date, users can choose to exit their position and profit at any time before maturity.
For example, ETH is sold at a 5% discount on Pendle with a 1-year term. This means a user can purchase the right to 100 ETH for the price of 95 ETH. A year later, they will have the right to claim all 100 ETH. If a user decides to exit before the PT matures, they can still sell the discounted ETH, although not the entire value of 100 ETH.
Liquidity Pool
Liquidity providers supply liquidity to Pendle’s pool and earn swap fees as revenue. Different pools have varying APYs due to the trading volume and PENDLE incentive mechanisms (decided through governance and voting). Liquidity providers can earn revenue from multiple sources: fixed interest from PT, protocol rewards from the underlying tokens, swap fees, and PENDLE rewards.
Pendle V2 AMM
The first version of Pendle’s AMM used SushiSwap’s liquidity pools, which followed Uniswap’s constant product formula x*y=k. As mentioned in the previous section, this curve does not account for the crucial factor of time variation. This means that liquidity providers will inevitably incur temporary losses as prices change over time. Therefore, Pendle’s newly introduced AMM V2 makes significant changes to protect the interests of liquidity providers. It is inspired by Notional Finance’s AMM with some enhancements, resulting in a new AMM curve that accumulates interest rates over time and narrows the price range of PT as it approaches maturity. This leads to increased capital efficiency in trading as the potential price range narrows when PT approaches maturity. Additionally, Pendle takes into account that the separation of principal tokens and yield tokens for each underlying pool is inefficient in terms of capital utilization. Pendle uses a single liquidity pool to facilitate the swapping of PT and YT. PT can be directly traded with SY through the PT/SY pool, and YT trading can be done through flash swaps. Pendle V2’s AMM takes into account the natural appreciation of PT’s price by adjusting the AMM curve over time to push PT’s price toward its fundamental value, reducing the uncompensated losses that occur with changing time. Furthermore, the IL caused by swaps is alleviated because both of LP’s assets are highly correlated with each other (e.g., PT-stETH / SY-stETH). If liquidity is provided before maturity, LP’s position is essentially equivalent to holding the underlying assets entirely, as PT appreciates towards the underlying assets. In most cases before maturity, PT trades within a range of interest rates, not fluctuating like the spot price of the assets. For example, a reasonable assumption is that Aave’s USDC loan interest rate fluctuates within 0%-15% over a reasonable time range (and PT trades within this range accordingly). This premise ensures low IL at any given time because PT’s price does not deviate significantly from the time of providing liquidity.
Pendle Current Situation
Pendle has emerged as the leading protocol in the category of fixed-rate Principal and Interest Separation models. As of mid-December, the Total Value Locked (TVL) across multiple chains in Pendle has reached a staggering $239 million. The innovative approach of Pendle’s V2 Automated Market Maker (AMM), which combines PT tokens and SY tokens, has significantly reduced the impermanent loss encountered by Liquidity Providers (LPs). This has encouraged more LPs to invest their funds to earn returns.
For traders of PT or YT, the concentration of liquidity has improved the trading conditions and price execution, thereby attracting more traders. Furthermore, Pendle V2 has capitalized on the popularity of Liquidity Swap Derivatives (LSDs). In January 2023, it launched its first pool, Aura’s rETH-WETH, in collaboration with Aura, Rocket Pool, and Balancer. This marked the beginning of a rapid growth trajectory for Pendle.
Building on this, Pendle subsequently introduced additional pools such as ankrETH and Stafi-rETH, and quickly expanded to multiple chains, thereby rapidly increasing Pendle’s volume. For other related protocols, the rewards offered by Pendle can effectively help these protocols attract liquidity. As a result, an ecosystem similar to Curve War, known as Pendle War, has begun to form around Pendle. The development of Pendle V2 demonstrates the power of collaborative benefits.
Pendle Pools Analysis
Different pools in Pendle behaves very differently. Let’s take some examples :
- crvUSD (Maturity 28 Mar 2024)
Upon evaluating liquidity depth, slippage, and potential returns, this pool in Pendle emerges as the superior choice. The Annual Percentage Yield (APY) is notably appealing, offering substantial yield potential for both Yield Token (YT) and Principal Token (PT). This allows investors with varying market anticipations to find an adequate depth window to express their views. Furthermore, a fund swap of $1 million only influences the price and slippage within an acceptable range. This makes it a preferred choice for many.
- stETH
Currently, there are three pools of stETH with maturities approximately at 1, 2, and 4 years. The underlying Annual Percentage Yield (APY) is not particularly appealing, albeit acceptable to those who short the Lido staking APY from a long term, standing at 3.95% currently in comparison to Lido’s 3.8%, which will drop if more ETH are staked into Lido in the future. However, a standard swap, approximately 100K in Notional, significantly alters the APY, rendering it unacceptable. Additionally, it has been observed that the swap in this pool operates on a discrete basis rather than a continuous one.
- sDai
Due to lack of liquidity, a very small swap will change the APY a lot thus make it almost not useable. And to LP, only 4.8% APY in contrast to sDai’s 5% APY in Spark Protocol, it’s for sure no one is willing to put capital into this pool.
We posit that the usefulness of the Pendle Pool is determined by the market interest rate or yield APY of the underlying asset. In the case of crvUSD, a yield of approximately 10% exists in the market, creating a broader yield window. This attracts Liquidity Providers (LPs) to contribute liquidity in exchange for a substantial yield. Deeper liquidity enables more counterpart players to express their preferred direction. An increase in swaps enhances the APY for LPs, encouraging more LPs to invest in liquidity. Conversely, for sDai and stETH, yield rates of approximately 5% and 3.8% have been consistent for a considerable duration. This results in a narrow window, limiting the alpha that LPs can obtain, thus affecting the depth of the pools.
That is to say, Pendle is more applicable to those assets that have higher or more fluctuant yield or interest rate.
3. Swivel Finance
Swivel’s design is centered around the concept of cash flow tokenization. Swivel offers depositors the ability to split an interest-bearing token into two separate cash flow tokens until a future date. One token represents future earnings (nTokens), while the other represents ownership of the underlying token, which can be redeemed on the future date (zcTokens). So, similar to the protocols mentioned earlier, fixed interest rates can be achieved by depositors selling interest tokens at the beginning of the term, retaining principal tokens to obtain fixed interest or directly purchasing zcTokens on the secondary market. However, unlike Element and Pendle, Swivel employs an order book model for market making.
AMM vs Orderbook
So far, AMMs have proven to be an effective mechanism for guiding liquidity. However, their effectiveness and capital efficiency in the derivatives market have been the most questionable. As mentioned in the previous section, existing AMMs do not adjust for the fact that the price of zero-coupon bonds changes over time. Moreover, the Principal and Interest Separation Protocols introduce interest tokens whose prices vary over time and with interest rates. This makes valuing interest tokens more difficult, and liquidity providers face significant risks if they are unable to adjust quotes based on standard derivatives pricing variables. Therefore, when trying to handle Swivel’s market with traditional AMMs, it would be necessary to establish an AMM that appreciates over time for principal tokens (similar to Element) and a devaluation AMM for interest tokens (similar to Pendle). Swivel has chosen to use an off-chain order mechanism to solve the pricing difficulties of principal and interest tokenization on AMMs, rendering those separate AMMs unnecessary. This allows real-time traders to balance market risk with their quotes. Swivel uses oracles and market participants to guide quotes on cash flows, and it seeks a balanced approach that meets the needs of both spot market participants and hedgers, all while avoiding the challenges of operating AMMs in the derivatives market.
Summary
The above three Principal and Interest Separation Protocols enable the creation and separation of principal and yield tokens through underlying assets or interest-bearing assets. Principal tokens resemble zero-coupon bonds, which are used to determine fixed interest rates, while yield tokens are akin to floating-rate bonds. Despite subtle differences, the essence of these protocols lies in leveraged variable-rate speculation enabled by the structure of principal and interest separation. The appeal of such protocols also lies in the ability to construct different trading strategies based on PT and YT. Users bullish on interest rates can purchase Yield Tokens, while those bearish on interest rates can sell YT at the current rates, locking in profits in advance. Leveraging long variable rates (Yield Token Compounding) involves repeatedly selling principal tokens, buying yield tokens to increase exposure, but the drawback is the high cost and complexity due to the need to pay substantial gas fees with each transaction. Additionally, the uncertainty surrounding the APY of YT and the Discount Rate of principal tokens in each transaction poses challenges. Therefore, this method of betting on interest rates, while innovative, is not efficient and comes at a high cost.
Furthermore, all three protocols share a high degree of homogeny, with the exception of Swivel, which has chosen a different path by opting for an order book market-making model. However, in terms of directly trading interest rates, Principal and Interest Separation Protocols are not as direct as Interest Rate Swap (IRS) protocols. IRS protocols have a larger market volume in traditional finance compared to fixed-rate lending. Additionally, from the perspective of creating fixed-income products, Notional Finance is more straightforward because zero-coupon bonds are concentrated in a single pool. In contrast, Element allows the creation of principal tokens through two methods: by minting them from underlying assets or by directly purchasing principal tokens in a pool. These two different AMMs result in different prices for principal tokens, creating arbitrage opportunities and rendering the price discovery mechanism ineffective.
In summary, Principal and Interest Separation Protocols find themselves in a somewhat awkward position within the fixed-rate landscape. Their primary focus seems to be on trading floating rates rather than fixed income, which can result in a lack of competitiveness compared to pure fixed-rate lending products and Interest Rate Swap protocols.
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