Written with the Pendle Team

This article aims to provide insight into the ways in which decentralized finance (DeFi) users can maximize the use of future yield. If you are unfamiliar with cryptocurrency or decentralized finance (DeFi), check out our introductory articles on crypto, DeFi, blockchain, and farming.

Is Future Yield the Future of DeFi?

DeFi is an ever growing ecosystem, bringing countless new technologies and mechanisms to revolutionalize traditional finance (TradFi) systems, especially with the advent of blockchain technology and the growing need for more decentralization, security, and custody of assets. One big draw of DeFi are the yields it provides, often unimaginably more than what TradFi platforms can offer, albeit with considerably higher risks. Building on that, a niche DeFi sector known as yield derivatives have surfaced, allowing users to maximize the use of future yield. In this article, we will explore ways in which DeFi users can benefit from future yield through:

Tokenization
Self-repaying loans

Tokenization of Future Yield

Yield derivative protocols that tokenize future yield deposit users’ underlying assets into several partner yield-generating protocols such as Compound, Lido, and Balancer, getting yield-bearing tokens in return. These yield-bearing assets are “tokenized” and split into principal tokens and yield tokens. Different DeFi protocols name these tokens differently, but in essence, all of them separate the principal tokens, which represent the amount of underlying assets deposited by the user; and yield tokens, which represent the potential yield from the underlying asset. For most such protocols, there is a native automated market maker (AMM) or secondary market for the principal and yield tokens through which the prices will be determined.

Treehouse APIs for Institutions provides comprehensive historical and current portfolio data and institutional DeFi analytics for Compound, Lido, and Balancer assets. Contact us if you are interested!

Principal Tokens

Principal tokens work similar to zero-coupon bonds in the TradFi market, providing users with an option of fixed rate yields. Since the yield is stripped from the principal tokens, they are usually sold at a discounted rate to their associated asset. After holding the principal tokens for a specified maturity period, users can redeem them at their full value, receiving guaranteed profit in underlying asset terms at a “fixed rate”. Like zero-coupon bonds, PTs are tradeable in the secondary market (such as Pendle) should the capital need to be unlocked immediately.

Yield Tokens

Buying and holding yield tokens gives users the right to receive the accrued rewards from the associated underlying asset after a specified maturity period. Users that are bullish on the yield of the underlying asset, predicting that the yield will increase across the maturity period, will buy this token at the current implied annual percentage yield (APY). They will likely profit if the actual APY of the underlying asset at the end or during the maturity period is higher than the original implied APY.

Conversely, if the APY after the maturity period is lower than the original implied APY, users will face a loss during redemption of their YT.

Considerations for Profit Using Yield Tokens

As illustrated in the figures above, YTs are generally low in value. This means that most YT strategies involve buying large amounts of YTs to optimize the chances of higher profit. Additionally, if the increase in APY across the maturity period is negligible, and the amount of YTs purchased is too small, the eventual profit may be negated by other costs incurred in the process such as gas or protocol fees.

An Example of Investing With YTs

Assuming 1 YT costs 0.1 DAI at an implied APY of 10%:

Bob has a capital of $1000 and he purchases 10,000 YT
After a one-year maturity period, the APY increases to 15%
1 YT gives Bob revenue of 0.15 DAI and a profit of 0.05 DAI
10,000 YT gives Bob a total revenue of 1500 DAI and a profit of 500 DAI

However, the converse is also true and if APY decreases from 10% to 5%, then Bob will have a total loss of 500 DAI.

Some examples of DeFi yield derivative protocols that tokenize future yield include Pendle, Element Finance (now known as DELV), and Sense.

Pendle Finance

Pendle is a permissionless DeFi yield-trading protocol that enables users to execute various yield management strategies. Pendle uses a dual-token model that breaks up any yield-bearing assets into two parts – the initial principal put up by an investor, and the future yield expected to be earned on that position in the form of token rewards.

This is done by wrapping yield-bearing tokens into a Standardized Yield (SY) token. That token is then wrapped into a Principal Token (PT) and Yield Token (YT), which can be freely traded on Pendle’s custom V2 AMM.

Through this, users are able access a host of advanced yield strategies such as:

Purchase assets like ETH and USDT at a discount
Buying PT to lock in a fixed yield for low-risk, stable growth
Long yield with YT for amplified yield exposure (e.g., generate yield through 100 YT-stETH instead of 4 stETH)
Speculate on yield movements by actively trading YT/PT (e.g., buy YT or sell PT to long yield)
A mix of any of the above strategies

Standardized Yield (SY)

Pendle’s EIP-5115 Standardized Yield is a crucial component that underpins the entire Pendle ecosystem.

DeFi protocols often employ different, unique yield-generating mechanisms. These differences mean that each asset has to be manually integrated through a custom solution, hampering the scalability of yield-tokenization platforms. Although the ERC-4626 standard has partially alleviated this issue, there are still other yield-generating mechanisms that cannot conform to it (e.g., liquidity provider (LP) tokens).

SY overcomes these challenges by allowing all yield-bearing tokens to be wrapped into a common interface, standardizing their yield-generating mechanics to be supported on Pendle. With SY, specialized contracts are no longer required and yield markets can be created effortlessly. The super composability of SY lays down the foundation for a permissionless future, where anyone can create a pool for any yield-bearing assets, à la the Uniswap effect.

Pendle V2 AMM

Another pivotal aspect of Pendle is their new AMM, which is optimized for yield trading with a range of features that enhance capital efficiency and flexibility. Pendle’s AMM highlights its capital efficiency by concentrating liquidity into a yield-band, deepening meaningful liquidity. The unique architecture of the AMM also allows both PTs and YTs to be traded using only a single pool of PT liquidity, with YT swaps being facilitated through flash swaps. This results in consolidated liquidity that benefits yield traders with deeper liquidity, while LPs can compound fees from two markets with only single-asset provision.

An Example of Buying YT-stETH:

Bob sends stETH into the swap contract (auto-routed from any major token)
Contract borrows more stETH from the pool
PT-stETH and YT-stETH are minted from all of the stETH in the swap contract
Contract sends the YTs to Bob
At the same time, the PTs are sold for stETH to repay the loan from step 2

An Example of Selling YT-stETH:

Bob sends YT-stETH to swap contract
Contract borrows an equivalent amount of PT-stETH from the pool
The YTs and PTs are used to redeem stETH
A portion of the stETH is swapped to PT-stETH to repay the loan from step 2
stETH is sent to Bob (or routed to any major tokens, e.g., USDT, USDC, wBTC, etc)

vePENDLE

Pendle’s governance is powered by vote-escrowed PENDLE, or vePENDLE. With the power to direct PENDLE rewards, vePENDLE opens up the possibility for protocols to attract liquidity by locking, voting, and nabbing more incentives for their own pools. Any deposits into these yield markets will also fully contribute and be reflected in the underlying protocol’s total value locked (TVL).

vePENDLE holders can also amplify their yield from liquidity provision, on top of other rewards that vePENDLE renders such as protocol revenue and swap fees. For example, Figure 7 shows that the base APY for the PT STaFirETH-WETH pool is 69.9%, while the boosted yield can go up to 146% APY for LPs holding vePENDLE.

Self-Repaying Loans Using Future Yields

Apart from the tokenization of future yield to create new investment opportunities for users, the birth of self-repaying loans is another mechanism that optimizes the use of future yield. Specifically, we will be exploring how Alchemix works.

Alchemix

Alchemix is a synthetic asset DeFi platform that offers interest-free, self-repaying loans to users. Users can obtain a loan by depositing yield-bearing assets such as DAI or ETH as collateral. Users can get a loan in either alUSD, a synthetic stablecoin, or alETH, a synthetic ETH token, which they can use in various DeFi activities, such as swapping for other tokens, leveraging, or providing liquidity. Users’ collateral generates additional yield on yield-generating DeFi protocols integrated with Alchemix, paying off the loan and resulting in no interest incurred. Alchemix’s flexible approach enables users to adjust their borrowed amounts based on the value of their collateral and the sources of yield.

Evolving Innovation to Unlock Future Yield

Alchemix is highly dependent on DeFi yields, meaning that bear markets and times of declining yields can limit the viability and potential of self-repaying loans. Alchemix alleviated this issue by adding support for new sources of yield, such as Lido and Rocket Pool ETH liquid staking derivatives (LSDs) as collateral (stETH and rETH, respectively). This provides DeFi users with an alternative and sustainable source of yield through Ethereum staking rewards, resulting in quicker loan repayment and more predictable repayment periods for users. Check out this article to learn more about Institutional ETH Staking in a Post-Shanghai World.

A key aspect to consider when using Alchemix is the risk associated with synthetic assets. alUSD and alETH are pegged to the value of the 1 USD and 1 ETH, which may depeg for various reasons such as fluctuations in DeFi yields or changes in the value of the deposited assets. In such a scenario, the value of the synthetic assets could decrease, potentially leading to a loss. Even though the Alchemix transmuter guarantees a 1:1 conversion of synthetic assets to DAI and ETH, unpredictable yields mean that the transmuter may not have sufficient liquidity to cover the conversion.

Conclusion

The DeFi ecosystem is continuously evolving, and the emergence of yield derivatives has opened up new possibilities for DeFi users. Pendle’s tokenizing of future yield and Alchemix’s self-repaying loans are just a few examples of DeFi innovations constantly work towards improving capital efficiency for crypto investments. As new DeFi protocols continue to develop, we can expect to see even more innovative solutions that offer greater returns on investment while still prioritizing decentralization, security, and custody of assets. We think there is significant potential to unlock in future yield derivatives and it will be exciting to see how this trend unfolds.

Disclaimer

This publication is provided for informational and entertainment purposes only. Nothing contained in this publication constitutes financial advice, trading advice, or any other advice, nor does it constitute an offer to buy or sell securities or any other assets or participate in any particular trading strategy. This publication does not take into account your personal investment objectives, financial situation, or needs. Treehouse does not warrant that the information provided in this publication is up-to-date or accurate.

Treehouse APIs for Institutions provides institutional DeFi analytics and comprehensive current and historical portfolio data to meet your monitoring, trading, and reporting needs. Contact us if you are interested, or check out our integration with CryptoSheets! Otherwise, check out Treehouse Academy, Insights, and Treehouse Daily for in-depth research.

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