Decentralized Finance Lego Game: Unveiling the Billion Rise Flywheel of Ethena, Pendle, and Aave

Original text: shaunda devens, Blockworks Research analyst

Compiled by: Yuliya, PANews

In the past 20 days, the supply of Ethena's decentralized stablecoin USDe has increased by approximately $3.7 billion, mainly driven by the Pendle-Aave PT-USDe looping strategy. Currently, Pendle has locked approximately $4.3 billion (accounting for 60% of the total USDe supply), while Aave has about $3 billion in deposited funds. This article will break down the PT looping mechanism, growth drivers, and potential risks.

The core mechanism and yield volatility of USDe

USDe is a decentralized stablecoin pegged to the US dollar, and its price anchor does not rely on traditional fiat or crypto asset collateral, but is achieved through Delta-neutral hedging in the perpetual contract market. In short, the protocol hedges ETH price volatility risk by holding a long position in spot ETH while shorting an equivalent amount of ETH perpetual contracts. This mechanism allows USDe to stabilize its price algorithmically and capture returns from two sources: staking rewards from spot ETH and funding rates in the futures market.

However, the yield volatility of this strategy is relatively high, as the yield depends on the funding rate. The funding rate is determined by the premium or discount between the perpetual contract price and the underlying ETH spot price ("mark price").

When market sentiment is bullish, traders will focus on opening high-leverage long positions, pushing the perpetual contract price above the mark price, thereby generating a positive funding rate. This will attract market makers to hedge by shorting the perpetual contracts and going long on the spot.

However, the funding rate is not always positive.

When market sentiment is bearish, the increase in short positions can cause the price of ETH perpetual contracts to fall below the mark price, resulting in a negative funding rate.

For example, recently AUCTION-USDT has seen a spot premium due to spot buying and perpetual contract selling, causing the 8-hour funding rate to reach -2% (annualized approximately 2195%).

Data shows that from 2025 to the present, the annualized return of USDe is approximately 9.4%, but the standard deviation has reached 4.4 percentage points. It is precisely this severe volatility in returns that has given rise to an urgent market demand for a product with more predictable and stable returns.

Pendle's Fixed Income Transformation and Limitations

Pendle is an AMM (Automated Market Maker) protocol that splits yield-generating assets into two types of tokens:

• Principal Token (PT - Principal Token): Represents the principal that can be redeemed on a specific future date. It trades at a discount, similar to a zero-coupon bond, with its price gradually returning to par value (e.g., 1 USDe) over time.
• Yield Token (YT - Yield Token): Represents all future yields generated by the underlying asset before the expiration date.

Taking the PT-USDe that expires on September 16, 2025, as an example, PT tokens typically trade at a price lower than the maturity face value (1 USDe), similar to zero-coupon bonds. The difference between the current price of PT and its maturity face value (adjusted for the remaining time to maturity) can reflect the implied annualized yield (i.e., YT APY).

This structure offers USDe holders the opportunity to hedge against yield fluctuations while locking in a fixed APY. During periods of historically high funding rates, the APY can exceed 20%; currently, the yield is around 10.4%. Additionally, PT tokens can receive up to 25 times the SAT bonus from Pendle.

Pendle and Ethena have thus formed a highly complementary relationship. Currently, Pendle's total TVL is 6.6 billion USD, of which approximately 4.01 billion USD (about 60%) comes from Ethena's USDe market. Pendle addresses the yield volatility issue of USDe, but capital efficiency remains constrained.

YT buyers can efficiently gain exposure to returns, while PT holders must lock 1 dollar of collateral for each PT token when shorting floating returns, limiting the yield to a small spread.

Aave Architecture Adjustment: Clearing Obstacles for USDe Circulation Strategy

Aave's recent architectural adjustments have allowed the USDe looping strategy to develop rapidly.

First, after the risk assessment team pointed out that the sUSDe lending has significant risks of large-scale liquidation due to price decoupling, Aave DAO decided to directly peg the price of USDe to the USDT exchange rate. This decision nearly eliminated the previously major liquidation risk, leaving only the interest rate risk inherent in arbitrage transactions.

Secondly, Aave has started to directly accept Pendle's PT-USDe as collateral. This change is more significant as it addresses two major limitations: insufficient capital efficiency and yield volatility issues. Users can leverage PT tokens to establish fixed-rate leveraged positions, significantly enhancing the feasibility and stability of cyclical strategies.

Strategy Formation: High-Leverage PT Circular Arbitrage

To improve capital efficiency, market participants have started to adopt leverage cycling strategies, which is a common arbitrage trading method that enhances returns through repeated borrowing and redepositing.

The operation process is usually as follows:

1. Deposit sUSDe.
2. Borrow USDC at a loan-to-value ratio (LTV) of 93%.
3. Exchange the borrowed USDC back to sUSDe.
4. Repeat the above steps to achieve approximately 10 times effective leverage.

This leveraged looping strategy has become popular across multiple lending protocols, especially in the USDe market on Ethereum. As long as the annual yield of USDe is higher than the borrowing cost of USDC, the trade remains highly profitable. However, once the yields plummet or the borrowing rates skyrocket, profits will be quickly eroded.

The key risk previously was in the design of the oracle. Positions worth billions of dollars often rely on AMM-based oracles, which makes them very vulnerable in the face of temporary price decoupling. Such events (as seen in the ezETH/ETH loop strategy) can trigger a chain liquidation, forcing lenders to sell collateral at steep discounts, even if the collateral itself is fully backed.

PT collateral pricing and arbitrage space

When pricing PT collateral, Aave adopts a linear discounting method based on the implied APY of PT, anchored against the price of USDT. Similar to traditional zero-coupon bonds, Pendle's PT tokens gradually approach their face value as the maturity date approaches. For example, in the case of PT tokens maturing on July 30, this pricing model clearly reflects the process of their price approaching 1 USDe over time.

Although the price of PT does not correspond completely to the par value of 1:1, the market's discount fluctuations will still affect pricing. However, as the maturity approaches, its yield becomes increasingly predictable. This is highly similar to the stable value appreciation pattern of zero-coupon bonds before maturity.

Historical data shows that the appreciation of the PT token price relative to the borrowing cost of USDC has created a significant arbitrage opportunity. The introduction of leveraged cycles has further amplified this profit margin, since September of last year, depositing 1 dollar can yield approximately 0.374 dollars in profit, with an annualized return rate of about 40%.

This raises a key question: does this circular strategy equate to risk-free returns?

Risks, Linkages, and Future Outlook

Historically, Pendle's returns have significantly exceeded borrowing costs, with an unleveraged average spread of about 8.8%. Under the PT oracle mechanism of Aave, liquidation risk is further reduced. This mechanism has a floor price and a kill switch. Once triggered, the LTV (Loan-to-Value) will immediately drop to 0, and the market will be frozen to prevent the accumulation of bad debts.

Taking Pendle's PT-USDe September expiry product as an example, the risk team set an initial discount rate of 7.6% per year for its oracle, and allowed a maximum discount of 31.1% (circuit breaker threshold) under extreme market pressure.

The figure below shows various secure LTVs (the calculation method is that once the discount reaches the lower limit of the termination switch, liquidation is practically impossible, so the PT collateral always remains above the liquidation threshold).

Interconnection of ecosystems

As Aave underwrites USDe and its derivatives at par with USDT, market participants are able to execute loop strategies on a large scale, but this also ties the risks of Aave more closely with Pendle and Ethena. Whenever the collateral supply limit is raised, the liquidity pool is quickly filled by users of the loop strategies.

Currently, the supply of USDC on Aave is increasingly supported by PT-USDe collateral, while users of the looping strategy borrow USDC and then invest in PT tokens, making USDC structurally similar to a senior tranche: its holders receive a higher APR due to high utilization and are mostly insulated from bad debt risk, unless extreme bad debt events occur.

Scalability and Ecological Benefit Distribution

Whether this strategy can continue to expand in the future depends on whether Aave is willing to continuously raise the collateral limit for PT-USDe. The risk team currently leans towards frequently increasing the limit, as they have proposed an additional increase of 1.1 billion dollars. However, due to policy regulations, each limit increase cannot exceed twice the previous limit and must be spaced at least three days apart.

From an ecological perspective, this circular strategy provides benefits to multiple participants:

• Pendle: A 5% fee is charged from the YT end.
• Aave: A 10% reserve is deducted from the interest on USDC loans.
• Ethena: Plans to take about 10% of the revenue after launching the fee switch in the future.

Overall, Aave provides underwriting support for Pendle PT-USDe by anchoring to USDT and setting a discount limit, allowing the circular strategy to operate efficiently and maintain high profits. However, this high-leverage structure also brings systemic risks, any issues on either side may have a ripple effect between Aave, Pendle, and Ethena.