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Interest Rate Derivatives (IRD) and Why They Are Important After ETH 2.0 Upgrade

Everyone is talking about LSDs (liquid staking derivatives), but typically only notice the most superficial layer that Lido provides — whereby users deposit their ETH tokens into a smart contract, which then pools the tokens with other users’ funds to create a larger, collective stake. In return for their contribution, users receive a corresponding amount of staked ETH tokens called stETH tokens.

However, to improve on this further, Interest Rate Derivatives can show the real beauty of DeFi. This article will use the Pendle protocol as an example.

Overview

The Pendle Protocol is a DeFi platform that enables the creation and trade of custom yield tokens, allowing users to combine various yield streams into a single token.

This is significant because it provides users with more flexibility and control over their DeFi investment strategies.

Allowing them to create customized yield tokens tailored to their specific needs.

Regarding the ETH 2.0 upgrade and the transition to a Proof-of-Stake (PoS) consensus mechanism, the Pendle Protocol could potentially be used to create yield tokens for staking rewards earned through participation in the PoS network.

This would provide PoS validators with more options to optimize their earnings and manage risk, as they could combine staking rewards from multiple sources and then trade them on the open market.

PT and YT

PT and YT are two types of tokens in the Pendle protocol. PT represents a fixed interest rate over a period of time, while YT represents a floating interest rate for the same period.

Users can use these tokens to trade fixed-rate contracts on the Pendle protocol. In other words, PT represents borrowing by users, while YT represents the asset provided by users for liquidity.

Pendle V2 has now launched a protocol designed specifically for trading fixed rates with PT in focused ranges. In V2, PT is always traded against its underlying asset, which minimizes IL. Swapping PT is a straightforward process of swapping between the two assets in the pool, while YT swaps utilize flash swaps in the PT pools. As PT and YT can be minted from and redeemed to one unit of the underlying asset, the protocol is able to express the following price relationship: P(PT) + P(YT) = P(Underlying Asset). Knowing that the YT price has an inverted correlation against PT price, Pendle makes use of this price relationship to route YT transactions through PT pools, effectively making use of one pool for both YT and PT trades.

The beauty of the Pendle protocol is that it allows users to easily switch between PT and YT depending on their investment strategy. For example, a user could start out by providing liquidity in a PT pool for a fixed-rate loan, and then later switch to a YT pool to earn variable interest rates.

IRD Narratives in ETH 2.0 Upgrade

There are two potential scenarios for what could happen with ETH staking yield after the Shanghai upgrade.

The staking yield goes up: Withdrawals enabled for stETH and unstaking ensues, staker will likely get a bigger cut of the reward, resulting in a boost in network activity and ultimately reward emission.

The staking yield goes down: Uncertainties in staking are removed after Shanghai, leading to an uptake in LSDs and staking. In this scenario, stakers would likely get a smaller cut of the emission pie, with network activity and reward emission decreasing.

In both scenarios, users can benefit from using the Pendle protocol to trade fixed-rate contracts using PT and YT tokens.

If you expect the staking yield to go up, there may be more demand for TY tokens, as YT-stETH at the current price (Implied APY) could also be undervalued. So profit is expected from purchasing YT-stETH.

On the other hand, if you expect the staking yield to go down, there may be more demand for PT tokens, as users may want to lock in the current interest on their staked assets, since PT is redeemable for its full amount at maturity and is a fixed-yield exposure on stETH.

As for those speculating on ETH price, PT-stETH will also provide you with long exposure whilst simultaneously earning a fixed yield.

In conclusion, if LSDs do become more widely adopted, they may have implications for platforms such as Pendle.

Users may be interested in using Pendle to boost their ETH yield by leveraging double-digit APY for one of the safest assets in crypto.

However, the extent to which LSDs will dominate the staked ETH ecosystem remains to be seen and is subject to various factors and uncertainties.

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