Pendle Finance

Investment Thesis

Of all the financial instruments in TradFi, interest rate derivatives have arguably one of the largest total addressable markets. To illustrate, interest rate derivatives occupied over ~$500T in notional value in H2 ‘22, according to BIS. This market is generally supported by participants who want to speculate on or hedge yields on a myriad of asset classes, including foreign exchange, equities, commodities, and credit.

This class of instruments has been largely untapped in crypto until the arrival of Pendle Finance. So far, DeFi yields have embodied the form of floating rates driven by demand and supply. The introduction of Pendle brings fixed rates to the space, allowing users to access deterministic yields and investors to hedge and speculate on yields instead of price. Similar to other primitives (such as options), we posit that the interest rate derivatives market is also an essential pillar for institutions to participate in the digital asset space.

While the Pendle initially launched in May ‘21, the protocol did not achieve meaningful product-market fit until it integrated ETH liquid staking derivatives (LSDs) into its product suite. The timing made a lot of intuitive sense as ETH staking yields are often referred to as crypto’s native “risk-free rate” and should garner significant speculatory and hedging interest from market participants. Pendle’s TVL has since ballooned to ~$150m at the time of writing.

Figure: Pendle Finance TVL

Yield Tokenization

Pendle Finance enables yield trading by wrapping yield-bearing tokens into a Standardaized Yield (SY) format, separating them into principal tokens (PT) and yield tokens (YT), respectively. As a refresher, users generally receive cTokens (which accrue yields) when they stake their tokens for yield in DeFi protocols.

Pendle’s segregation of cTokens into PTs and YTs is analogous to bond stripping in TradFi, where the face value and the coupon rates are divided into their respective components. PTs can be redeemed at maturity at a 1:1 ratio for the underlying asset, while YTs entitle holders to the yield generated and is claimable in real-time until maturity.

Figure: Yield Tokenization Illustrated

Users holding both PTs and YTs can redeem the underlying asset at any time. Should they only hold the PT, they will only be able to redeem it for the underlying at maturity. This is why PTs generally trade at a discount. On the other hand, YT holders collect generated yield until maturity.

Pendle AMM

Both PT and YT are tradeable on Pendle’s AMM, allowing users to make bets on yields produced by yield-bearing assets.

Figure: stETH Yield Markets on Pendle

It is imperative to understand the different terms used to trade on Pendle’s AMM:

• Maturity is the time period until a PT can be redeemed for the underlying asset and the window within which the YT produces yield.
• Underlying APY shows the seven-day moving average APR of the core asset (in the above example Ethereum staking rewards from Lido).
• Implied APY is what the market (PT) thinks the future APY of the core asset will be.
• Long Yield APY is the reward for buying and holding YT assuming the asset’s base yield remains constant.
• Fixed APY is the guaranteed APY users can expect for holding a PT until maturity.

As such, if a user believes that ETH staking yields (underlying APY) will plummet due to low on-chain activity on mainnet, they can lock in 3.66% (implied APY) by purchasing stETH’s PT. Conversely, if a user believes ETH staking yields (underlying APY) will increase (for example due to a prolonged memecoin season that we are witnessing now), they can purchase stETH’s YT.

Key Milestones

Pendle has had a few notable improvements since launching its first product on mainnet. For one, it improved capital efficiency in v2 by introducing concentrated liquidity, auto-routing, and a dynamic curve that reduced impermanent loss. The protocol expanded beyond Ethereum to launch on Arbitrum in March and BNB chain via a launched on Binance’s Innovation Zone a month ago, which saw its price retrace from highs of $1.20 (commonly observed among launchpad listings). However, given its total addressable market in TradFi, we believe the project is in the early innings of capturing market share.

Apart from pioneering the first fixed interest rate product that has some semblance of product-market fit, the protocol recognizes the importance of composability and has such decided to propose SY in EIP-5115 as a new token standard. ERC-5115 aims to create a unified interface for yield-generating tokens, allowing developers and users to interact with various DeFi projects seamlessly.

Other protocols have recognized the significance of yield segregation and have begun to build atop of Pendle Finance. Penpie and Equilibria are two examples of this, enabling users to deposit their vePENDLE on their platforms a-la Convex Finance. To date, ~16% of circulating PENDLE supply has been locked on these derivative platforms that grant instant liquidity instead of waiting until their locks end.

Figure: vePENDLE locked on Penpie and Equilibria

Tokenomics, Supply Schedule, Unlocks

PENDLE is the governance token for Pendle Finance. Drawing inspiration from Curve, Pendle has also adopted a ve-Token model, whereby vePENDLE holders channel incentives to different pools on the platform. The platform has two revenue sources, being 80% of all swap fees generated by Pendle’s AMM and 3% of all yields accrued by YTs. All protocol revenue are distributed to vePENDLE holders with no allocation to the Pendle treasury, subject to change via governance voting in the future.

Figure: vePENDLE Revenue

So far, 16% (38m out of 232m) of Pendle total supply has been locked as vePENDLE. Team tokens have also fully vested at the time of writing. Weekly emissions increase by 1.1% per week until Apr ‘26, after which PENDLE will have a terminal inflation rate of 2%. Pendle previously raised a $3.7m in their Series A led by Mechanism Capital in 2021 and $11.8m from their IDO in 2023, but all sold tokens are vested. This presents a compelling supply-side case for PENDLE as any increase in circulating supply would be linear and attributable to incentives and ecosystem building.

Figure: Pendle Finance Tokenomics

Entry Suggestions and Liquidity

As Pendle has recently witnessed a violent run up due to the LSDfi narrative, our recommended buy zone for Pendle falls between $0.40 – $0.60, for an implied market cap of $39m – $59m and an FDV of $93m – $139m.

Figure: Pendle Finance Entry Suggestion

From a trade execution perspective, the deepest on-chain liquidity pool for Pendle lies on Uniswap v3 on Arbitrum, with $2.33m in liquidity. On that pool, a $100k purchase will incur a ~4% slippage. Thus, as with other tokens in Liquid Ventures, we recommend scaling into the position in smaller clips.

Risks

As we have most recently seen with Curve Finance, one cannot discount the smart contract risk that exists even with established DeFi protocols. This risk is amplified with the introduction of SY as a new product, as the former takes staked tokens and further separates them into PT and YTs. Such is the double-edged sword of open-sourced development, as participants get transparency in exchange for potential threats from malicious actors.

The second most important risk to the thesis is that fixed interest rates and interest rate derivatives do not take off in the digital asset space. While it may well be possible that this scenario plays out, it would have larger implications for crypto as it would signal a lack of sophisticated (and larger) participants. As such, our base case is that this risk is fairly subdued and not specific to the interest rate derivatives vertical only.

Bottom Line

Pendle Finance represents a zero-to-one primitive in the crypto space that is essential for institutional and retail investors to hedge and speculate on asset yields. The protocol has achieved early semblance of product-market fit through the integration of LSDs, with the potential for a larger market share and other markets in cTokens and LP tokens for growth. Future supply issuance for PENDLE will largely be composed of incentives and ecosystem building, making for an attractive supply-side case.