A Pendle in Motion: Analyzing the Investment case for DeFi Yield Tokenization
In the midst of the 2023 bear market, Pendle has emerged as a shining beacon, exponentially increasing its Total Value Locked (TVL) 10x from $17.3M to a staggering $172.3M, while amplifying its Fully Diluted Valuation (FDV) by 13x from $11.7M. Setting its sights on revolutionizing the colossal $400 trillion interest rate derivatives market, Pendle aims to transition this market onto the blockchain, marking a significant leap in the integration of finance and technology.
Pendle benefited from the LSD narrative prevalent in the bear market of 2022–2023 and attracted capital with its high yields and industry-leading UI. This article aims to help the reader understand how Pendle works, what its use cases are, and — after 13x’ing in value — whether it's still worth investing in.
Pendle Use Cases
Pendle’s yield tokenization and its trading product are confusing — even for DeFi natives, so let me give a brief overview of how the protocol works before I delve into its use cases.
At its core, Pendle uses EIP-5115 (authored by Pendle) to split yield-bearing tokens like stETH into its yield and principal components. Then Pendle uses an AMM to facilitate trading and price discovery. I’ll delve deeper into how this works later, but for now, all you need to know is that Pendle tokenizes the yield of tokens like stETH so they can be traded.
Using EIP-5115 and their AMM, Pendle has three primary use cases:
- Yield Trading
- Fixed Yields
- Increased yields through Liquidity Provisioning
Yield Trading
Pendle’s yield trading product provides traders and investors the ability to clearly express their bearish or bullish views on DeFi yields.
Let me give an example. Let’s say GLP is yielding 8% but you think the interest rate will likely increase to 15%. Perhaps you think a large volume of longs will be liquidated within the week, generating higher fees and yields. How do you express this view to the market?
Well, you could buy GLP to capture the higher future yield or buy GMX if you think the higher yield will translate to a higher price. However, these are not clear expressions of your thesis that yields will increase. If you buy GLP, you are exposed to all the underlying assets in the pool. You could buy GMX, but there are many factors such as supply inflation or the macroeconomy influencing GMX price other than fee generation.
Pendle solves this. Pendle unlocks price discovery for yield itself, so now you can long GLP’s yield directly and minimize exposure to its underlying assets or macro factors.
Fixed Yield
The tokenization of yield also allows users to lock-in fixed yields. Crypto yields can fluctuate wildly, so locking in yields could be useful for users who believe yields are at peak or for businesses that desire predictable interest rates for business planning.
Liquidity Provisioning
Pendle uses an AMM to facilitate permissionless trading, so the third use case is liquidity provisioning. If you deposit yield-bearing tokens into Pendle liquidity pools you retain the native yield on the token you deposited but also $PENDLE emissions as well as swap fees.
Protocol Mechanism
Yield Trading
As I mentioned before, Pendle uses the token standard EIP-5115 (authored by the Pendle team) to wrap yield-bearing tokens (like stETH, sDAI, GLP) into SY tokens (exp. SY-stETH, SY-sDAI, SY-GLP). After these yield-bearing tokens are wrapped, they are split into their yield (YT) and principal (PT) components. Similar to a bond, the yield and principal tokens have a fixed maturity date.
The YT represents all the yield that the yield-bearing token will generate until its maturity date. At the maturity date, the yield token will stop earning yield. Therefore, the price of the yield token is an expression of the market’s expectation of future yields.
The PT represents the underlying yield-bearing token. At the maturity date, the holder of the PT can redeem the PT for the original yield-bearing token. For example, PT-stETH can be redeemed for 1 ETH worth of stETH at maturity. Therefore, the PT will always trend to and eventually equate to the value of the original yield-bearing token token.
The PT should always be discounted versus the original yield-bearing token since the buyer/holder is not earning any yield and it cannot be redeemed until maturity. The discount of the PT to the original yield-bearing token represents the yield the market is willing to lock in.
For example, if the price of PT-stETH with a 1-year maturity is 0.5 ETH, that means you can lock in a fixed APY of 100% since in 1 year you would be able to redeem the PT-stETH for 1 ETH. The market price (assuming sufficient liquidity) would only settle at this price if participants believed stETH’s yield to be similar to 100%. If market participants believed stETH’s yield should be ~5% for the next year, they would bid up PT-stETH until its price had an implied yield of 5% (or 0.952 ETH).
This can be seen clearly in Pendle’s trading view.
Underlying APY — 7-day actual average of the yield of the token
Example: If you held stETH over the last 7 days you would have averaged an APY of 3.9%
Implied APY — The implied yield of the token is based on the price of the PT. Implied APY is numerically the same as the Fixed APY. Again, you can also think of Implied APY as the market’s expectation of average yield until maturity
Example: The fixed yield/implied yield you can lock in for stETH based on the price of the PT is 3.61%
Long Yield APY — Pendle simulates what your annualized return would be if you purchased the YT and the Underlying APY was the yield until maturity instead of the Implied APY/Fixed APY
Example: If you purchased the YT for stETH and the yield until maturity was 3.9% you would have earned a return of 5.9% or $7.54 per YT
$PENDLE Tokenomics
Fees and Rewards
$PENDLE is Pendle Finance’s native token and is used by the protocol for governance and incentivizing liquidity through emissions.
$PENDLE is useless unless locked and converted into vePENDLE. Similar to other locking mechanisms, the longer a user commits to locking their $PENDLE, the more vePENDLE they receive. Uniquely, the value of their vePENDLE decays as the maturity date approaches. $PENDLE holders can extend their staking duration to increase their vePENDLE balance.
Holders of vePENDLE can boost their LP rewards by up to 2.5x, and receive 80% of swap fees, and 3% of all tokenized yields. Currently, 100% of fees and revenue generated by Pendle go to either $PENDLE holders or LPs.
Similar to CRV/CVX, vePENDLE has a voting mechanism. PENDLE emissions can be directed to specific pools to incentivize liquidity and are voted on weekly. Voting for a pool entitles vePENDLE holders to 80% of the swap fees generated by the pool, distributed according to your proportion of the pool. This is called “Voter APY”. Base APY refers to 3% of all tokenized yields that vePENDLE holders earn.
Voter APY = 80% * LP Swap Fees * (User Vote to Pool/Total Vote to Pool)
Base APY = (3% * Yield on PENDLE Unclaimed Yield)* (User vePENDLE/Total vePENDLE)
Max APY = Base APY + maxVoterAPYBase APY has historically been less than 0.5% and Max Voter APY is typically between 5–10%. You can see the relationship between Max APY and Base APY below.
Supply and Issuance
As of October 2022, PENDLE had a weekly emission rate of 667,705. This weekly emissions rate decreases at a rate of 1.1% until April 2026 at which point the protocol will reach a terminal inflation rate of 2% per year. All $PENDLE tokens are vested as of April 2023.
Farming on Pendle
Providing liquidity on Pendle is pretty attractive since you can earn protocol emissions and swap fees on top of your native yield.
If you choose to buy Pendle to further boost your liquidity rewards as well as earn additional swap fees and the 3% platform fees on all yields, you can earn up to 10.1% yield on your Pendle. However, since Pendle’s inflation as of September 6th is 10.1%, this ends up being a net 0 real yield.
Of course, if you believe Pendle usage will increase over time, then as issuance decreases to 2% the real yield should increase as well.
Pendle’s Investment Case
Pendle’s Fees (annualized) are $353K and its FDV is $156M. 100% of fees are revenue since at this point the protocol does not contribute any fees to a treasury. This means for every $1 of Pendle you purchase, you are earning $0.002 per year which is an awful return on investment. Compare Pendle’s FDV/Fee ratio of 442 with GMX’s 7 and CVX’s 6.5. With such a sky-high valuation you should only buy Pendle if you believe its fees will increase significantly over time or as a trader you believe you have an edge in the market.
Pendle’s fees can increase in two ways. Either the usage of the platform increases or Pendle’s take rate increases. Let’s evaluate both from the POV of a bull and a bear.
Pendle Bull Case
According to the Bank for International Settlements, the TradFi interest rate derivatives market is worth over $400T, roughly 75% of which has a central counterparty (such as the US Federal Reserve or European Central Bank). The potential TAM is so large that Pendle could 10,000x its TVL of $166M and still only own 0.4% of the market.
One of the major narratives and trends in Crypto is the tokenization and financialization of everything. As the amount of on-chain yield products grows, it is plausible that the demand for trading derivatives of these interest rates would increase as well.
Additionally, there are few sources of fixed yield on-chain. In the future, when businesses are managing their finances, they may want to purchase fixed interest rates so they can better plan their business. Pendle can step in to enable guaranteed fixed yields.
Pendle could also increase its current fees. Most notably, Pendle only takes 3% of the yield on the platform. This is significantly lower than its competitors. For example: Convex takes 17%, Rocket Pool takes 14%, and Lido and Frax take 10%. If Pendle were to increase its take rate to match Lido, it would immediately 3.33x its fee generation from yields.
An additional source of fees could come from bribing. Pendle has a very similar locked voting structure to Convex. One significant source of revenue for Convex and Curve is bribing gauge voters. Protocols will bribe CVX holders to increase emissions for their liquidity pools and thus increase liquidity. Increased liquidity on Pendle could lead to additional demand for the token as users purchase tokens to deposit into liquidity pools and earn a higher yield. Increased liquidity in Pendle pools could also stabilize yields thanks to a more liquid interest rate derivatives market.
Beyond that, Pendle has some of the best UI in DeFi. Their site is clean, easy to use, and fast.
From a Tokenomics perspective, emissions are high, but they will asymptotically approach 2% which is relatively low. Unlocks are also complete so there are no VCs with 100x returns waiting for exit liquidity.
Pendle Bear Case
While Pendle has an almost unlimited TAM to expand into, its product-market fit is questionable. Pendle’s TVL growth has been healthy, even resilient, in the face of a DeFi bear market, but the usage of its core products has been limited.
This can be seen in the swap fees generated in the liquidity pools. Swap fees are a representation of how much actual trading is occurring on the platform and they are pretty anemic.
Trading volume could be low because interest rate derivatives are simply much more complicated than trading spot or even futures or options. In the latter case, no matter what the specific mechanism if the price goes up, then the value of your spot, future, or options go up. However, if the price of ETH goes up that doesn’t necessarily mean that staking yields will increase.
It’s also possible that interest rate derivatives are not unique enough of a product. Crypto is a reflexive market. If the price of a token goes up, typically usage of the protocol will go up which will in turn increase yield. Increased yield attracts buyers for the token and that starts the whole process over again. This reflexivity may limit the attractiveness of trading interest rate derivatives. Why trade interest rate derivatives and increase smart contract risk when you could just trade spot, futures, or options all of which are more liquid and would likely move in a similar direction to interest rates?
Currently, Pendle is inflating its supply at a rate of 10% per year and the issuance is incentivizing liquidity, but as the issuance rate drops to 2% by April 2026, there will need to be a significant increase in swap fees to offset the decline in yield. In other words, money flows onto Pendle because it is an easy way to juice additional yield out of tokens like stETH, sDai, or GLP, but this additional yield is currently being paid by Pendle holders in the form of inflation.
Pendle’s business will only be sustainable if there is enough demand for its yield trading/fixing product to generate attractive fees and yields for liquidity providers.
It’s possible that Pendle could find other fee generation sources such as gauge voting/bribing similar to Curve/Convex, but the value of increasing the liquidity of a token’s interest rate derivatives market is dubious whereas increasing the liquidity of a token itself is necessary.
Conclusion
Pendle brings interest rate derivative trading on-chain with a slick UI. Although the technology is innovative, the investment case of the token is questionable. $PENDLE’s FDV is extremely high versus the fees it generates which means it is priced for high growth. Pendle’s TVL growth could satisfy this need for growth, but there has been little usage of its core products.
In my opinion, while the Pendle protocol is exciting and fun to use, I don’t think the risk-reward ratio is favorable for investing in the token and the protocol is better saved for yield farming. However, I’m impressed with the Pendle team and the product they’ve built so far, so I’ll continue to watch from the sidelines.
Disclaimer: The content is for informational purposes only, you should not construe and such information or other material as legal, tax, investment, financial, or other advice
