The three core issues of Pendle

1.  What is the market potential for Pendle's industry?

2. 
   Can Pendle maintain its competitive advantage and sustain its leading market share?

3.  Token benefits and business development status of Pendle?

 Market space in which Pendle operates?

The Pendle mechanism can split any underlying asset with returns into two parts, YT and PT, to meet the needs of speculators seeking higher returns and willing to take on high risks to purchase the YT portion, while those seeking low risk and fixed income can purchase the PT portion. This business is similar to traditional financial markets' Interest Rate Swap (IRS) and has the following use cases:

• 
  Interest rate hedging: Some institutions have fixed-rate debts but wish to have floating rates; or institutions wish to convert floating rates into fixed rates to plan expenditure cash flow.

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  Reduce financing costs: Different borrowers have different loan interest rates in different markets, and by leveraging comparative advantages, both parties can achieve a reduction in the total borrowing costs.

• 
  Speculation: Traders make judgments on the direction of interest rate changes and trade to earn profits based on them.

 What is the size of the interest rate swap market in traditional finance?

The ISDA report mentions that the trading volume of Interest Rate Derivatives in 2022 reached as high as $292.8 trillion, compared to $231.2 trillion in 2021. Interest rate swaps are traded over-the-counter, with major trading venues being SEFs (such as CME in the United States) and MTFs (such as London Stock Exchange Group - LCH in the UK). The chart below shows the outstanding notional value at various clearinghouses as of the end of June 2023, with LCH being the largest at 80.5%, followed by CME at 8.9% and Eurex at 8.7%.

 Crypto interest rate swap market space?

The speculation about Pendle's potential market space involves many assumptions with weak logic, such as using the scale of IRD in traditional financial markets to calculate the proportion of futures and stock markets, which is not actually suitable for comparison with the market where Pendle is located. However, the outstanding nominal scale of 29.2 trillion IRD mentioned above, as well as the global GDP of approximately 101.3 trillion US dollars in 2022, still provide a rough idea that IRS-type businesses have great market potential.

Although comparison is not a good method, we can still logically qualitatively analyze the market space of Pendle. There are three conditions for the development of interest rate swap businesses like Pendle and an increase in trading volume.

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  The size of interest-bearing assets in the crypto market is growing: the increase in interest-bearing assets such as aUSDT (Aave), stETH, Dexs LP, etc., all indicate a potential increase in Pendle's tradable assets.

• 
  The return on invested assets fluctuates: If the return rate (interest rate) does not fluctuate, the demand for using Pendle's services will decrease.

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  The direction of yield rate changes is difficult to predict: if the yield rate only decreases unilaterally, it can be easily predicted (such as during the increase in ETH collateralization phase of stETH), then users will only buy and hold PT, without generating more trading demand.

The core of the Crypto market's emergence is the value storage brought by decentralization. Where there is money, there will be a search for returns. The growth of interest-bearing assets fundamentally requires answering whether the Crypto industry will attract more external funds. Therefore, confidence in the industry is needed to assess Condition One, without delving into the reasons for my optimistic bias towards the industry.

The volatility and forecasting difficulty of yields will persist in the current Crypto industry environment, which is essential for the development of interest rate swap business. Taking Beefy's yield pool as an example, we can see the various types of yield assets currently on-chain. Firstly, there are assets like stETH obtained by staking ETH, with yields sourced from ETH's consensus and execution layers. There is also a significant category of yield assets such as DEX LP tokens, as well as lending platform loan certificates. Among these, stETH-like assets have relatively low yield volatility, while LP tokens and loan certificates' yields fluctuate significantly based on market conditions and supply and demand. The recent popularity of staking to earn yield projects also offers asset categories with high yield volatility and forecasting difficulty, providing a larger market space for the interest rate swap market.

Can Pendle maintain its competitive advantage and sustain its leading market share?

We can take a look at the current competition in this field, but how the future market landscape will evolve can only be observed as we go along.

 Competitive Landscape of Interest Rate Swap Market

In the traditional financial industry, LCH holds 80% of the outstanding notional value in the interest rate swap market, while the second tier of three exchanges - CME, Eurex, and JSCC (Japan) - accounts for the remaining 18%, creating an oligopoly market. The core reason for this competitive landscape is the strong network effect of trading activities, where a large number of participants build a liquidity pool. Good liquidity attracts more participants, deepening the moat of the business and driving out competitors. In traditional finance, exchanges are highly cash-flow positive businesses, often to some extent controlled by the government, and also benefit from regulatory moats, making their monopolistic effects stronger. In the crypto industry, offshore centralized exchanges (such as Binance, OKEx) and on-chain exchanges (such as Uniswap, Curve) operate in a business environment without regulatory moats, leading to intense competition where liquidity becomes the most critical competitive factor. For competitors in a liquidity disadvantage position, a few breakthrough points lie in the strategy of misaligned competition. For example, a crypto exchange focusing on perpetual contracts rather than engaging in commoditized competition in the spot market. As the industry matures, a liquidity moat will bring significant bargaining power, leading to sustained and excellent cash flow.

 Competition in the Crypto Interest Rate Swap Market

Because the Crypto industry itself is in a developmental stage, the interest rate swap market based on this industry is in an even earlier phase. Currently, only Pendle operates a scaled interest rate swap market. The challenges faced by this business can be seen in Simon Jones' article "Why DeFi interest rate swaps may be the next frontier of finance," where he is the founder of the now-closed interest rate swap protocol Voltz. Looking at the competitive landscape within the Crypto industry's interest rate swap market, Pendle's market share even surpasses that of LCH, the leading traditional financial interest rate swap market. However, in an early-stage industry, competitors are almost inevitable. This is a crucial test for the team's operational capabilities, including efficiency, resource allocation, choice of underlying assets, and more. Additionally, at this stage, competitors have more opportunities to find points of differentiation, such as avoiding Pendle's public chain and underlying asset types.

From a capital perspective, the business model of the interest rate swap market is excellent, with predictable good cash flow. Therefore, it is highly likely that some investors (who have not invested in Pendle) would be willing to provide financial and resource support to Pendle's competitors. It can be foreseen that there will be intense competition in this field for a period of time, leading to price wars on transaction fees and likely liquidity battles.

Spectra Finance (APWine) is a project still in the testing phase, having undergone partial auditing. Its mechanism is similar to Pendle, with PT and YT remaining unchanged, and SY referred to as IBT (Interest Bearing Token). Its token is APW, with a current FDV market value of approximately $41.5 million (as of March 2024). This project may be a formal competitor that Pendle will face, and its development and impact on Pendle are worth observing once it goes live.

In addition, the current leverage effect of YT comes from PT, and the protocol as a whole does not have capital leverage, while the traditional interest rate swap market has high capital leverage. In the future, interest rate swap agreements with higher capital efficiency may emerge to compete. Of course, the source of capital leverage is based on credit assumptions, and how to implement this in the DeFi field without the need for trust is another issue.

 Token benefits and business development status of Pendle?

PENDLE holders can only enjoy the most important rights, such as receiving a share of the pool's transaction fees, by locking their PENDLE tokens as vePENDLE. The longer PENDLE is locked, the more vePENDLE one receives, leading to downstream projects involving liquidity tokens. The diagram below illustrates the distribution channels for Pendle transaction fees, highlighting that holding locked PENDLE to obtain vePENDLE is the primary method.

In the three types of cash flows in Pendle, let's take a look at the potential changing trends. First, let's remove the third type of PT Yields, which come from PT holders forgetting to redeem. Assuming that the market consists of rational individuals who would not make such basic mistakes.

YT Yields are the returns derived from underlying assets, currently accounting for a small proportion. However, with the increasing presence of interest-bearing assets in the Crypto industry, this segment could potentially bring substantial cash flow to Pendle. The most crucial indicators to observe in this cash flow segment are TVL and underlying asset yield. With the development of the Crypto market, both of these indicators have significant potential for growth.

Trading fees are currently the main source of cash flow and will continue to be the core benefit for Pendle holders in the future. Given this cash flow channel, monitoring Pendle's trading volume is of utmost importance.

 Unreliable Cash Flow Outlook for Pendle Business

Let's take a look at the current situation (March 24, 24). After selecting Double count in Defillama (because Pendle is suitable for derivative products with yields), the total TVL of Ethereum and Arbitrum is $111.39 billion. In most cases, there are locked positions, corresponding to interest-bearing assets such as Uniswap LP.

Around March 20, 2024, Pendle TVL is about $2.35 billion (2.11% of the total TVL of the two chains), with a daily trading volume of about $225 million, accounting for approximately 9.6% of the protocol TVL. Based on this, let's make some unreliable assumptions and speculate on Pendle's revenue in five years:

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  Ethereum and Layer 2 networks achieve $1 trillion Total Value Locked (TVL) (if Crypto becomes the world's third superpower?)

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  10% of which is captured by Pendle, amounting to $100 billion TVL

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  The average daily trading volume accounts for 5% of TVL (with temporary increases in trading volume due to points and Boost at the end of March 24), which is $5 billion, and $1.825 trillion annually.

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  If the fee is 5 basis points, then the cash flow would be $910 million (slightly higher than traditional financial interest rate swap transactions)

There are many details not deeply explored in this, and the assumptions are very subjective, just a vague directional thinking. For example, if Ethereum has competitors emerging, and Pendle has not expanded its business in the past, or because of maintaining the current competitive landscape, Pendle's fees are actually much higher than 5bps, all of these could lead to significant cash flow deviations.

 The bottleneck of Pendle's business development

Pendle's market launch requires negotiation and collaboration with the underlying asset project party, especially for the recent accumulation projects, where the calculation of points also needs to rely on the partner's provision. This places very high demands on Pendle's operational capabilities. The speed at which Pendle has entered the market indicates that it is already a highly efficient team. However, due to business expansion still resembling CEX manual listing, it is unable to go public independently, which will to some extent limit short-term business expansion. At the same time, the accumulation projects need to rely on compatible YT token calculations for points provided by the partner, making it prone to risks such as integration errors. In the long run, Pendle is likely to leverage DeFi's AMM mechanism to establish permissionless market protocols, shifting part of the market's operational needs to collaborating project parties.

 The ups and downs of Pendle

The article was written in the first half of 24, a stage of rapid market recognition of Pendle's value, with many optimistic articles and discussions describing the advantages of Pendle. I also optimistically believe in the growth potential of the Crypto market, as well as the moat of interest rate swaps on it. At the same time, Pendle's first-mover advantage, the team's strong competitiveness and execution have made it one of the few excellent investment opportunities in the entire DeFi field. However, at this stage, objectively recognizing both the tailwinds and headwinds of Pendle, discussing more about the risks, may be a more valuable perspective.

 Current market factors favoring Pendle:

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  The points system perfectly meets the three conditions for the increase in trading volume in the interest rate swap market mentioned above.

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  Expectations of loose liquidity have led to the market optimistically pricing points and showing a high enthusiasm in acquiring them.

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  The Crypto interest rate swap track is currently in a monopoly period dominated by Pendle, which enhances its bargaining power and sets high transaction fees. For example, the transaction fee for the eETH pool launched after Arbitrum increased from the previous 0.1% to 1%.

Long-term growth potential, experiencing a temporary decline due to short-term factors, it is always an excellent investment opportunity that is hard to come by. Potential headwinds that Pendle may face in the future:

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  The current business model places extremely high demands on Pendle's operational capabilities, with a probability of bugs occurring in the coordination between collaborating project parties and Pendle, which will also restrict Pendle's business growth (changes will be made in subsequent versions).

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  The implementation of projects such as Eigenlayer may lead to the gradual ineffectiveness and eventual abandonment of the points mechanism if the subsequent project's points yield does not meet market expectations.

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  Competitors are bound to emerge, this will be a necessary test for Pendle to grow into a larger business, possibly leading to temporary price wars, and predatory attacks.