Interest Rate Derivatives and Pendle

Pendle Finance innovates by allowing users to tokenise and trade the yield component of yield-bearing assets separately from the principal, unlocking new liquidity and yield management strategies.

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Executive Summary

• Interest rate derivatives (IRDs) are crucial in global financial markets, enabling investors to hedge macroeconomic risks by reducing uncertainty on rates (e.g., bank interest rate). The notional value of IRDs exceeded US$579 trillion in 2024, making them the largest component of the over-the-counter (OTC) derivatives market. However, access to these tools is mainly restricted to institutions and managed by centralised authorities, limiting availability for retail investors and lacking transparency.
• Pendle has introduced an innovative way to bring IRDs into decentralised finance (DeFi) by splitting yield-bearing assets into the principal token (PT), which represents the underlying asset, and the yield token (YT), which represents the future rewards generated by that asset. The combined price of these tokens equals the price of the underlying asset.
• Pendle’s yield trading fills the missing piece of the interest rate trading market in TradFi and offers more powerful tools than just interest rate swaps with its innovations:
  • Liquidity: Users can sell or trade the yield portion (YT) without unlocking the principal asset, increasing capital efficiency.
  • Yield Management: Enables strategies like locking in fixed yield (by holding PT), investing on future yield (by trading YT), or hedging against yield fluctuations.
  • Time-Decay AMM: Pendle’s Automated Market Maker (AMM) accounts for the time-dependent value of yield tokens, helping to prevent mispricing due to yield decay over time.
• While Pendle remains a powerful tool for yield trading, the complexity of Pendle’s mechanisms poses a steep learning curve and risks. One key assumption is that historical APY could reliably imply the future yields, which may not hold true in volatile or rapidly changing markets. Additionally, YTs on Pendle are generally priced higher at launch because of optimistic yield expectations. If the market fails to sustain or increase the underlying asset’s yield, the returns from YTs may not justify their initial cost, leading to potential losses.

1. Introduction

Interest rate derivatives (IRDs) are a core component of global financial markets, as they allow investors to hedge macroeconomic risk via reducing the uncertainty on rate movements (e.g., bank interest rate, foreign exchange rate, etc.). As the most common IRD in TradFi, an interest rate swap (IRS) is a financial derivative contract between two parties who agree to exchange streams of interest payments over a specified period, based on a notional principal amount that is not exchanged. The most common form involves swapping a fixed interest rate payment for a floating interest rate payment (or vice versa), allowing parties to manage or hedge their exposure to interest rate fluctuations. The floating index is commonly an interbank offered rate (IBOR) of specific tenor in the appropriate currency of an IRS (for example, SOFR in USD, LIBOR in GBP, and EURIBOR in EUR). These swaps help stabilise exposure and are especially relevant when monetary uncertainty, such as the impact of tariff shocks or rate hikes, is high.

At the end of 2024, the notational value of interest rate derivatives exceeded US$579 trillion and was the largest component of the global aggregate in the OTC derivatives market. However, access to these tools is largely limited to the institutions and managed by centralised authorities, making them out of reach for retail investors and lacking in transparency.

In response, DeFi protocols have emerged to replicate or complement IRD functions in a decentralised and permissionless context. While some protocols like Pendle directly offer on-chain fixed and floating rate swaps, others like Convex Finance and Aura Finance focus on yield optimisation through boosted rewards. Together, these protocols help users manage returns, discover rates, and use capital more efficiently.

As of May 2025 Sources: DefiLlama, Crypto.com Research

Amongst these, Pendle stands out for its innovative mechanism on yield trading, fulfilling the demand for both institutional and retail investors. The following sections illustrate the mechanism and markets of Pendle.

2. Overview of Pendle

Pendle is a permissionless yield-trading protocol that allows users to implement a range of yield-management strategies. It enables tokenisation of yield-bearing assets by splitting ownership into two separate tradeable components: the principal (the underlying asset) and the yield (the future rewards generated by that asset). These tokens can be freely traded, sold, or staked independently, allowing users to separate and manage their principal and yield exposure.

Pendle’s total value locked (TVL) fluctuated during the last 12 months, following the trend of ETH’s price. The TVL dropped by 34% from last June’s peak of $6.7 billion to $4.4 billion on 1 June 2025.

The trading volume saw strong growth, surging by 186% in the last 12 months.

2.1 Concepts and Mechanisms

At the heart of Pendle’s mechanism is a simple idea: split a yield-bearing asset (e.g., stETH, sUSDe) into two parts: one that represents the principal (PT), and one that represents the yield (YT) generated in the future.

The separation offers users flexibility in gaining exposure to fixed or floating yields, speculating on yield changes, or even hedging against them.

A helpful way to understand Pendle’s mechanism is to think of the underlying yield-bearing asset like a real estate property:

• Principal: The rights to the ownership of the property.
• Yield: The rights to the rental income of the property, which can grant its owner the right to collect all the rental income generated by the property for a certain length of time.

The table below shows how the value of a single deposited asset (e.g., 1 stETH) can be broken down into PT and YT over time. PT increases in value as it approaches maturity, while YT declines as yield accrual slows:

Pendle supports a variety of yield-bearing assets by wrapping them into tradeable tokens.

2.2 Design of AMM

Unlike traditional AMMs like Uniswap, which follow a constant product formula and treat all assets as time-independent, Pendle’s AMM accounts for both time-decay and interest rate expectations. it is programmed specifically for trading principal and yield based on the equation:

PT Price + YT Price = Underlying Asset Price

The essence of Pendle’s yield tokenisation is to divide a yield-bearing token into PT and YT. The combined price of these two tokens equals the price of the underlying asset. Consequently, PT and YT prices are inversely correlated: as the price of YT increases, the price of PT decreases, and vice versa.

A unique innovation of Pendle’s AMM is its single pool structure, where both PT and YT trades are facilitated through a shared PT-SY pool. SY is a token standard that implements a standardised API for wrapped yield-bearing tokens within Pendle’s smart contracts. All yield-bearing tokens can be wrapped into SY, giving them a common interface that can be built upon. For example, stETH can be wrapped into SY-stETH.

The conversion between the underlying asset and its corresponding SY token can be automatically done in Pendle’s platform, where users can mint PT and YT by depositing the yield-bearing asset (e.g., stETH). Additionally, base assets (e.g., ETH) are auto-converted into the yield-bearing asset before PT and YT are minted:

ETH → stETH → SY-stETH → PT-stETH + YT-stETH

The SY token, which represents the underlying asset (e.g., SY-stETH), is decomposed as:

SY = PT + YT 

2.3 APYs in Pendle

There are different APYs in Pendle that measure the strategy and yields:

Underlying APY: Represents the 7-day moving average yield rate of the underlying asset. It shows the realised performance of the asset.

Implied APY: The current market expectation of the yield of an asset. In other words, it is the ‘price’ of YT, denoted in percentage terms. The implied APY fluctuates with market supply and demand for YT and PT. When more individuals purchase YT or sell PT (they represent two aspects of the same token), the implied APY increases, leading to a higher cost for YT (or a lower cost for PT), and vice versa.

Long Yield APY: Refers to the anticipated return, shown as an annualised percentage yield, that comes from purchasing YT and holding it until it matures, assuming the current underlying APY stays the same. This value can be negative, indicating that the future yield’s total value, based on the existing underlying APY, could be lower than the purchase price of YT. Simply put, the long yield APY reflects the gap between the underlying APY (expected yield to be received) and the implied APY (cost of YT). When users buy and hold YT, they aim for this value to remain positive, ideally as high as possible.

Fixed APY: The guaranteed yield a trader receives if they buy and hold the PT. This value is numerically equivalent to the implied APY.

The below table summarises what is going in favour or against for a YT holder:

2.4 Liquidity Provision

Beyond directional positions, users can also become liquidity providers (LPs) in Pendle’s AMM, earning swap fee rewards, PENDLE token rewards, as well as gaining access to yield-bearing stablecoins. LPs earn fee revenue from PT-YT trades and benefit from PENDLE emissions, which are distributed via a gauge voting system governed by holders of vePENDLE, a non-tradeable governance token that grants voting rights and decays over time. Users who have locked their PENDLE tokens for a specified period (up to two years) receive vePENDLE, and the more emissions a pool receives, the higher the effective APY for LPs. Pendle is also integrated with yield optimisers, such as Penpie and Equilibria, allowing LPs to auto-compound their returns and boost effective yield even further.

While impermanent loss (IL) can still occur if funds are withdrawn before maturity — due to changes in the price of PT and YT — Pendle’s design helps reduce this risk. Its AMM gradually adjusts PT prices upward over time, reflecting their natural increase towards full value. If liquidity is held until maturity, PT reaches its full redemption value and YT expires, making the LP’s position effectively equal to holding the original asset. Moreover, the PT-SY pair (e.g., PT-stETH and SY-stETH) in the liquidity pool are closely related and tend to move in sync, further reducing IL from price differences. Pendle also uses incentives like token rewards to support stable liquidity and reduce slippage, especially as maturity approaches and trading activity increases.

At the time of writing, the total PENDLE locked as vePENDLE is $247.4 million. This governance mechanism is highly rewarding for participants, with vePENDLE holders earning approximately 40% APY on average throughout 2024.

3. Trading Strategies

Pendle offers different trading strategies depending on a user’s view on future yield and their risk preference. The main trading strategies include holding PT, buying YT, and selling YT, as illustrated in the table below:

3.1 Long PT

In this strategy, users buy PT at a discount price and can:

• Hold until maturity to receive the full face value (for example, 1 stETH).
• Sell the PT before maturity with current market price.

The return from this strategy is calculated using the formula:

ReturnPT=(1+implied APY)days to maturity365-1

The more days there are until maturity, the more interest accumulated.

As the implied APY fluctuates over time, so does the fixed return from buying PT. For example, in the PT sUSDe (USDe) pool – the second largest by liquidity(~$123M at the time of writing) and with a fixed maturity on 31 July 2025 – fixed yields (APY) for PT purchases ranged from 2.49% to 1.24%.

3.2 Buy YT

In the YT Buy strategy, users purchase YT to gain access to the floating yield generated by the underlying asset. The return depends on whether the actual APY (base APY) ends up higher or lower than what the market expected (implied APY). The return is estimated using the formula:

ReturnYT Buy=(1+ base APY1 + implied APY)days to maturity365-1

If the base APY is higher than the implied APY, then buying YT is profitable because the user is earning more than what was priced in. However, if the market overestimated the yield and the implied APY turns out to be too high, the user could lose money, as the yield they actually receive is less than expected. This strategy carries higher risk because the user’s return depends entirely on how accurate the market’s forecast of yield turns out to be.

However, buying YT carries inherent risks, as YTs are often priced higher at launch due to optimistic yield expectations. Unless there is a significant increase in the underlying asset’s yield, the returns from YTs may not justify their initial cost, potentially leading to losses. This was suggested by the APY chart below. 

Based on Pendle’s data, the average performance of buying YT was almost zero (0.03%) in the period from 7 Apr to 5 June, indicating the presence of losses and market mispricing.

Additionally, another strategy related to buying YT token is Pendle’s ‘points trading’, where users buy YT not just to speculate yield, but to accumulate points that may qualify them for future rewards or airdrops from the platform. These points are often part of incentive programmes designed to encourage participation in the platform.  

3.3 Sell YT

In the YT Sell strategy, users can mint PT and YT from a yield-bearing asset and then sell the YT while holding the PT until maturity. This allows the user to receive upfront payment (by selling YT) while still getting back the full value of the PT at hand. The return is calculated using the formula:

ReturnYT Sell=(1 + implied APY1 + base APY)days to maturity365-1

If the market is overly optimistic, and the implied APY is higher than the actual base APY, then YT is overvalued, meaning that selling it at that time brings a profit. The larger the difference between implied and base APY, the higher the return. A positive spread (i.e., when implied APY is greater than the base APY) leads to a profitable YT sell. This strategy produces moderate positive returns in the range of 0.11% to 0.57%, indicating consistent opportunities for gain, though generally smaller than those observed in PT Long strategies. 

Similarly, the average performance of selling YT-sUSDe was almost zero (-0.03%) in the period from 7 Apr to 5 June.

4. Conclusion

Pendle’s yield trading fills the missing piece of the interest rate trading market in TradFi and offers more powerful tools than just interest rate swaps with its innovations, including the split of PT and YT, AMM design, and liquidity provisioning. Its mechanisms make it more than a yield optimiser but offers a market place for implied APY (future APY) of the yield-bearing assets, allowing users to trade, manage risk, and make informed decisions directly on-chain. It introduces multi-layered yield strategies that go beyond what most standard yield optimisation platforms offer.

Unlike other platforms that offer basic auto-compounding or vault-based strategies, Pendle allows users to take directional approaches on yield, arbitrage between implied and actual APYs, or construct more complicated position loops. For example, advanced users can use their PT tokens (the principal) as collateral in AAVE and borrow additional yield-bearing assets and then deposit back to Pendle for trading yield or providing liquidity.

Pendle currently holds a clear first-mover advantage in the interest rate derivatives market. It has established deep liquidity and a dominant market share over 50% of the total yield market in terms of TVL, though emerging protocols like Spectra Finance introducing similar functions like Pendle with some  innovations. Spectra uses a Curve-style AMM, supports yield and principal tokens, allows anyone to create markets, and is exposed to a wider range of assets. Its developer-friendly environment makes it more flexible and composable. 

For the outlook, Pendle could diversify the assets offerings in real-world assets (RWAs), such as tokenised treasuries and yield-bearing stablecoins and could be set to become a pricing layer for fixed income in DeFi, making TradFi concepts transparent. Additionally, as the Pendle ecosystem grows and expands beyond Ethereum, its development on non-EVM chains could also open up to new liquidity and yield opportunities.While Pendle remains a powerful tool for yield trading and interest rate speculation, it also comes with certain risks and complexities that users new to the platform or the industry have to adjust to. One key assumption is that historical APY can reliably imply and predict future yields, which may not hold true in volatile or rapidly changing markets. Also, the mechanisms of splitting assets into PT and YT, managing liquidity, and executing recursive strategies can be more complex than traditional yield farming protocols, potentially posing a steep learning curve for less-experienced users. Additionally, there is liquidity risk if users need to exit positions in thin markets. As with any DeFi strategy, understanding the underlying mechanisms and risk exposures is crucial before committing capital.

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Authors

Crypto.com Research and Insights team

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