Functionalization of metal-organic frameworks with metal nanoparticles (NPs) is a promising way for producing advanced materials for catalytic applications. We present the synthesis and in situ characterization of palladium NPs encapsulated inside a functionalized UiO-67 metal-organic framework. The initial structure was synthesized with 10% of PdCl2bpydc moieties with grafted Pd ions replacing standard 4,4'-biphenyldicarboxylate linkers. This material exhibits the same high crystallinity and thermal stability of standard UiO-67. Formation of palladium NPs was initiated by sample activation in hydrogen and monitored by in situ X-ray powder diffraction and X-ray absorption spectroscopy (XAS). The reduction of PdII ions to Pd0 occurs above 200 °C in 6% H2/He flow. The formed palladium NPs have an average size of 2.1 nm as limited by the cavities of UiO-67 structure. The resulting material showed high activity towards ethylene hydrogenation. Under reaction conditions, palladium was found to form a carbide structure indicated by operando XAS, while formation of ethane was monitored by mass spectroscopy and infra-red spectroscopy.