The crypto community has a love for two things: Lamborghinis and McDonalds. Sure, part of that is for meme value, but – just as with lies – behind every meme lies a hint of truth. It’s well-known crypto markets are volatile and that volatility leads to greed and fear. Of course, in a mature market, people don’t have to go to bed with alerts turned on in case markets crash in the middle of the night. Thankfully, signs point to crypto maturing before our eyes. New products exist to serve the needs of investors and guarantee peace of mind. Take Tranche Finance, a yield-fixing risk-management protocol, as an example.
The Origins of Tranche
The origins of Tranche Finance date back to the last bull market. Before Tranche Finance existed, there was Jibrel, a crypto startup started by the same co-founders. Jibrel launched as a company dedicated to real-world asset tokenization under a regulated umbrella. Project development was wholly funded by the Jibrel Network Token (JNT) – but as Jibrel’s business model began to creep more and more on-chain over time, the team realized building applications on the blockchain would have a much greater impact on the crypto ecosystem. Thus, the transition from Jibrel to Tranche Finance started in 2021 when the SLICE token replaced the JNT token. During this process, existing JNT tokenholders were airdropped with new SLICE tokens at a 10:1 ratio and the latter became the native token for the new protocol.
A Win-Win Proposition
So why did the co-founders pivot and what opportunity did they see? Tranche Finance became a protocol designed to restructure the interest rate on yield accruing tokens for those interested in taking on more – or less – risk. Yield accrual tokens are one of the most important building blocks in DeFi. On a functional level, these are what lenders get back when they lend out tokens in the ecosystem: Take DAI for example in Compound, lenders deposit the stablecoin with the lending platform and receive cDAI in return. The cDAI collects interest at some variable yield for the investor. Unfortunately, yields can be volatile, a feature attractive to degens but not for institutional investors.
Tranche Finance splits yield accrual tokens into two tranches, each with their own level of riskiness. The less risky tranche (Tranche A) allows holders to receive a fixed rate whereas the riskiest tranche (Tranche B) pays holders a variable rate higher than Tranche A, but is liable to cover losses first when loan defaults occur.
Risk-tranching is a win-win mechanism: Risk-averse investors have the chance to avoid volatile interest rate fluctuations and be certain of their returns. On the other hand, risk-seeking investors can increase their returns by betting on the zero-loss scenario in which borrowers do not default.
Deep in the Trenches
To understand how tranches work, let’s use an example. Alice and Bob lend out 100 DAI and 10 DAI respectively on Compound and subsequently receive cDAI, a token earning a 3% variable yield. Alice is worried about her borrowers’ ability to pay back the loan whereas Bob is confident and would like to give his return a boost. They both go to Tranche Finance and deposit their cDAI. Alice mints a Tranche A token that yields a fixed rate equal to 2 % whereas Bob mints a Tranche B token that yields a variable rate of 13 %.
If borrowers pay back their loans, Alice earns 2 DAI (100 DAI x 2%) and Bob earns 0.3 DAI (10 DAI x 3%) from his cDAI plus whatever Alice didn’t earn from hers, namely 1 DAI (100 DAI x 3%-2 DAI). The total DAI Bob takes home is then 1.3 for a 13% return.
If any default occurs, Alice earns 2 DAI anyway whereas Bob earns 1.3 DAI minus interest due from borrowers who didn’t fulfill their obligations.
Is it Solvent, SIR?
The calculations shown above highlight the role of a key factor in the tranching remuneration: The share of Tranche B holders relative to Tranche A holders.
The lower the ratio between Tranche B deposits and Tranche A deposits, the higher the Tranche B remuneration and vice versa.
This mechanism originates from Tranche B holders earning what Tranche A holders give up in exchange for fixing the latter’s rate. When there’s fear in the market, investors can choose to hedge against negative fluctuations by minting Tranche A. Tranche B holders will then earn a sizable return for taking the same risks most investors want to protect from. On the other hand, when markets are euphoric, investors are more likely to increase their exposure to risk and choose Tranche B. Compared to the previous case, Tranche B returns will be lower because the pie left on the table by Tranche A holders will be split among a higher number of investors.
However, it’s possible two extreme situations can occur:
1. Tranche B TVL approaches Tranche A TVL: In this situation, Tranche B returns decrease asymptotically towards the underlying protocol return (e.g. the return offered on cDAI by Compound). To avoid this scenario, SLICE rewards are distributed to Tranche A holders in order to restore any imbalance.
2. Tranche A return exceeds underlying protocol return: This scenario could happen if a sharp decrease in the borrowing volume occurs in the underlying protocol. In that case, the relationship between Tranche B returns and Tranche A returns becomes inverted: The higher the Tranche A TVL, the lower the Tranche B return. Indeed, Tranche B holders are forced to pay the Tranche A fixed-rate out of their own pockets. Shifting SLICE rewards entirely to Tranche B holders helps restore the returns’ trajectory towards zero.
The solution is to distribute SLICE rewards between Tranche B and Tranche A returns and prevent the extreme scenarios illustrated above from occurring.
Given a certain number of daily SLICE rewards allocated to each market, the proportion of rewards allocated to the senior tranche is defined as the Solvency Incentive Ratio (SIR). The SIR can be expressed as follows:
Unlike solvency ratios in traditional banking, it’s not necessarily true that a higher SIR is always better. When Tranche A returns trail the underlying protocol returns, a higher SIR will increase Tranche A TVL and, therefore, the Tranche B returns will grow as well. However, when Tranche A returns exceed underlying protocol returns, a lower SIR will increase SLICE rewards for Tranche B holders, increasing Tranche B TVL and, therefore, their returns.
TVL variations do not have a linear trend. A higher SIR will increase Tranche A TVL up to a certain point where fixed yields will be much less attractive than variable yields. The same applies for Tranche B TVL as SIR gets lower. This tendency of moving towards an asymptote can be tweaked by a “balance factor” used to establish an equilibrium between the two Tranche TVL. Without the balance factor, it would be much easier for one of the two extreme scenarios to occur.
The Everlasting Tranches
When setting a risk management strategy, the duration of risk exposure is one of the most important aspects to factor in. What would make tranches maximally flexible in terms of duration? Simple: Infinite duration. Tranche Finance provides epoch-less tranche tokens. The advantages to using a perpetual tranche consist of the following:
Better user experience: Investors don’t have to worry about rolling their position from one maturity to another
More uniform liquidity: Not having a maturity implies no risk of liquidity drainage when approaching the tranche expiration date.
Enhanced composability: A token that expires at some point in time has a utility that is limited by its duration. Instead, a perpetual token can be easily used outside its native protocol for many different application
Perpetual fixed-rate tranches could be used as collateral to borrow funds against or could be employed as a hedge against rate fluctuations to be added in a diversified portfolio.
Project Tokenomics
As touched upon, Tranche’s token shifted to the SLICE token following the airdrop to JNT tokenholders in 2021. The token has three use cases:
Staking: SLICE tokenholders can provide double-sided liquidity on different DEXes and stake their LP tokens to earn rewards. SLICE can also be staked directly on the protocol to serve a “backstop” function: In case of protocol insolvency, staked SLICE will be used to cover losses. Stakers are compensated by rewards in SLICE tokens that depend on the lockup period.
Governance: SLICE holders can propose and vote on governance proposals on the main parameters that govern the protocol functioning.
Holding: Fees collected from Uniswap liquidity pools pairing SLICE and a stablecoin such as ETH/USDC/DAI will be used to purchase SLICE for the Tranche Treasury. This buyback mechanism would create buying pressure on the SLICE token as trading fee revenues consolidate around a stable trend.
The total supply is 20 million SLICE with allocation amounts vesting over multiple years. The amount allocated towards development will be unlocked linearly over 5 years. The team tokens will be unlocked over 5 years with a 2-year cliff. Should the supply of SLICE tokens need to increase, a Tranche Improvement Proposal (TRIP) to implement a 2% inflation mechanism can be voted on by the community at any date.
The Risk-Tranching Market
If someone wonders why a DeFi protocol should focus on risk-tranching derivatives, a detail may help put things in perspective: There’s a $ 610 trillion market out there.
Yeah, the total derivatives market is worth trillions. Interest rate derivatives in particular make up the lion’s share with $488 trillion as of June 2021, according to the Bank for International Settlements. Imagine what would happen if the crypto industry were able to capture just 1% of this market. That would amount to $4.8 trillion, almost 20 times the current total value locked in DeFi ($257 billion).
Given the opportunity in the market, competition is vast and only growing. Neutralizing or leveraging yield risk can be done through a variety of financial instruments. The landscape Tranche Finance competes in is much more complex than what would seem at first glance. Broadly, three categories of products can be highlighted in the yield risk management framework:
Yield Risk-Tranching: These protocols allow users to purchase tranches with fixed yield and limited risk or variable yield and unlimited downside. Tranche Finance belongs to this category together with Barnbridge, Saffron, NAOS Finance and 88mph. Out of these many protocols, Tranche Finance is differentiated as the only protocol with perpetual-based tranches.
Yield DEXes: These protocols allow users to split yield risk in a zero-coupon fixed yield token and a variable yield token with a certain maturity. The main players in this category are Pendle, Element, Tempus and Sense. Users can also trade zero-coupon and variable yield tokens against stablecoins (Pendle, Element) or one against the other (Tempus).
Yield Options: These protocols allow users to invest in automated trading strategies based on the price of yield-bearing tokens at a certain expiration date. Two of the most popular strategies used in protocols like Ribbon Finance and Opyn are covered calls (holding the yield-bearing token and selling a call on such a token) and put selling that allow investors to collect premiums upfront and benefit from steady future yields.
These three categories are not necessarily substitutes but can rather be seen as complementary to each. Each services its own niche and depending on the situation can provide investors with a wide range of strategies encompassing all the possible scenarios.
The Road Ahead
The main milestones the project is on track to accomplish in the next future are:
The on-chain voting and execution (Governance 2.0) will be implemented through GovernorBravo, the governance mechanism used by Compound. This will effectively provide tokenholders direct control of the treasury.
Users that deposit the likes of COMP, AAVE, MATIC will be entitled to earn Governance token rewards
The SLICE token distribution within the SIR mechanism will move from being epoch-based to perpetual
Staking and tranching contracts will be revised to achieve higher gas efficiency
As far as growth, the Tranche Finance team was initially aiming for $20 million TVL by the end of 2022 but has experienced outperformance of expectations, leading them to revise the target to $50 million. The team has successfully executed the integration with Aave on Avalanche and Polygon, BenQi on Avalanche, and Yearn on Fantom. While interest in the protocol is great, it’s worth mentioning the team understands growth should never come at the expense of security. Tranche Finance has chosen a conservative approach to mitigate smart-contract risk. All smart contracts have been independently audited and the team is running a bug bounty program focused on preventing loss of user funds, economic exploits, and smart contract security risk. Payouts are denominated in US Dollars but are paid out through a mix of stablecoins and ERC-20 tokens. Furthermore, flash loans have been disabled: there is a minimum number of blocks that must be written between deposits and withdrawals. This restriction prevents the protocol from being a victim of flash loan exploits.
Backers of the ecosystem expect DeFi to become a more hospitable environment for TradFi institutions over the next few years. This transition must bring sound and structured tools for holistic risk management to investors who want crypto to be a portion of a well-diversified portfolio. Tranche Finance has the right ingredients to navigate a nascent, yet very competitive, industry thanks to its multi-chain presence, solid incentive mechanism, and decentralized on-chain governance. Don’t be led astray by the low glamor and buzz around it, the future for risk-hedging products is bright and the inflow of smart money is only a matter of time.
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