As DeFi grows and evolves, more financial products are exported from traditional finance into the crypto space. Tranches are one of those products that have large applications in the financial system rails but are still unexplored in decentralized finance. When you first hear about tranches, it may sound like a very complex financial term. I confess I had this impression too, but studying them with an example we can see that they are, in fact, easy to understand.
This article will go through how tranches works, then, it will explain how we can use zero-coupon bonds to leverage fixed income tranche, and finally, do an overview of some of the projects using tranche solutions on the DeFi ecosystem.
Tranches, in simple terms, are a way of splitting a financial investment into different portions with different risk/reward profiles. Take a look at the situation below:
Ana and Bia, two persons, different profiles
Suppose Ana is risk-averse. She has $1000 USDC to invest but is much more comfortable with fixed-rate yields. She needs a guarantee on the returns she will have. She is willing to give up a higher return in exchange for a predictable gain. On the other hand, Bia is very used to the financial market. She is always looking to make more with her money and also has the capital to invest.
A first naive solution
An intermediary (a decentralized one), observing Ana’s situation, could take her $1000 USDC and offer her a 10% fixed rate for a year. He would deposit her capital into a yield-generating protocol with a variable rate, which will generate yield for the whole one-year period.
After one year, the intermediary could pay Ana $1000+100 USDC with the interests generated in the protocol.
The problem is: what if the protocol doesn’t yield what he expected? What if the protocol returns, after the end of the term, is less than $100 promised to Ana? Simply doing the above would be very risky for the intermediary, so he sells this risk to Bia.
The resulting scheme
Bia is willing to buy Ana’s $100 debt in exchange for any extra return that the variable yield protocol produces over Ana’s capital. So let’s analyze the possibilities:
In scenario A, both Ana and Bia’s capital were deposited into the yield-generating protocol. As the return after one year is $132, the protocol can pay Ana what was promised and Bia can have all the extra return.
In scenario B, the protocol yield was less than what was promised to Ana, so Bia assumed the loss with her capital.
Applying tranche vocabulary
Essentially we divided an investment in Compound into two products: Ana’s offer could be called a senior tranche which typically contains assets with less risk and guarantees. At the same time, Bia bought a junior tranche, an investment with more volatility but higher returns.
In this case, juniors assure the fixed-rate interest of the senior’s deposit with their capital right from the beginning. In exchange, they get all the floating rate interest generated by both deposits.
Juniors provide liquidity for seniors because they expect an extra reward generated by the capital locked in by seniors when the resulting variable APY is higher than promised to the seniors. That allows them to get leverage on their investment in a scenario of increasing rates.
The example above covered only a tranche split with varying yield return and risk, but the term tranche is much broader and can be used in several other configurations (we will show it with Saffron). We’ve used the example above because many new protocols are adopting almost the same structure to provide crypto-native products with fixed-rate yields when only variable rates were available before.
Tranches are a powerful tool for financial applications because they can attract users with different appetites for risk, investment maturity or interest rate acceptance. It also allows investors and liquidity providers to customize their strategies to address their needs better.
Although the above example works, there is some user experience to be fixed. The amount a senior wants to invest might not match the amount a junior seeks to provide. Also, it would be much better if there was a way for the market discovery of the fixed-rate interest instead of the tranche protocol imposing one.
A way to sell locked tokens at a discount
A better way to set up a tranche is through the issuance of zero-coupon bonds. These are bonds traded at a discount price that later can be redeemed for their full-face value when they become mature on a specific date.
The scheme works like this: A liquidity provider (LP) locks its capital in a contract that will deposit it into a yield-generating protocol up until the maturity date. For each unit of the capital lock, the contract will issue a token representing the rights on the principal after the maturity date. The LP now sells its principal token at a discount price. The user buying this token is essentially purchasing a bond with a fixed rate defined by the size of the discount and the maturity date, thus creating a marketplace for fixed-rate income positions. There’s no credit risk for purchasers since the tokens are backed by the principal capital locked by the LP. The LP is left with any yield return that the protocol generates.
Back to Ana and Bia
Let’s see this with an example. Bia locks 1100 USDC into a contract that will lend the money in Compound for a whole year. Further, the contract issues 1100 “P:USDC” tokens that anyone can use to redeem the principal share at the end of the maturity time. These tokens will represent zero-coupon bonds for the holder. She now sells these tokens to Ana, who is willing to pay 1000 USDC to hold them until the maturity date. At the maturity date, Ana can use the tokens to redeem 1100 USDC. An implied interest of 10% can be calculated using the one-year maturity date and the price paid for the tokens. Bia is left with the yields of Compound over the 1100 USDC.
When the redemption date for the principal tokens are the same, they might be mutually interchangeable, allowing users to enter in and out of the position easily in a secondary market, even if the maturity date has not been archived yet. It is expected that users and the protocol will set specific maturity dates to concentrate liquidity. With the introduction of zero-coupon bonds, depositors can easily trade their deposits on DEXs.
In the following sections, we dive into the three most promising tranche solutions on the market.
The 88mph was deployed in nov/2020 and focus on tranches’ strategies with fixed interest rates. Their products offer fixed-interest rates for deposits in plain stable coins like USDC, Dai and sUSD but also on Curve LP tokens, including BTC pools besides UNI and aLink. The user can choose different yield generator protocols such as Compound, Aave, Harvest and yEarn.
In their senior tranche product, interest rates for fixed income are rigidly defined using 75% of the Exponential Moving Average (EMA) of the underlying yield protocol’s APY over roughly a monthly window. The protocol does not allow for market discovery of a fair rate. Thus, using Compound as an example, the fixed rate in 88mph will be 75% of the Compound mean rate over the last month. Senior tranche investments are tracked by a ERC-721 non-fungible token that represents the deposits. Users can choose custom durations from 7 to 365 days in which their investment will mature. Investors are allowed to withdraw early but will only get the principal back, not the interest compounded during the time of deposit.
Junior tranches in 88mph are called floating-rate bonds. Because the fixed rate 88mph offers is 75% of the yield protocol, junior investors will remain profitable as long as the floating rate doesn’t drop by more than 25%. To buy a floating-rate bond, users need to provide amounts that match senior tranches. They can’t choose the investment value arbitrarily and neither the maturation time, which are sorted from newest to oldest relative to their maturation.
In 88mph Zero Coupon bonds are ERC20 tokens wrapped around fixed interest rate deposits. Users deposit their ERC-721 LP token and the protocol mints a proportional amount of ZCB tokens to the deposit size. Only two assets are available for ZCB, UNI and 3CRV.
Having the objective of bringing structured products in traditional financial markets to DeFi, BarnBridge was first introduced in September 2020. Still, its first product was deployed only on 15 March, called SMART Yield.
SMART Yield is a two tranche investment offering investments into Compound, Aave and Cream Finance. Only stable coin stakes are available so far, including DAI, USDC, USDT and GUSD.
BarnBridge’s senior bonds (sBONDs) are represented by ERC-721 non-fungible tokens, which offer a guaranteed yield for the life of the sBOND. To redeem senior bonds, the investor needs to wait until the bond’s maturity date without the possibility of early withdrawal.
Junior tranches, on the other hand, are represented by ERC-20 tokens (jTokens). For them, two kinds of withdrawal are offered: instant withdrawal of at least part of funds and a two-step process in which their funds stay locked but an IOU (I own you) ERC-721 NFT is issued to be sold on secondary markets.
Pendle approach consists of splitting an investment into a yield-generating protocol into two separate tokens, the Ownership Token (OT) and a Yield Token (YT), both fungible. At Pendle, users can deposit yield-generating tokens from Compound and Aave. At launch, Pendle accepts aUSDC and cDAI. You are responsible for depositing your collateral into the yield-generating protocol, as they accept the receipt of this deposit (c and a tokens) and not the collateral itself.
When minting, an LP can choose one of the redemption dates proposed by the protocol. For each unit of the base asset (USDC, DAI) deposited, he receives the same amount of ownership tokens, representing the rights to the principal after the end of the term. The LP will also receive the same amount of YT, representing ownership of the yields that the capital has generated during this period.
Both tokens can subsequently be sold or provide liquidity for the protocol pools. Pendle uses a proprietary pool for YT, that takes time for the maturation date of the contract, and helps to reduce IL. OT uses regular Sushiswap pools.
On the other hand, instead of minting their own tokens, users can buy OT and YT tokens straight for LP in the pools representing the secondary market, effectively opening their senior or junior tranche positions. OTs tokens will be priced at a discount, akin to securing a fixed-rate yield. This way, Pendle enables the market to set the price for fixed and variable yield rates.
Although not being deployed in mainnet yet, Element Finance design is optimized to create liquidity for tokens issued by the protocol. The protocol has a testnet running that allows users to experiment with its main functionalities.
Element is very similar to Pendle Finance. Users mint Principal Token (PT) and the Yield Token (YT), both fungible. As stated in their whitepaper, initial positions will be collateralized by Yearn Vaults and users can deposit collateral straight from Element interface.
As with Pendle, when minting, an LP can choose one of the redemption dates proposed by the protocol. Both tokens can subsequently be sold or provide liquidity for the protocol pools powered by Balancer labs. For liquidity provision of PTs, Element provides a custom trading curve built on Balancer V2 that reduces slippage and impermanent loss as the maturity period of the term comes closer.
Saffron’s main products are not fixed-rate bonds but risk/reward tranches. In this configuration, users have the option to contribute to two pools. They can deposit into an “S tranche”, an equivalent of a senior tranche, or an “A tranche” equivalent to a junior tranche.
Both deposits pool are loaned to yield-generate protocols such as Compound and Rari Protocol. Each of the two tranches takes different risks in the event of a shortfall such as a bug or an economic exploit that results in funds lost. If any fund is lost, depositors into the A tranche will lose their funds before the S tranche, mitigating credit risks for S. In exchange for this extra risk taken, tranche A gets 10x more interest than S tranche.
Saffron deposits need to be made during an epoch. Epochs are 14 days in length and, throughout an epoch, liquidity is locked in the pool and earns interest. Liquidity providers can only withdrawal their principal when an epoch ends, along with interest earned.
Saffron recently announced the launch of version 2 of its platform that, among other things, implements a fixed interest rate pool, like the examples above.
Tranches pools are one very innovative technology being developed in the crypto space. They are able to take advantage of what is DeFi’s biggest power, composability. They enhance network effect and address many of the market needs, which is a key to growth. Their properties take an essential role in market completion because of how flexible they can be.
However, DeFi tranches are in their infancy. They still need to develop and elaborate more management methods and grow the available liquidity. Combined with other technologies, tranches will establish more appropriate roles that shall increase the confidence in it.
For you, as an investor, lending in tranches can be an excellent alternative investment. It is a great way to diversify your portfolio, leverage your position or minimize your losses. It may be wise to watch this market grow.