Structured (De)Finance

Exploring tranching techniques of DeFi credit protocols

Intro

Integrating off-chain financial assets into DeFi has presented itself as one of the most significant opportunities for growth of the space, but also comes with a large set of challenges and tradeoffs. 

Even though the Real-World Asset (RWA) sector of DeFi remains nascent (~$500mm in active loans today, closer to $1.5bn at peak according to rwa.xyz), a surge of protocols aiming to facilitate on-chain solutions for off-chain debt has emerged.

Despite perceived benefits, these protocols possess many inherent limitations (as we covered previously here). Current on-chain debt offerings often lack the diversity needed to attract a broader audience, and the uncollateralized nature or use of illiquid collateral tied to off-chain legal agreements introduces additional risk. This risk profile only fits a certain group of investors. 

As a result, protocols have used financial engineering mechanisms to mitigate risk and provide investors with opportunities less correlated to the actual performance of the underlying assets. Numerous innovative solutions have been developed to address these challenges, with tranching emerging as the core concept to mitigate risk and repackage assets. 

This post takes an in-depth look at tranching mechanisms implemented by the leading credit protocols today.

What is Tranching? 

Tranching is a technique used to cut a particular financial instrument or a basket of financial instruments into different parts with different risk profiles, expected returns, and even maturity dates. In theory, a single basket of instruments can be cut into as many tranches as the creator of the product wants. Typically, tranches sorted from the most senior to the most junior would have respectively increasing interest rates, increasing risk levels, and potentially a farther out maturity date.

A simple example can be built on a basket of 5 bullet loans, each with a principal value of $1 million, an interest rate of 10%, and a duration of 1 year. For simplicity let’s assume that all interest and principal will be paid back on the same day. A total principal of $5 million and interest of $500k will be paid back after exactly 1 year. Now this investment can be cut into 3 tranches:

• Senior tranche: $2 million principal, earning 4% fixed rate interest

• Mezzanine tranche: $2 million principal, earning 8% fixed rate interest 

• Equity tranche: $1 million principal, earning variable interest depending on loans’ performance

After a year, the loans are repaid on schedule, returning $5 million in principal and $500k in interest to the pool. The senior tranche will get $80k of interest, the mezzanine will get $160k in interest and the equity will get the remaining $260k of interest. In this case, this is a return of 26% to the equity tranche. The equity tranche’s outsized return comes with a risk though. In a case where one of the loans is not repaid at all and the portfolio is missing $1.1 million in expected repayments at maturity, then senior and mezzanine will still be repaid in full, but the equity tranche will only get back $160k, and experience a loss of -84% of the original principal. 

In such a system, the number of tranches, their interest rate, payment schedules, and other parameters can be set in an infinite number of ways, creating virtually a set of instruments using a single source of yield.

Let us now examine how different DeFi credit protocols have approached tranching.

Protocols

TrueFi

TrueFi provides infrastructure for on-chain loans and capital structures. It offers a suite of products that can power capital raising and deployment for off-chain/RWA-focused credit, lines of credit, and even index / fund-of-funds-type products.

TrueFi’s various pool, or “vault” structures (TrueFi refers to them as Credit Vaults, Index Vaults, and Asset Vaults) can each be configured as unitranche or multi-tranche pools, up to three tranches.

In the TrueFi ecosystem, a unique ERC20 LP token is issued for each specific tranche within a pool. Using a three-tranche vault as an example, the debt waterfall works as follows on TrueFi:

• The more senior ‘A’ and ‘B’ tranches (i.e. “Senior” and “Mezzanine”) accrue fixed rates, compounding interest set by the pool’s manager at the time of deployment. The interest rate for these tranches remains constant throughout the vault’s lifecycle.

• The junior-most ‘C’ tranche (e.g. “Equity”) accrues variable interest, based upon the pool’s overall performance and amounts accrued by the A and B tranches. This tranche has a claim to any residual funds held after A and B tranches are paid.

Two-tranche vaults on TrueFi are composed of one fixed rate ‘A’ tranche and one variable rate ‘C’ tranche. A unitranche vault has the same behavior as a single variable rate ‘C’ tranche.

An interesting and unique property of senior (and mezzanine) tranche is that they earn the full coupon rate, independent of the vault’s performance or utilization. This means that the junior-most tranche bears the cost of paying interest to more senior tranches in the case where the vault performs below the levels promised to senior tranches.

The waterfall mechanism ensures that payouts to the junior-most tranche occur only after the more senior tranches have been fully repaid, including interest.

When a TrueFi vault is created, it starts in a capital formation period where the vault accepts deposits but cannot deploy capital until certain funding thresholds are met. Once the vault moves to the live state, ongoing deposits and withdrawals are available; however, the tranche ratios (preset by the manager at the vault deployment) cannot be violated. This means that new deposits to the senior tranche may not be feasible if the junior tranche is insufficiently funded, or withdrawals from the junior tranche may be restricted if they would cause its size to fall below the minimum level needed to ensure the security of more senior tranches. In the event of write-offs or defaults within the vault, withdrawals remain an option, but the affected tranches might have to withdraw at a substantial discount.

A crucial aspect of TrueFi's configuration is its ability to house multiple loans, deals, or instruments within a single vault. In this scenario, a three-tranche structure can be constructed around an entire collection of diverse instruments. This vault structure serves to safeguard the senior tranche, such that senior LPs can redeem for positive returns of full principal plus coupon, even when a portfolio experiences significant defaults.

Centrifuge

Centrifuge is a real-world asset credit protocol that allows borrowers to borrow from certain pools after pledging tokenized real-world collateral. Centrifuge’s core smart contract product is called Tinlake. Each pool on Tinlake is an evergreen pool that allows investors to invest in one of two tranches:

• DROP - senior tranche earning fixed, compounding interest

• TIN - junior tranche earning variable interest

The DROP interest rate depends on the interest rates of the underlying loans and the ratio of deployed capital to idle capital. The TIN interest rate is determined by the overall performance of the pool and the amounts paid to the senior tranche. 

In theory, TIN should accrue faster than DROP, and thus accrue an increasingly larger share of the deployed funds' interest over time. However, it’s unclear from Tinlake documentation whether this is the case, or if the DROP-to-TIN proportion is solely affected by deployments and repayments.

Similar to TrueFi, the payment waterfall prioritizes the senior DROP tranche, paying it in full before allocating any funds to the more junior TIN tranche. Unlike TrueFi, pools are evergreen meaning there is no event of final settlement. Therefore, the pool has to always maintain a sufficient level of funds in the TIN tranche. 

To enable efficient fund transfers in and out of the pool, deposits and withdrawals are processed in settlement events following a designated period called an epoch. Users can sign up for deposits or withdrawals at any time, but these transactions will be executed in batches after the epoch ends. This mechanism eliminates the race for withdrawals. 

If withdrawal requests exceed available liquidity (e.g., funds are locked in loans or the junior tranche is disproportionately small compared to the senior one), they will be executed on a pro-rata basis. In some cases, this mechanism can function entirely on-chain. However, if the settlement is unable to accommodate all requested transactions, an off-chain solver mechanism is activated. In this flow, the calculations of the deposits or withdrawals amounts are performed by an off-chain piece of software and then the result is fed to the smart contract. To maintain as much transparency and decentralization as possible, there is a time window after the solver provides the contract with the answer, for anyone to challenge the originally provided solution, with a more optimal one.

Centrifuge has several layers of additional tech worth mentioning, outside of the core, Tinlake. These include the previously mentioned solver mechanism, a P2P network that stores private information about RWA NFT collateral, and the Centrifuge Chain,  a parachain within the Polkadot ecosystem. The Tinlake version designated to be deployed to the Centrifuge Chain is said to support more than two tranches. However, although the chain is live, the official app does not currently showcase any pools deployed on it. As of May 13, 2023, they are coming soon!

Goldfinch

Goldfinch is a decentralized credit protocol that allows for crypto borrowing, without crypto collateral - with all loans collateralized off-chain. Goldfinch takes a radically different approach than the protocols described above. In Goldfinch, there is one large, automatically managed pool of funds deposited by senior investors (“liquidity providers”), and a community of junior investors (“backers”) that have a vastly extended set of responsibilities and need to individually assess each and every particular loan that they will have exposure to. 

When a borrower comes to Goldfinch, they set up a new loan and preconfigure all loan parameters like interest rate, term, etc. Then, the backers need to assess the attractiveness of the terms and the trustworthiness of the borrower. After performing the assessment, backers independently decide how much they want to invest in a deal. After placing their deposit, when the loan is about to go live, the protocol calculates the size of the senior tranche that will be added on top of the junior funds and automatically pulls the funds from the senior liquidity pool. It not only takes the amount of junior capital into account but also the number of individual investor addresses and how evenly the capital is spread between them.

The payment waterfall in Goldfinch differs from Centrifuge and TrueFi. 

In Centrifuge and TrueFi, junior tranche investors can redeem in full when liquidity is available, and an explicit write-off in a pool is necessary to reduce the token's value and prevent full redemption, even when sufficient liquidity is present. 

Goldfinch backers, by contrast, hold an NFT that entitles them to redeem a pro-rata portion of subsequent repayments. This unique mechanism prevents competition among junior tranche investors for liquidity in a pool that may face future defaults. This aspect is particularly important since, unlike in TrueFi and Centrifuge, a single junior investment in Goldfinch is not diversified but instead linked to a single deal and a borrower.

Let’s summarize the characteristics of investing in these two distinct instruments:

Junior tranche investors:

• Are called Backers

• Willing to take risks, seeking high yield

• Competent to assess a particular loan application on their own

• Responsible to diversify their portfolio across different loans

• Earn underlying loan interest, plus 20% of senior interest

• Holding an NFT LP token

Senior tranche investors:

• Are called Liquidity Providers

• Seeking safety, okay with earning less yield

• Participants of a large liquidity pool that will automatically allocate funds in all kinds of loans

• Heavily diversified by design

• Earn underlying loan interest, minus 20%

• Holding a standard, fungible LP token

Credix

Credix is a decentralized credit marketplace available on Solana. A single instance of the Credix protocol, called a “Market”, shares some similarities to the Goldfinch protocol. It has a single, large liquidity pool used to fund senior tranches of specific deals, which must first be evaluated and invested in by the junior investors. 

In Credix, these junior investors are called Underwriters. Underwriters scrutinize the details of a particular deal application and, if they deem it attractive, make their investment.  Once a predefined threshold of junior capital is reached for a specific loan, the remainder of the loan is automatically funded by the senior liquidity pool. In Credix, the sizes of these tranches are fixed rather than variable, resulting in a more predictable system.

Credix is notable for its ability to support up to 10 tranches, which can be useful in specific situations. This flexibility allows for more nuanced risk distribution and enhanced return potential for different risk profiles. In contrast to TrueFi, where the mezzanine tranche interest accrual mechanism replicates the mechanism of a senior tranche, Credix mezzanine tranches’ interest accrual mechanism replicates the mechanism of the junior tranche.

The waterfall payout at Credix is standard in the sense that it always pays back senior tranches in full, before passing any funds to any of the junior tranches. Junior tranche investors cannot withdraw any funds before the loan ends. Interest earned by all tranches depends on the interest rate of the underlying assets. Each of the junior tranches earns the underlying asset yield, plus some fixed, predetermined percentage of the interest. Senior tranche earned interest depending on the underlying asset yield minus the costs of junior tranches. When a repayment comes, it specifies how much of it is the interest and how much is the principal and is spread across the tranches according to the waterfall.

Maple

Maple Finance is an institutional on-chain capital market that allows asset managers, referred to as “Pool Delegates”, to establish pools and execute various lending strategies. Lenders can deposit their funds into these pools, allowing delegates to disburse funds at their discretion. Similar to TrueFi and Centrifuge, lenders are exposed to a diverse range of loans and financial instruments. Deposits and withdrawals are possible whenever liquidity is available; however, like Centrifuge, withdrawals occur after a certain time has elapsed and, if pool liquidity is insufficient, are executed pro rata.

Despite being a significant player in the on-chain credit landscape, at present, Maple Finance does not utilize fully developed tranching mechanisms. 

There is one feature of the pool that helps align the incentives of the delegate and the lenders. A first loss capital buffer can be set within a pool, to which the Delegate would be the sole contributor. In the event of a loan default, up to 20% of the buffer may be slashed and reimbursed to the pool to replace the defaulted funds. It is unclear whether the delegate earns interest on the posted first loss capital. Historically we believe that this was the case, but at this date, the details of this mechanism are not detailed in the Maple Finance documentation.

As Maple’s docs state, 

Pool Delegates are the sole providers of First-Loss Capital. This directly aligns incentives between Lenders and Delegates. The amount of first loss Capital is determined through negotiations with the Maple team and will be re-assessed as the pool grows in size. Delegates will have a liquidation maximum per default. This rate is a percentage of the total first loss capital provided.

If a Pool Delegate has less First-Loss Capital than required, they will be unable to fund loans and all due to the delegate will be routed to Lenders.

At the same time, it’s worth noting that in all of Maple’s active pools, no delegate appears to be posting any pool cover (“Delegate First Loss Capital”).

Comparison

After examining the protocols above, we have identified two types of approaches to tranching. The first approach is represented by Credix and Goldfinch, and the other is represented by Centrifuge and TrueFi (Maple doesn’t really fit into either group).

The Credix/Goldfinch approach implements tranching on a deal level, with junior investors taking on a higher level of risk while evaluating the terms of each capital deployment. Then the protocol, depending on the junior investors’ participation automatically adds a senior component from a joint pool. Details of the mechanism differ between Credix and Goldfinch. 

In Credix:

• The amount of capital is fixed, 

• The junior interest rate is determined by the average performance of the loans plus a fee taken from the senior-most tranche

In Goldfinch:

• The amount of capital is dynamically calculated,

• The junior interest rate is determined by the average performance of the loans plus 20% of the nominal senior’s interest

For this approach to work effectively, it requires:

• A dedicated community of junior lenders: These lenders should be willing to invest significant effort in conducting their own due diligence and research. This group of lenders must also have sufficient capital available to commit to new deals.

• Larger deals: Bigger deals allow for the movement of larger amounts of senior capital while maintaining the same level of effort from junior lenders.

This approach provides an interesting method of risk management by involving junior investors in the process and utilizing the senior component from a joint pool. By refining the mechanisms and ensuring an active community of junior lenders, these protocols can potentially improve risk distribution and return on investments.

TrueFi and Centrifuge differ as they implement tranching on a portfolio level, where a particular investment portfolio issues multiple fungible LP tokens. Investors in each of the different LP tokens get different treatment and priority. In both of these protocols, senior tranches earn fixed and compounding interest, while the junior-most tranche takes the rest. 

There is no joint pool that automatically funds the senior component, but instead, each investment portfolio needs to find investors in all of the tranches. This approach allows a single portfolio to carry on through multiple deals, fund various loans, and execute complex investment strategies. 

In this approach, some particular deals or loans can go to zero and still, the senior tranche will be made whole (of course it depends on how diversified the portfolio is, and how thick the junior tranche is). 

TrueFi and Centrifuge both implement tranching at the portfolio level, but there are notable differences between the two:

• Number of tranches: TrueFi supports three tranches, while Centrifuge supports two.

• Pool/vault maturity: Centrifuge pools are evergreen, whereas TrueFi vaults have a set maturity date.

• Deposits and withdrawals: TrueFi serves deposits and withdrawals continuously, while Centrifuge operates in epochs.

• Senior tranche interest: The senior tranche in TrueFi earns stable interest regardless of pool utilization, while the senior tranche in Centrifuge is vulnerable to capital management inefficiencies.

The portfolio-level tranching approach adopted by both TrueFi and Centrifuge does not necessitate as much effort from junior lenders in underwriting individual loans. Although junior lenders still face potential risks, their proactive actions are not required for the business to operate efficiently.

This approach works best for a diversified portfolio of instruments managed by a skilled portfolio manager. By taking advantage of the fact that individual deals can fail without affecting the senior tranche, as long as the portfolio remains sufficiently diversified, this approach can effectively manage risk and deliver strong returns for investors.

The table below summarizes key characteristics and differences among the credit protocols that offer tranching:

Tranching outside of credit and RWA

Tranching mechanisms are not limited to credit and RWA spaces. They can also be applied to DeFi native projects, offering innovative solutions for risk management and return optimization. One notable example is Idle Finance, which has implemented a two-tranche DeFi-native system.

Idle Finance's approach is unique in that both the junior and senior tranche sizes and APRs are regulated by the free market. This method has the potential for self-regulation, but there may be concerns about its performance under extreme conditions.

For those interested in implementing simplistic tranching in their own systems, 0xSplits offers a waterfall-based solution with limited but powerful functionality. By specifying the number of tokens to be sent to particular parties in a specific order, the 0xSplits mechanism can save significant effort when distributing tokens. Say, for example, the first user (or contract) has to get 2,000,000 tokens, the second 1,500,000, and the third the rest, you can send any amount to a split set up with 0xSplits and it will make sure to direct the first 2,000,000 to the first address, then 1,500,000 to the second and so on. 

Summary

Even though RWAs and on-chain credit volumes are small today, there are several protocols on the market that can support these deals. All the protocols discussed in this post occupy similar niches but have some key differences between them. Before making a final decision (as an investor, asset manager, or borrower), one needs to take these differences into account and assess which one will suit their needs best. 

We are in the early stages of on-chain credit. Over the coming years, we expect tranching and structured finance within DeFi to become more widespread. We are optimistic that such features will help on-chain credit grow.

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