Leverage without Liquidations: A Deeper Look at Tranching
Struct Finance is a DeFi protocol that allows investors to create customizable structured financial products that offer exposure to digital assets.
The development of strong underlying primitives in DeFi, such as Options Vaults provides the infrastructure that can be leveraged to build strong structured financial products.
The success of these primitives also suggests that DeFi investors are increasingly looking for more sophisticated products that can help them navigate periods of turbulence without sacrificing returns.
Struct Finance offers a wide range of structured financial products, tailored for the investors’ desired level of risk and returns, by combining different derivatives or transforming risk and liquidity.
Current Issues with DeFi Investment Opportunities
- Most opportunities come with volatility or trading risks and may be unsuitable for risk-averse users seeking stable returns.
- Protocol-level solutions offer low returns and pre-defined maturity dates which may not align with every investor’s needs.
- Leveraged products have current limitations due to high gas fees and high collateral requirements: this in turn makes them less appealing as investors will have to sacrifice optimal capital utilization and profitability.
What is the value provided by Structured Financial Products in DeFi?
- A wider range of investment selection is better suited for every investor’s profile: investors can leverage structured financial products to manage their risk exposure and generate higher returns;
- The development of structured financial products generates demand for the underlying primitives, increasing their liquidity in a virtuous cycle.
Interest Rate Products
The first product of our suite of Struct Finance will be Interest Rate Products.
Interest Rate Products allow anyone to split and repackage the risk of any yield-bearing assets on DeFi to fit their risk profile, through a process known as “tranching”.
Yield-bearing assets are cashflow-generating positions from different DeFi protocols, including Decentralised Exchanges, Liquidity Pools, Yield Aggregators, Yield Optimisers, Decentralised Option Vaults, Insurance Funds, or Bridges.
Tranching works by splitting any source of yield into more parts.
It is a mechanism that changes the risk profile of investments by prioritizing the way in which the cash flows from these assets are returned to investors. This allows investors to choose the tranche that better fits their risk and return profile.
How Tranching works in practice:
- The yield-bearing assets are split into different parts, called tranches;
- Each tranche will have a different level of risk;
- The lower-risk (fixed) tranches will receive a prioritized return as fixed cashflow;
- The higher-risk (variable) tranches offer instead amplified returns through leveraged exposure to the performance of the underlying assets.
The fixed tranche and variable tranche investors are counterparties to each other in the ratio: the more people on the fixed side and the more people will be able to join on the variable side.
Usually, the ratio is 50/50. By changing the initial ratio, we can tailor the exposure of the variable tranche to the performance of the yield-bearing asset and the correct leverage of the vault.
Struct Finance uses a waterfall mechanic that structures the order in which the yields are returned. At the end of the investment period, the principal and fixed rate are returned to those who subscribed to the fixed-income tranche before the rest is passed to investors in the variable tranche.
How do the Interest Rate Products work in practice?
- When a new Struct interest rate product is created as a vault, a subscription period opens, where investors’ deposits are queued. Users can decide whether they want predictable/fixed returns or are willing to take the risk of variable returns. Struct Finance is at work to streamline subscriptions to vaults to improve user experience;
- Users depositing in the contract get a Struct Product (SP) token as a receipt of their position;
- When the subscription period is over, the funds will be invested in the yield-bearing asset;
- The “variable tranche” of the underlying assets will be traded with a 2x leverage (this will also be customizable in later versions of the protocol);
- The funds deposited in the different tranches are balanced at a certain ratio. Users might need to claim back their deposit if a tranche is over-subscribed;
- The funds remain in the yield-bearing asset until the expiration date, during which Struct Finance handles the compounding of rewards;
- At the end of the investment periods, funds will be removed from the assets and allocated according to tranches:
a. The fixed tranche with the principal and fixed returns.
b. The variable tranche will receive the remaining funds.
- Investors return their SP tokens and redeem their investments.
Let’s have a practical example of the returns for the two different tranches.
Assuming a 25% APR for the yield-bearing assets, these are the expected returns:
Given a 50:50 ratio, the variable Tranche trades with 2x leverage, hence why it provides higher returns.
In Struct Finance, the fixed tranche acts as a sort of vault for the variable side, which can borrow funds from it, allowing leverage.
If we want to allow 3x leverage for the variable side, then the ratio will have to be 67:33.
The smaller the variable % and the greater the leverage that is allowed.
At the same time, risk management will improve with the fixed tranche being more secure as the % of the variable tranche decreases.
The tranching process is none other than a prioritization of cash flow: the larger the variable side and the larger the safety “buffer” of the fixed side.
Compared to standard Lending, Tranching has no liquidations but could suffer from “draining” TVL from the borrower. There is, in fact, a risk that the variable side of the tranche might drain the fixed tranche in case of an unforeseeable impermanent loss.
However, the pros outweigh the cons for tranching because drawdown risk is preferable to liquidation risk.
Tranching accommodates risk-on and risk-off investors, is extremely liquidity efficient for the protocol, and most importantly, grants variable takers access to liquidation-free leverage.
We’ll write more about tranching and interest rate products in the upcoming articles. Stay tuned!