The Math Behind Tranche

Understanding Tranche Mechanics

4 min readNov 7, 2021

Tranche is a decentralized protocol for managing risk, and maximizing returns. The protocol integrates with any interest bearing token to create two new tokens; a fixed-rate asset that provides stable returns to users looking to manage risk and prefer predictability; and a variable-rate, levered asset that allows users to maximize returns. This post will walk through the mechanics behind Tranche.

Debt Seniority & Waterfalls

Tranche brings the concept of debt seniority to decentralized finance. By integrating with interest bearing tokens (e.g. Compound cTokens, AAVE aTokens, Yearn yTokens), and creating a debt waterfall — Tranche creates a low-risk fixed-rate asset (Tranche A), and a high-risk variable-rate asset (Tranche B). We’ll get into what this means in the sections below.

Example Waterfall

In this section we’ll show how you can convert an extremely risky asset (50% default rate) into two new assets; a stable safe asset and an even riskier asset.

In this example, we have four loans — Alice, Bob, Charlie and Dave. Each for $1.00.

These loans have a 50% default rate, implying only 2 out of the 4 obligors (borrowers) will meet their obligations (repay their loans). So it’s safe to say, that out of the $4.00 of loans issued, only $2.00 (50%) will be collected by the lender (in our case, the protocol). So how do we create stable, predictable returns from risky assets that have a 50% default rate? We use a debt waterfall, and create two new “Tranches”.

We structure these Tranches in such a way, that the first Tranche (we call this Tranche A on the protocol) gets paid fully before the second Tranche (we call this Tranche B) begins to get paid.

Example Debt Waterfall — the lendees pay Tranche A before Tranche B

We also structure it so that Tranche A is smaller than Tranche B and smaller than the predicted cashflows — giving it a very high probability of collecting in full — i.e. this would be a AAA asset.

Default Scenario

So what happens when inevitably only 50% of the borrowers repay? Tranche A is unaffected. Since Tranche A is smaller then the predicted cashflows, its probability of collecting its $1.00 is very high.

If three of the four default, Tranche A still collects in full. While Tranche B bears the cost

This is how Collateralized Debt Obligations (CDOs) work in CeFi. In the next sections we’ll review the Tranche Protocol implementation — what we call Crypto-CDOs.

Tranche Implementation

Tranche has the ability to deliver extremely high APYs, sometimes reaching 60% paid in the deposited asset (USDC in the example below), through implementing this debt-seniority mechanism to cashflows from Compound, AAVE and Yearn.

Example Calculation

In the screenshots below the Compound rate on USDC is 7.15%. This is the rate the protocol receives when depositing into Compound. This return is split into two new assets — the fixed-rate USDC asset (Tranche A USDC — AcUSDC) and a variable rate bucket (Tranche B USDC — BcUSDC).

Compound Rate on USDC is 7.15% at time of writing

The fixed-rate promised to Tranche A holders is only 1.14%. Implying that whatever excess generated by Compound is given to the variable-rate, Tranche B, holders.

At the time of writing, there are $1,103,000 in deposits in Tranche A earning the fixed-rate of 1.14% paid in USDC in addition to 19.24% paid in the native token ($SLICE).

Tranche A deposits are augmented with $SLICE rewards to incentivize deposits

So these depositors provide the protocol with a 7.15% return in USDC — but only claim 1.14% in USDC (the rest they collect in $SLICE). They forgo the USDC return in favor of the native token rewards — just like you see in other liquidity mining programs.

The difference (7.15% minus 1.14% = 6.01%) is given to Tranche B. This 6.01% difference generates an excess of $66,290.30 a year ($1,103,000 multiplied by 6.01% =$66,290.30) in returns.

This value flows down into Tranche B, which currently contains $189,633.

Tranche B Depositors are earning 7.15% from Compound plus the excess of $66,290.30. This excess relative to their deposits is an extra 34.95% APY ($66,290.30 divided by $189,633 = 34.95%).

Adding the Compound Rate to the excess rate:

7.15% + 34.95% = 42.10% APY paid in USDC.

You can visit the Tranche analytics pages to see historical APYs and better understand how these change over time.