How Tranche Lending Will Bring Fixed Interest Rates to DeFi
This is part of a series of articles from ConsenSys Codefi’s Q4 2020 Ethereum DeFi Report. Download the full report to learn more about token standards for assets and payments, NFT marketplaces, social and community tokens, flash loans, wrapped Bitcoin and Filecoin, lending projects and more.
One trend in DeFi to watch out for in Q1 2021 are new tranche products, which are being spearheaded by BarnBridge and Saffron Finance. There has been significant interest in these products, as evidenced by BarnBridge’s nearly $500 million in TVL just for farming its governance token. It is important to recognize that Saffron Finance contracts have not been audited.
Specifically, there is innovation in new tranche lending products that will be coming to market shortly. What is a tranche lending product, you might ask? One of the biggest issues with DeFi lending is that the interest rates are always variable, which means they are constantly changing. While you might earn 6.7% APY lending your DAI on Aave today, that rate might be 10% tomorrow or 1% a week from now. The volatility in these variable rates impedes any individual or institution that is looking for predictable and stable returns in their lending products. Innovators in DeFi are devising a solution to this problem: tranches. At the most basic level, a tranche works as follows:
- Users deposit their digital assets into a pool, which has a fixed rate attached to it. This pool of assets is then lent out via lending protocols such as Aave or Compound.
- When the user initially deposits their assets, the user has the option to deposit into Tranche A of the pool or Tranche B.
- Depositors in Tranche A are guaranteed to receive the fixed rate attached to the pool over a fixed time period. For example, if the pool has a fixed return of 10% APY and you deposit $100 into Tranche A, you will receive $110 ($100 principal + $10 in interest) in one year.
So, you must be asking yourself, how can a fixed rate be guaranteed to Tranche A depositors when the pool of assets is being lent out via a protocol that only offers variable rates? That is where the speculators who deposit into Tranche B enter. Depositors in Tranche B are effectively speculating on what they think the realized APY of the pool will be. If the realized interest rate is higher than 10% APY after one year, then all of the extra interest that was generated would be distributed to the depositors of Tranche B.
But what happens if the realized interest rate ends up lower than the rate listed on the pool, in this case 10%? Tranche A will still be rewarded their 10%, but in this scenario, the realized interest rate would not cover the listed rate. Thus, the principal of deposits in Tranche B would be reduced in order to compensate the depositors in Tranche A. You can probably see why the depositors in Tranche B are called speculators now!
Tranche lending is only one of the many new innovative technologies being developed in DeFi. Furthermore, tranche lending exemplifies just how composable all of these innovations are. The teams who devised this tranche lending system did not come from Compound or Aave, yet they built an entirely brand new product on top of the existing lending protocols.
That being said, there are inherent risks to the composability of Ethereum smart contracts. The more that various financial products rely on one another, the more intertwined the risks of these products become. If one of the underlying protocols fails, they present a systemic risk to the other related products that interact with the protocol. The crypto market crash on March 12th, 2020 is a recent example. Over the course of 36 hours the price of ETH fell sharply, rendering MakerDAO vaults inaccessible due to network congestion, which also caused price oracles to fail and ultimately, cost users millions in losses.
Will these tranche products yield a repeat of the 2008 financial crisis?
One must not overlook the other inherent risk in the tranching of assets, especially given the mortgage-backed securities crisis that precipitated the 2008 financial crash. Tranches of junk mortgage-backed securities were repackaged as CDOs, further sold.
Few anticipated the dynamics of how these new structured products would interact with macro economic trends, like a housing market crash. Another distinct risk with these tranche products is that they are largely new types of structured products being built by non-financial experts. Structuring products is an incredibly complex practice usually only done by the savviest financial engineers at investment banks. Conveying a robust understanding of how these structured products in DeFi will work to market participants will be imperative in order to avoid significant financial loss.
That being said, many of the problems with the 2008 financial crisis had to do with the rating agencies inaccurately rating CDOs rather than there being issue with the structured products themselves. Since there are no rating agencies within DeFi inaccurately rating these structured products, the risk of a miss rating does not exist at this point in time.