Implementing these two tranches in code makes them first class citizens of the DeFi ecosystem and thus a much more powerful tool.
Tinlake is built to support a variety of different setups and is highly customizable. One of the aspects that can be customized is how the investor tokens are configured. Tinlake can be configured with two investor tokens (Tin & Drop) to support a two tranche system. If the portfolio should be set up without this structure it can be deployed with just one (Tin).
A Drop purchaser taking the senior tranche would want to have a guarantee that there is at least a minimum percentage of Tin in the pool to make sure that they are protected against a certain amount of losses. Setting this variable guarantees them a certain risk profile. When deploying a pool this variable needs to be set and enforced by the contracts. When the minimum ratio is broken, investments and the issuance of additional Drop token is stopped until the minimum ratio is restored.
The Drop token’s return is defined by a fee function. Our default implementation let’s the deployer set an interest rate compounding per second on the deployed capital but one could also quite easily peg it to say Maker’s stability fee or any other externally defined fee function.
The Tin token only gets a return on their investment if the Drop token holders have all been fully redeemed. Therefore, Tin token holders do not have a guaranteed fee or return but measure their return by what the Drop token contract determines to be the appropriate return.
The distinction between investing in Tin or Drop gives investors two different choices in terms of risk and return profile — one rather stable and safe, but lower yielding token and offering a higher risk but also potentially higher returns. However, investors are not bound to only invest in one of the tokens. By allocating their investment across both tokens they can create their individual risk/return profile, that caters to their specific risk/return appetite.
Using smart contracts to codify these two behaviors and implement the tranches does not only guarantee that the system will behave the way it is expected at all times but it also comes with a huge amount of flexibility. Investors can allocate their investment between the two tranches on a sliding scale adjusting their own risk exposure on demand.
In the context of DeFi our two tokens open up a wide range of options for leveraging these two different kinds of assets. Let’s take MakerDAO as an example. People often call Maker the central bank of crypto. They have an appetite for large amounts of collateral but want these assets to be as low risk as possible. Maker is the ideal candidate to invest the Drop token. Let’s look at how asset originators can use their loans on MakerDAO as collateral.
An asset originator (such as an invoice factoring business) can configure their Tinlake portfolio with a junior tranche and fund part of that tranche. They can work with investors who know their particular asset class and have an appetite for leveraged exposure through the Tin token to their risk. Knowing these assets extremely well and having a very good idea about their risk, they have the confidence to put up some initial capital but lack the financial resources to scale it. Having set up the Tin tranche they can now turn to Maker for leverage, offering a chance to approve the Drop token as collateral on MCD, while guaranteeing that MKR holders are only affected if default losses exceed Tin’s allocation.
In this scenario, the question MKR holders have to ask themselves is not anymore: what’s the risk of even a miniscule amount of losses in this large diversified portfolio of loans? But rather, do we believe that this portfolio is going to have a default rate of less than X%?
Conversely, the two token setup which makes the value of the Drop token extremely stable could also push the collateralization ratio that MCD could accept into much lower numbers. The reason for that is that by investing in the Drop token, to use our example from above, Maker gets a portfolio of loans worth $1.09M to back a debt in Drop token of only $840k. Part of the equation for MCD is not just what their investment is and the possible return but also how much “insurance” in form of Tin investment is available. The MKR governance community can thus give a much lower collateralization ratio and still be well protected.
If you like what you’ve heard and want to learn more about how we’ve built the contracts and how Tinlake works in detail, I’m hosting a community call on the the contract internals for both technical and non technical folks to learn more on Feb 25th at 9am PST/6pm CET.
Stay tuned for more on the upcoming release of Tinlake.