After reading Andre Cronje’s post, I realized that Saffron and the risk tranching primitive can be confusing to even the most sophisticated DeFi users. The purpose of this post is to explain how tranching works in its simplest form and why I believe it will grow the market by facilitating the entry of new sources of capital into the ecosystem. Saffron Finance offers protection for risk averse investors, but also allows degens to lever up and make a lot of money by getting paid to take on risk.
Let’s start with the basics. “Tranches” are simply individual portions of an investment with different risk characteristics.
To help visualize this, take a look at the crudely drawn picture above. In this example, Alice and Bob both invest DAI into a pool, and their DAI is allocated to a single risky investment (let’s pretend it’s depositing DAI into a lending protocol) that is expected to return 10%. Alice is more risk-averse, and is willing to sacrifice some potential upside to ensure she gets a 5% guaranteed yield. Bob is willing to take the other side of the deal — he is willing to guarantee Alice her desired 5% yield and cover the loss if anything goes wrong, but he needs to be compensated by getting a higher return if everything goes right. (Don’t worry about the exact % numbers, I just made them up)
To accomplish this, Alice’s DAI investment would be in a “senior tranche”, whereas Bob’s DAI would be in a “junior tranche” of their pooled investment. Additionally, Bob’s DAI investment would be smaller than Alice’s (effectively giving him leverage) such that his return could be considerably higher than the 10% he could expect to earn if he didn’t make this deal with Alice and just made the risky investment himself. Bob is not only bearing this risk for his capital but for Alice’s as well.
This simplified example only scratches the surface of what is possible, but the bigger point to grasp here is that Saffron’s tranched risk pools allow investors to choose which risks they want exposure to and which they want to offput (sell) to others who are willing to get paid to take those risks.
This creates a market for the distinct risks of an investment.
Importantly — don’t just think of risk tranching as a way for a conservative investor to protect against risks. Tranching enables a two-sided market for risk — if you are comfortable with a given risk, you can lever up your exposure and earn higher returns.
For an example of how this works in practice today, let’s look at the Saffron Finance Compound pool.
Rounding the numbers slightly, Saffron users have contributed $4.5mm of DAI into a pool that is deposited into the DAI lending pool at Compound. $3.5mm (77%) is in the S tranche, while $1mm (23%) is in the A tranche. Using my example from above, S is the equivalent of Alice’s senior tranche, and A is the equivalent of Bob’s junior tranche.
What would happen if there is a shortfall of DAI?
In the Saffron Compound pool, the primary reason a shortfall could occur is if Compound suffered a smart contract hack that resulted in the loss of funds. In this scenario, the DAI that Saffron users had deposited into the A tranche be exposed to the first loss — meaning A tranche owners would lose the full $1mm DAI they had deposited before the $3.5mm S tranche holders would experience any loss. (In the future, A tranche holders will also required to lock up some of their SFI tokens as additional collateral in case there were to be a smart contract hack so severe that the entire A tranche was wiped out. This collateral further ensures that the S tranche faces no loss of principal.)
Today, each Saffron pool lasts for a 2 weeks in what is called an epoch. At the end of each epoch, the DAI everyone deposited into the Saffron pools will be returned to investors, along with the interest they earned. Currently, the Saffron Compound pool has a 10x multiplier — meaning that A tranche holders will receive 10x the return that the S holders receive.
However, it is worth noting that the 2 week epoch duration and the 10x multiplier are just arbitrary numbers used in Saffron V1. In the future, these variables can be customized in many ways. Interest can be fixed or variable, the contract can be for a specific duration or perpetual, and junior tranches can be explicitly designed to protect only against specific risks. These factors can be decided by market forces or determined by community governance proposals that SFI holders vote on.
Smart contract failure risk on a single lending pool on a single protocol is just the beginning.
Another scenario to consider is for Impermanent Loss: let’s say Alice wants to be an LP on the SFI/ETH pool on Uniswap. Alice is interested in earning LP rewards, but she is worried about the IL she may face if SFI and ETH prices drift too far from each other. Using Saffron, Alice could create an S tranche that would protect her from any loss she’d take from IL. Effectively, she would be looking to sell the IL risk to someone who is willing to bear it for a price. In this scenario, Bob could then buy the corresponding junior A tranche, guarantee the senior S tranche against losses from IL (any IL Alice faces will come out of Bob’s return), and receive a greater corresponding share of the LP rewards for doing so. Bob’s share of the LP rewards can be arranged ahead of time, or dynamically adjust over time and priced on a bonding curve based on the market of how many Saffron users are looking to sell or bear that IL risk.
These examples are just scratching the surface of what is possible. Smart contract failure and impermanent loss are only two risks that can be bought and sold between market participants. Imagine a DAI pool that doesn’t just go into the Compound DAI pool but rather numerous DAI lending pools across multiple protocols of varying levels of interest and risk. Today Saffron products have 2 tranches, but in the future, this can expand to numerous tranches, some of which offer fixed or variable interest rates and protect against specific sources of risk. Different types of investors can uniquely create individual risk profiles from particular investments, creating a market for risk between Saffron users.
Everything I have described may sound similar to insurance/cover products in the market already because they all create a market for smart contract risk. While it is functionally similar, tranching allows for greater flexibility in terms and can be baked into an asset.
Saffron is such an elegant solution to risk exposure because of how flexible it can be. As more users come into DeFi, there will be a greater sophistication level required for them to enter. Today, most DeFi users have deep technical knowledge and are comfortable with bleeding edge technology. They are willing to take these risks. In the future, larger institutions and other types of investors will want to access the high yields offered in DeFi, but given their relative lack of technical sophistication and discomfort with smart contract risks, they will be looking to offset these risks to willing buyers.
