Tranches

How Tranche Lending Will Bring Fixed Interest Rates to DeFi | ConsenSysConsenSys

How Tranche Lending Will Bring Fixed Interest Rates to DeFi

Depending on the context, "tranche" usually means the immutable interest rate.

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!