The credit tranching mechanism is a protocol that enables the creation of the FinCypher CDO tokens which have the claims over defi lend pools as underlining debt token representing a claim to funds deposited or “locked”.
Each tranche is specified by its attachment and detachment points as the percentages of the total collateral. The lower tranche boundary is called the attachment point, while the upper tranche boundary is called the detachment point. The CDO tranche loss occurs when the cumulative collateral loss exceeds the tranche attachment point.
Furthermore, the protocol itself enables creation of the both Fincypher standard CDO mechanism as well as variable attachment point mechanism. In the case of the last mechanism the attachment/de-attachment points (which define the tranching structure) may vary over time.
The tranche spread is defined as a fraction of the total collateral. The amount of money that the originating bank should pay per year (payments are usually made quarterly) to have this tranche “insured” is the spread times the tranche size. In a standard CDO contract, the attachment and detachment points for each tranche are the same for the whole contract period. Therefore, the bank originator should make the same payments every period (if the tranche has not defaulted)
Overall the interaction of the end-user (CDO originators) with the FinCypher CDO smart contract involves the following steps:
(1) a selection of the crypto that will be included in a CDO ( also includes a decision on the crypto asset will be applied as underlying as well as the collateral if the CDO is insured by the originator) ;
(2) structuring of Fincypher CDO contract and setting of attachment/detachment points, (which is the process of tranching and has a direct impact on the returns of the CDO tokens issued for each tranch;
(3) further, the originator can choose to define the size for the whole pool (close-ended) of the underlying or keep the pool open-ended which would that new
eThe FinCypher CDO instruments can be traded in the secondary market. Any discrepancies regarding the actual share of the CDO in the underlying and the price generated can be efficiently eliminated in the market. Such as if the sum of value of Defi loans (and other crypto assets) which are applied as underlying for a particular CDO is greater than the sum of price of the particular CDO tranch (compared in the tokenized form), the CDO originator or any market participant can arbitrage it away in the crypto market.
If the any of the portfolio of the tranch experienced default the distribution of the crypto assets is conducted based on the priority levels specified in the smart contract.
The FinCypher CDO enables the stabilization of the interest rate of the pool of the loans involved in the system. Each of the class of tranches provides a different interest rate which is based on the class. The interest rate is directly correlated with the riskiness of the tranch. Tranches with higher seniority in the contract (less risky considering the payback of the underlying), provide a lower fixed interest rate than the other tranches which are riskier.
If we define the interest rate of the n tranches by . Then the following comparative value of the interest rates between tranches will hold:
In a nutshell, tranching through Fincypher smart contract is a way to structure DeFi loans strategically to protect risk averse users against interest rate volatility by breaking up the debt into tranches. It creates a functional mechanism to reduce lending risks thus potentially attracting new users and capital to space.
If in the total there are N attachment points in the contract during the configuration of the attachment points the originator should make the decision regarding N-1 attachment points. In terms of the configuration of the attachment points in the contract, the originator should determine their structure.
The originator can insure the tranche via positing collateral to the smart contract. If we denote the tranche n spread by , the cumulative loss due to unpaid crypto commitments in the period by , and configurated attachment point in the smart contract for the period by .
If the size of the tranche is 70% of the total collateral, than the Fincypher CDO originator should post in the contract following amount in the period t to insure the tranche:
If the originator chooses to insure the all traches (which he originated) than the collateral that need to be posted in the contract in the period t is:
Where the function is defined as follows:
The probability that a loss will hit a tranche attachment point in the first period is much smaller than the probability that a loss will hit it in the last period, that is the reason that enabling variable structure for the attachement/ disattachment points can enable the stability of default risk probability distribution for individual tranches. Our protocol will enable originators to define also variable structrue based on their needs.