📊Risk Management: Tranches

Enhancing LP scalability via risk-reward customizability

Summary

As we've mentioned in the USDC Vault section, investing in the vault is not risk free. The LPs are essentially taking a bet that even if traders make profits, the trading fees should at least protect the LPs principal. Hence, Avantis has designed a risk management system to ensure that LPs can opt into self-selected risk buckets:

Senior Tranche (Low Risk): Our lower risk product, which receives ~35% of the fees going to LPs. However, it also only shares in ~35% of any losses
Junior Tranche (Higher Risk): Our higher risk product, which receives ~65% of the fees going to LPs. However, it also only shares in ~65% of any losses

Note: the profit / loss share of the junior and senior tranche will be programmable via governance in the future, and we will monitor data post initial launch to observe LP and trader behavior.

Architecture / Game Theory

Avantis' smart contracts continuously monitor whether the protocol is in a state of "normal" or "constrained" liquidity

Normal Liquidity: This is the desired state of the protocol, where there is enough liquidity across both vaults to reserve leverage in the desired profit / loss ratio

Below you can see two examples of the tranches in action under "normal" liquidity conditions

Written example: A trader wants to execute $1,000 worth of a trade. The senior tranche has $2,000 and junior tranche has $1,500. Of the $1,000 trade, $650 can be reserved from the junior pool and $350 can be reserved from the senior pool

Constrained Liquidity: This is a state in which the protocol where there is not enough liquidity across both vaults to reserve leverage in the desired profit / loss ratio

Example: A trader wants to execute $1,000 worth of a trade. The senior tranche has $800 and junior tranche has $400. Of the $1,000 trade, $350 can be reserved from the senior pool but $650 cannot be reserved from the junior pool.

In this situation, the protocol is in a constrained state of liquidity as condition I. is violated. In this state, leverage is reserved from both pools in the actual proportion of the pool balances (hence ~33% of the trade i.e $330 is reserved from the junior pool and ~67% or $670 is reserved from the senior pool).

Gains Multipliers

In situations where there is a large delta between the junior and senior tranches, we apply a gains multiplier to the yields in order to nudge LPs in rebalancing the two tranches. The delta between the tranches must be larger than 35%, before multipliers are applied on the yields.

This multiplier exponentially increases as more people invest in the senior pool (to direct LPs towards the junior pool by making yields very enticing for new LPs). On the other hand, when the junior pool becomes an excessively large proportion of the overall tranche liquidity, we give the junior tranche no additional return benefit (while junior LPs face a higher risk of loss than the senior tranche). Game theoretically, these dynamic multipliers influences the movement of TVL across both tranches in a way that brings the protocol back to a healthy state.

The chart below shows our dynamic multipliers in action. When the delta between junior and senior tranches is an acceptable range (i.e when the junior pool represents 32.5%-67.5% of overall vault liquidity), the junior pool receives 65% of the trading fees. When the junior pool is under-allocated, it receives disproportionately more fees (e.g, >30% fees at 20% allocation). Similarly, when the junior pool is over-allocated, it receives disproportionately less fees (e.g, <75% fees at 80% allocation). This is because of dynamic multipliers

Tranche Balancing - Aligning Incentives

To encourage a healthy balance of assets across tranches, there are several ways to incentivize existing and new LPs to take the right actions for long term sustainability of the protocol. In particular, when the liquidity between Junior and Senior tranches begins to stray from the ideal ratio of 50-50, there will be two types of fees that help balance the tranches.

Vault Buffer Ratio - Maintaining Sustainability

In volatile market conditions, there are times where LPs do not have enough of a buffer to sustain any potential impacts from a traders' open PnL. The vault buffer ratio tracks how much buffer the vaults have to sustain any negative impacts from a traders PnL. Vault buffer ratio of 100% indicates that LPs currently have zero buffer against open PnL (i.e a traders' profits that haven't been realized). Similarly, vault buffer of 110% indicates that a trader can draw down 10% of the vault's value, before an existing LP starts losing their principal (note - this is an oversimplification, and does not apply to all LPs equally as LPs enter and leave the protocol at different times)

To avoid panic and maintain a healthy experience for traders, a vault buffer fee is taken to manage risk for LPs and traders, and preventing over utilization, which can be risky for LPs. In the long run, this maintains healthy liquidity, which brings confidence for traders, and ultimately generates more fees with less risk for LPs.

Vault\ Buffer \ Ratio = \frac{Current\ \ TVL\ +\ Vault \ \ Buffer -Open\ \ PnL \ }{Current\ \ TVL}

Where:

A. Open PnL = The net Profit / loss from open trades on any given day. These are trades that have not been closed, hence Open PNL is not yet realized.

B. Current TVL = The TVL in the vaults at the time of calculating the ratio

C. Vault Buffer = The difference between the Vault manager (the contract that holds all open collateral and undistributed PnL) - Open Collateral in the system (collateral sitting in currently open trades). Vault buffer shows how much excess capital is sitting in the LP pools to absorb PnL shocks during market volatility.

Note: Vault buffer ratio is a daily snapshot, and fees are only charged on withdrawal when buffer ratio is low. Other times, it is completely free to withdraw. The fees are also tiered based on the buffer ratio of the vault as shown below