Pools, Tranches, and Tokens: What's the difference?

Hey everyone, @Esther_Centrifuge here with a special explanation update. Last week @Nico introduced us to some of the main principles of the Centrifuge application. See his post here. In this post, I will explain the relationship between pools, tranches and tokens.

Our prototype testing (you’ll learn more in a future update) has confirmed that it’s hard for investors to distinguish pool, tranche and token.

I will create an imaginary pool in this post to clarify the differences. I’ll keep it low tech and low finance at the start, and add slightly more financial details and some definitions towards the end of the post.

  1. First let’s start a company, “Esther Ltd.”
    Let’s assume we finance real estate and have built a good track record.
    This is done off-chain, outside the Centrifuge environment, and in your own country according to your own laws, etc.

  2. Now, as a company, “Esther Ltd.” can become an issuer of a pool.
    This means “Esther Ltd.” can apply to Centrifuge to create a new pool on the Centrifuge chain. There is a governance process (“POP”) for this; next week’s post will detail how to become a pool issuer.
    The purpose of a pool is to allow people to invest money into the pool (via its tranches and tokens, as I’ll explain below). The liquidity provided by investors is used by the issuer to finance loans. The financed loans are paid back to investors with interest, providing “profit” expressed in terms of an Annual Percentage Yield (APY).

  3. The pool is built from different tranches; each tranche has a token investors can invest in. The tranches differ in protection (risk buffer) and APY. In general the more senior the tranche the more protection, the less risk and lower the APY the investment gives the investors.

Risk buffer definition

The risk protection is the minimum value of the junior token in relation to the pool value. It denotes how much of the pool is always protected by the junior tranche against asset defaults

Current status overview: We have a company, with a pool consisting of 2 tranches.
Junior tranche has high APY but no protection (0% risk buffer)
Senior tranche has a lower APY but a 17% risk buffer.

  1. Now what do tokens have to do with this?
    Let’s imagine Kevin is an investor and wants to invest in Esther’s pool.
    The senior tranche seems interesting for his investment plan.
    Kevin wants to invest 1000 aUSD into the senior tranche.

a. First Kevin has to onboard as an investor for this pool (more details on this in a future blog).
b. Once onboarded, he can lock his investment.
c. When the epoch is closed/ended, his investment will be deposited into the pool and in return he collects tranche tokens worth 1000 aUSD.
This means that Kevin has these tranche tokens in his wallet as proof of his investment. On the Centrifuge Chain, this will be done automatically.
d. In the future, Kevin can redeem his tokens for aUSD and get back his investment plus his yield / profit.

I hope this example helped you understand the relationship between pools, tranches and tokens.

That’s all for now - as usual, please add any questions in the thread :hammer_and_wrench: :v:

Please see below “official” definitions of pool, tranche and crypto token.

Financial definitions

Pool

In capital budgeting, the concept that investment projects are financed out of a pool of bonds, preferred stock, and common stock, and a weighted-average cost of capital must be used to calculate investment returns. In insurance, a group of insurers who share premiums and losses in order to spread risk. In investments, the combination of funds for the benefit of a common project, or a group of investors who use their combined influence to manipulate prices.

source

https://www.nasdaq.com/glossary/p/pool

Tranche

Tranches are pieces of a pooled collection of securities, usually debt instruments, that are split up by risk or other characteristics in order to be marketable to different investors.

Tranches carry different maturities, yields, and degrees of risk—and privileges in repayment in case of default.

source

Felix I. Lessambo (2021) International Finance: New Players and Global Markets, Springer Nature Page 132

Crypto Token

Crypto tokens are a type of cryptocurrency that represents an asset or specific use and reside on their own blockchain. Tokens can be used for investment purposes, to store value, or to make purchases.

source

Crypto Tokens Definition

7 Likes

Thank you so much for this explanation, @Esther_Centrifuge!

It certainly makes it more clear and understandable when it is kept in a simple language like this and with specific examples.

I only have one question; how exactly does the “Risk buffer” work and how is 17% for the Senior tranche calculated?

Sorry maybe that wasn’t clear it’s in the foldout of the post like this

risk buffer

The risk protection is the minimum value of the junior token in relation to the pool value. It denotes how much of the pool is always protected by the junior tranche against asset defaults

Did that answer your question?

1 Like

Good day Esther and thank you for your awesome explanation in a clear and simple manner.

I have a few questions.

  1. You are talking about tranches and I would like to ask if this is mean that could be more than 2 tranches in one pool?
  2. Who and how will be defined the buffer risk protection?
  3. The minimal amount of investing will be definite for all tranches or each Pool could set up the min. invest the amount for each tranche?

Yes it did indeed! Thank you for clarifying - I missed the foldout option…

Hello again, thanks for your questions let me try to answer them for you.

  1. You are talking about tranches and I would like to ask if this is mean that could be more than 2 tranches in one pool?
    Yes :slight_smile:

  2. Who and how will be defined the buffer risk protection?
    First lets define risk protection again just to be clear we all speak about the same thing

The risk protection is the minimum value of the junior token in relation to the pool value. It denotes how much of the pool is always protected by the junior tranche against asset defaults

This risk protection amount is defined during he tranch creation per tranche. Per example:
The pool has a Junior tranche with 0 Protection
The pool has a Medium tranche with 10% Protection
The pool has a Senior tranche with 30% Protection

  1. The minimal amount of investing will be definite for all tranches or each Pool could set up the min. invest the amount for each tranche?
    They can be set up by the issuer per tranche but it’s not mandatory to have a minimum investment amount

I hope that answered your questions

1 Like

Wow! Finally!

Yeah, thank you Esther!

Thanks for the visualization and explanation of the financial terms. Very easy to understand and if there are still open questions everyone can ask in Discord or here in the forum.

One question: are the abbreviations aUSD and kUSD already a preview which currencies will be used in pools on Centrifuge chain? :upside_down_face:

Not necessarily, these are just for explanation purposes over time we will support more currencies on the application (and chain) but it’s a good question I’ll add it as a topic for a future update in which I can share more