Example of how it works

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Let’s take an example with 2 separate yield generating assets (A & B) and a Waterfall DeFi Tranche (WDT) packing asset A & asset B in equal weightage.
Scenario 1: 
Asset A gives a fixed yield of 5%
Asset B gives a fixed yield of 10%
An investor wants to invest $1000 and allocates it 50% in both Asset A & Asset B
The total weighted APY the investor earns will be 7.5%
Without Tranching
Scenario 2:
Asset A gives a fixed yield of 5%
Asset B gives a fixed yield of 10%
A WDT is packed with Asset A & Asset B in equal weightage. This WDT is sliced into 2 tranches Senior & Junior. Senior tranche has a fixed APY of 4% and the remaining 3.5% APY of senior tranche is additionally rewarded to the junior tranche (7.5% + 3.5%).
The investor with $1000 portfolio has 2 choices now:

Waterfall Defi Tranche (WDT)
Essentially, investors in the junior tranche can earn a higher leveraged earning as compared to directly investing in the underlying assets. While risk-averse investors can enjoy a relatively high risk-adjusted yield from a pool of high-risk assets. 

Imagine the following tranche structure with the following optics:
Waterfall Defi Tranche (WDT)
Now the user, with $1000 principal, decides to put its entire amount in the Senior Tranche and fills up the entire allocation (cap). Now assume there are other users that fills up the Junior tranche, making the total portfolio value at inception = $2,000
Waterfall Defi Tranche (WDT)
At maturity, if the asset performs as intended while keeping its principal value intact, the total portfolio value will become:
Total portfolio value = (Asset A Principal + Yield) + (Asset B Principal + Yield)
 = [ $1000 x (1.05) ] + [ $1000 x (1.10) ]
 = $1050 + 1100
 = $2,150
In this case, Senior Tranche Deposits would receive $1,000 x 4% = $40, plus their original deposit amount of $1,000 which equates to a total of $1,040.
Now imagine within the pool of Assets, due to certain extraordinary events Asset B experienced a capital loss of 30%; while the yield of asset B was still realized the total portfolio value has now broken below the original amount:Total portfolio value = (Asset A Principal + Yield) + (Asset B Principal + Yield)
 = [ $1000 x (1.05) ] + [ ($1000 x (1-30%)) +  ($1000 x (0.10)) ]
 = $1050 + 800
 = $1,850 (-7.5% loss)
Even as the total value of the portfolio has become less than original, the User who has its allocation in Senior Tranche will not be affected as the loss has not eaten up to its tranche yet. Therefore the user will still have its $1,040 USD back. This is a clear example of how the waterfall protection would protect and benefit the Senior Tranche holders.
However in the case of Junior Tranche Holders, since they have to accept the first loss, in this case they would only receive $810 (-19%) at maturity.
On the flipside, imagine the portfolio of assets rises by $500 in value along with the yield earned:
In this scenario, Despite the portfolio appreciated by 25% on its principal, Senior Tranche users will still be receiving its 4% with $1040 returned. Junior Tranche Users, will receive whatever is left on the table which is $2650 - $1040 = $1610, representing a whopping 61% return. 
Now imagine the possibilities. Institutional investors that were previously too risk-averse for a particular yield-generating pool can now obtain inherent downside protection for less returns. While investors seeking high returns can enjoy leveraged returns (without the actual cost of a high leverage trade) for the added risk from the senior tranche. 
ELI5: Tranching
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Portfolios in Waterfall DeFi
Last modified 9mo ago
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