Paving the way for DeFi mass-adoption: Risk-Tranching Protocols

“Risk tranching will expand the total addressable market of DeFi by offering both higher yields and lower risk options to users” - PsyKeeper, Founder of Saffron Finance

Among the many pain points holding back DeFi from mass adoption is poor risk management infrastructure. Without this infrastructure it is challenging for users to appropriately manage their risk exposure when using DeFi protocols, which prevents some users from even using DeFi at all. If a project were to solve this issue DeFi would not only benefit enormously, but the project would likely benefit enormously as well.

Unsurprisingly a handful of new DeFi protocols are pouncing on this opportunity, and are doing so through securitization and risk-tranching. In traditional finance securitization and risk-tranching are well-understood concepts and very large markets. At a high level, securitization is the merging or pooling of financial assets into interest-bearing securities. Tranching is the slicing up of those securities into buckets to be sold according to their unique risks, maturities etc.

DeFi without risk-tranching is very much binary, you either take the full risk of lending/providing liquidity or none by not participating. However as more users come into DeFi it is likely these binary options will not be enough.

“As more users come into DeFi, there will be a greater sophistication level required for them to enter. Today, most DeFi users have deep technical knowledge and are comfortable with bleeding edge technology. They are willing to take these risks. In the future, larger institutions and other types of investors will want to access the high yields offered in DeFi, but given their relative lack of technical sophistication and discomfort with smart contract risks, they will be looking to offset these risks to willing buyers.” (BlockCanela)

Financial derivatives allow investors to better calibrate their risk profiles, which enables more efficient capital allocation. While risk-tranching might be a niche market in DeFi right now, it will likely become one of the most important verticals in the coming years as the industry moves from the “Early Adopters phase” to the “Adoption phase” where established financial institutions use DeFi products.