As with all DeFi protocols, there are a host of risk factors to consider, ranging from poor incentive alignment and economic design to smart contract risk. We actively encourage everyone to perform their own due diligence before using Tren Finance. We hope that you’ll take the time to read the rest of this blog and our docs to get a clear understanding of the protocol as well as the logic behind our approach.
Protocol Design
In order to better comprehend the protocol, there are a few concepts to first understand. The first concept is overcollateralization. In order to borrow trenUSD, the loan position must always be overcollateralized. This means that the value of the collateral asset that is being used for the loan must always be worth more than the value of the trenUSD being borrowed. This is a key factor in the safety of the protocol. Because loans are always overcollateralized, Tren Finance is able to list riskier long-tail assets, and trenUSD is able to maintain its peg. Now, savvy DeFi users will already know that overcollateralization by itself will still expose the protocol to high levels of risk - “what if the long-tail asset isn’t able to be liquidated properly? What about the subsequent bad debt and its effect on trenUSD peg?” We will be answering those questions throughout this blog.
Another concept to understand is isolated modules. This means that each collateral asset will have separate markets and custom risk parameters. As an example, let’s say that there is an isolated module for ETH, and an isolated module for long-tail asset A. Because ETH is a safer asset, the module will have a higher max Loan-to-Value (LTV) ratio, and a higher liquidation threshold. Long-tail asset A will have lower risk parameters due to its higher risk profile. Now let’s say that long-tail asset A flash crashes without recovery and without a profitable liquidation, leaving the protocol in debt. The bad debt would only apply to the trenUSD allocated to long-tail asset A’s isolated module, and would not have cascading effects on other modules.
Asset Listings
The example of long-tail asset A flash crashing is not something that we expect will happen often (although the protocol does account for such instances). The goal of the asset listing process is to avoid listing such risky assets, while at the same time listing innovative assets that users will want to use as collateral on Tren Finance. It’s easier to think of this process as a sliding scale. There’s the risk-averse side on one end. Being too risk averse, however, will just lead the protocol to list only a small number of blue chip assets. Then there’s the risk tolerant side, with too much risk tolerance leading to too many instances of the long-tail asset A example above.
When conducting a risk evaluation of an asset, a few key factors are taken into consideration. These factors include the market cap of an asset, number of holders, and total liquidity (more details in our Asset Risk Methodology docs page). A technical security risk evaluation is also conducted, along with oracle, and centralisation risk reviews. These evaluations are then used to assist in determining the risk parameters of an asset, along with the trenUSD allocation for an asset’s isolated module.
While much of the risk review process relies on empirical data points, we maintain a flexible approach when evaluating assets and setting risk parameters. For example, we would not evaluate an LP token in the same way as any other spot asset. Employing a rigid one-size-fits-all approach to asset risk would make it impossible for Tren Finance to list long-tail assets and different asset types such as receipt tokens, vault tokens, etc.
Liquidations
So what happens when a collateral asset on Tren Finance slips through the cracks of the asset risk evaluation process, and goes through a black swan flash crash liquidation event? The protocol will initially start with a v1 liquidation model using the Stability Pool, and evolve into a v2 liquidation model to handle such situations.
First, let’s take a look at the Stability Pool model. In this model, users stake their trenUSD into the Stability Pool to become Stability Providers. This entitles users to collect yield that is generated from discounted assets in loan positions that have passed the liquidation threshold. For example, a collateral asset such as ETH with a liquidation threshold of 90% would result in roughly a 10% gain for the Stability Pool because the ETH would be swapped for the trenUSD in the Stability Pool at a 10% discount. A riskier asset with a 65% liquidation threshold would result in roughly a 35% gain. Over time, Stability Providers lose a pro-rata share of their staked TrenUSD, while gaining a pro-rata share of the liquidated collateral assets at a discount. In the event of a flash crash, there is a risk that the value of the collateral asset becomes lower than the amount of trenUSD used to liquidate the position due to further price decline. This is only expected to be a rare occurrence however, with most liquidations ending in profit for the Stability Pool and Stability Providers. To read more about how the Stability Pool works, please read our v1 liquidations docs page. What happens in a last case doomsday scenario of the Stability Pool becoming empty? We’ve designed a Redistribution mechanism, which you can read more about in our docs page here.
The v2 liquidation model will make a few significant changes as to how liquidations are executed on the protocol. The main change is that the Stability Pool will no longer directly handle liquidations, and external liquidators will play a more significant role in the liquidation process. In v2, the Stability Pool will become the Backstop Pool, which acts as a backstop mechanism to cover bad debt in the event that a position cannot be liquidated. In return for taking this risk by staking trenUSD to the backstop pool, users earn yield by receiving a portion of the profits generated by external liquidators, and Tren Finance’s own liquidation bot. There are a few major benefits of this upgraded model. First, the trenUSD in the backstop pool is not used in the liquidation process, ensuring that stakers do not lose their deposits during a liquidation unless a shortfall event occurs. As external and internal liquidators now liquidate collateral, the risk of unprofitable liquidations for trenUSD stakers is significantly reduced. TREN is also introduced as the uniform reward token so that backstop providers no longer need to manage multiple tokens. These changes are designed to address the challenges of scaling the protocol to include a diverse range of long-tail assets. To read more about how v2 liquidations will work, please check our docs page here.
trenUSD Peg Stability
Maintaining trenUSD peg is dependent on a number of factors, much of which has already been discussed throughout this blog. One important factor is the risk and reward ratio for trenUSD stakers (Stability / Backstop providers). If unprofitable liquidations occur too frequently, the risk is too high, and trenUSD is no longer a desirable asset. In order for unprofitable liquidations to not occur frequently, the liquidation models above must be correctly designed with aligning economic incentives. Collateral assets must also be chosen carefully with the right balance of risk aversion vs risk tolerance, and with appropriate risk parameters. The points we have discussed throughout this blog are all essentially intertwined to some degree, and work together in creating a safe protocol.
Sometimes, particularly in raging bull markets, even high rewards (yields) are not enough and a large number of users could decide to sell their trenUSD, as we’ve seen with other synthetic dollar tokens. There are soft peg and hard peg mechanisms in place for when trenUSD is trading at above and below $1 USD. As a soft peg mechanism for when trenUSD is trading at above $1, users can initiate loan positions and sell the borrowed trenUSD to allocate funds elsewhere, which can contribute to a decrease in the price of trenUSD. When trenUSD is below $1, users can purchase trenUSD at this discounted rate to reduce their debt, which can drive up the price of trenUSD.
As a hard peg mechanism for when trenUSD is trading at above target peg, the protocol will mint additional trenUSD to sell for stablecoins. These stablecoins, along with the newly minted trenUSD, are then used to bolster trenUSD liquidity pools. When trenUSD is trading at below target peg, the protocol uses a redemption mechanism. Anyone can initiate a redemption, where for each dollar of trenUSD redeemed, the equivalent dollar value of collateral is transferred to the redeemer’s wallet. The protocol will treat 1 trenUSD as equivalent to $1 USD, even when trenUSD is trading at below $1 USD. This process acts as a hard peg by allowing redeemers to make a profit by restoring trenUSD to its target peg. However, not all user positions are eligible to be redeemed against. For each asset, Tren Finance will have a 0% interest module, and an interest bearing module. The 0% interest module allows for 0% interest rate loans, as the name suggests, but loan positions in these modules are eligible to be redeemed against. In exchange for 0% interest loans, users expose themselves to redemption risk. With interest bearing modules, users pay an interest rate, but their positions are not eligible to be redeemed against. This system design provides users the flexibility to choose between redemption risk vs cost.
Summary
For a DeFi protocol that is as sophisticated as Tren Finance is, risk is something that is intertwined with nearly all parts of the protocol. From the protocol level design selection to use isolated modules, to how asset listings are chosen, liquidation mechanisms, and how trenUSD maintains its peg, there’s a delicate balance between managing risk and reward. With this, we hope to offer users a diverse array of functionalities and options on Tren Finance suited for different levels of risk appetite.
If you’ve made it this far, congrats! You now have a great understanding of how risk is accounted for in Tren Finance, and how risk factors into collateralized debt position (CDP) protocols in general. To learn more about Tren Finance, please visit our website and follow our social media accounts linked below for continued updates.
About Tren Finance
Tren Finance is a CDP protocol designed to provide liquidity for various types of assets. Our team comprises of core contributors from various successful DeFi projects, boasting a combined TVL surpassing $1 billion. Drawing insights from our experiences at Venom, MakerDAO, Ajna, Parity Technologies, Parallel Finance, Casper Labs, and more, we bring a wealth of knowledge to the table.
We are excited to unveil numerous use cases for users interested in exploring leveraged staking, restaking and farming opportunities.
