How Royco Risk Tranching Is Working Through Its First Real World Stress Test | DeFi Frontier
- Royco (formerly focused on incentive-based yields) pivoted to RWA risk tranching after on-chain incentive spend collapsed about a year ago and “our business started shrinking alongside it.” Jai Bhavnani's core insight: an RWA yielding 7–12% is “too much risk for an institution... and not enough return for a crypto-native degen” — tranche it into a perhaps stable, conservative 6% senior for institutions and a high-risk, high-yield junior for degens, and issuers unlock customers who previously said no.
- The episode doubles as a live stress test: between recordings, APYUSD — a stablecoin backed by volatile MicroStrategy credit instruments, including Stretch and another instrument — depegged and triggered a 30-day observation period on Royco Dawn. Senior share price stayed flat while the underlying fell because juniors absorb losses first; if the period ended today, seniors exit whole at 1.0008 while juniors are down ~15% — “you still walk away with 85 cents on your dollar,” not the DeFi norm where “you wake up and you're totally dead.”
- Mechanism details worth knowing before allocating: minimum senior coverage on the APYUSD market is 15%, with a current junior surplus lifting it to ~31%, and seniors “break glass” when coverage reaches roughly 5%, market-dependent — not zero — exiting with a small buffer. Junior withdrawals freeze during observation and senior yield is redirected to recovery, so losses aren't marked and realized; Jai claims peer-group tranching products let entrants “buy the bottom” at incumbent juniors' expense, while “Royco junior tranches are significantly outperforming everybody else.”
- Know what tranching does and doesn't cover. Jai's framing is that black-swan events can be binary — “you're either screwed or you're not screwed” — and insurance is meant to cover those risks; “tranching is built for when you have a spectrum of outcomes,” such as credit instruments. What a given senior is protected against depends on the pool's oracle: bank cash balance via Accountable plus RedStone versus a Chainlink secondary price feed. His caveat: “maybe a non-answer, but it depends on the pool.”
- On the ideal asset to tranche, the filter is “net new deposits,” not maximum risk. Overcollateralized lending doesn't transform risk enough to justify giving up yield, whereas a hedge fund with volatility “going up 30% and down 40%” does; a second angle is issuers posting their own junior as first-loss capital to “signal to the market, hey, look, we actually believe in this.” DeFi Dad argues that BarnBridge-era tranching lacked yields worth separating, while today most DeFi products provide de facto junior exposure.
- Security is the tail risk on the whole thesis: “DeFi security today is extremely cooked.” DeFi Dad noted that AI tools are being used to find zero-day-type exploits; Jai says “we're not going to be able to catch all of the bugs,” so Royco uses delayed settlement for withdrawals as a circuit breaker — “How many Aave depositors wish that there was a T+1 settlement inside of Aave today?” — and he calls for industry-wide formal verification, citing Vitalik's article on AI reducing its cost.
- First public reveal — Royco Dusk: junior tranches will LP an AMM (stablecoin versus senior tranche) instead of holding the underlying, providing exit liquidity for seniors and, more importantly, creating a visible on-chain pool against which lenders can extend credit and leverage to otherwise hard-to-underwrite RWAs. Illustrative math: a 9% credit asset with quarterly redemptions becomes a ~6% instantly liquid senior and a ~20% duration-holding junior. Also note positioning: of the 8 markets introduced, only 2 sit off Ethereum, because “all of the serious capital allocators... want to stay on Ethereum.”
1. The pivot: when incentive yields died, Royco rebuilt around tranching RWAs
- Jai's candid origin story: Royco was “indexed so heavily” on incentive-based yield that when spend on incentive programs started shrinking about a year ago, “our business started shrinking alongside it... it was a really hard time, to be honest.” The reallocation call — capital migrates to organic, primarily off-chain yields — has since “come into play,” with Sky allocating the vast majority of its backing to RWAs “of sorts.”
- The product thesis in one move: the customer base splits into institutions chasing a spread over risk-free for their LPs and “retail degens... that everybody knows about.” An RWA earning 7–12% appeals to neither — “too much risk for an institution... not enough return for a crypto-native degen” — but tranched, it becomes a conservative ~6% senior “secured by a massive junior tranche” plus a high-yield junior, and issuers “love it” because it unlocks both.
2. The RWA arc: dead native yields, battle-tested primitives
- Jai on the last few years of being an on-chain user: it “sucked” — native yields dried up, smart-contract risk keeps worsening, and “none of these DeFi protocols are innovating on the security side of things, not to the degree that they need to be.” What survives are deep, battle-tested primitives — Morpho, Pendle, Uniswap — into which RWAs, “the only source of scalable and safe yield” generally, will flow at every level of the stack.
- His best concrete contrast: fixing the yield on an off-chain security takes “months of paperwork, finding counterparties” — on-chain, “Now I can just go use Pendle. That is it. So freaking cool” — and it opens trades to issuers previously too small to do them at all.
- DeFi Dad's reframe of the meta: DeFi as a distribution network for real-world yield, with T-bills as the most distributed example and stablecoins themselves as real-world assets — “this is what we all wanted all along,” it just arrived abruptly.
3. What deserves tranching: net new deposits, not maximum risk
- Asked, as Strata Markets was recently, what the perfect asset to tranche is, Jai's internal filter is where tranching unlocks “net new deposits.” Overcollateralized lending fails the test — “who would go and give up some percentage of their yield to go into that senior?” — while a hedge-fund-like strategy “going up 30%, down 40%” passes, because the senior genuinely transforms the risk.
- The non-risk angle he flags: new issuers struggle to instill trust, and posting their own junior tranche as first loss lets them “signal to the market, hey, look, we actually believe in this” — their own money on the line.
- DeFi Dad's history lesson: BarnBridge-era tranching ran into a lack of yields worth separating; in an Aave-like USDC lending example, there was demand for little beyond basic USDC yield. Today, DeFi Dad argues, most DeFi products hand you junior exposure by default — his quoted quip: “you can earn T-bill yield on chain. The only risk you take is that you can lose it all once a year.”
- The Dawn endgame goes beyond tranching: an RWA issuer “shouldn't need to go and deal with Pendle and then go and deal with Morpho and go and talk to all these curators” — Royco wants to run the issuer's full on-chain capital strategy.
4. The live book: Ethereum-first, and APYUSD's pre-stress numbers
- Eight markets were introduced, with only two off Ethereum — one on Avalanche and one on Arbitrum — and Jai expects that ratio to hold: “all of the serious capital allocators that we talk to on a daily basis, they want to stay on Ethereum.” They won't bridge and change their security profile, and the RWAs will follow where people's assets are.
- The demo showed two layers: a Dialectic-managed vault allocating across senior tranches (“very diversified, very safe... similar to a yield-bearing stable”), and individual markets scaled to the public only ~3 weeks prior after running privately.
- The APYUSD market, pre-stress: a stablecoin backed by volatile MicroStrategy credit instruments, with the senior at 9.83% versus 11.88% underlying — give up ~2% of yield for a minimum 15% coverage, then actually 41.48% thanks to a junior surplus (NAV could fall to ~60 cents with seniors untouched). The junior risk premium was 2.92%, its lowest in weeks after heavy junior inflows pushed “the markets back into calibration.”
5. The stress test arrives: observation period, frozen juniors, 85 cents
- Weeks after the first recording, the hosts brought Jai back: APYUSD — holding Stretch and another credit instrument, both of which had drawn down — depegged and triggered a 30-day observation period, with 21 days remaining. The senior share price stayed flat while the underlying fell because juniors absorb losses first; senior yield is paused and redirected to recovery, since “in a recovery state, it doesn't make sense to continue paying out yield to the senior tranche.”
- The design choice Jai emphasizes versus the peer group: junior withdrawals halt and seniors can only withdraw up to the surplus, so losses aren't realized mid-drawdown. Peers “are marking these losses as they're coming in,” letting new money buy the bottom against incumbent juniors — by his account, “Royco junior tranches are significantly outperforming everybody else.”
- On contagion into seniors, a flat “No”: seniors break glass not at 0% coverage but at roughly 5%, market-dependent, exiting with a small surplus — safe “outside of a crazy volatility event where this thing draws down 80% in a second.” Current coverage sits at 31%, far above the protected-exit threshold.
- The hosts' surprise at the payoff math: if the period ended today, seniors walk away at their full value of 1.0008 while juniors absorb the ~$172,000 of losses (down ~15%, with withdrawals denominated in APYUSD) — “you still walk away with 85 cents on your dollar?” versus the DeFi norm where “you wake up and you're totally dead usually.” Junior yield had ranged roughly from 13% to 29%, and share price had run from $1 to nearly $1.02; holders now have “eyes on that clock,” with 21 days remaining.
6. Boundaries of protection, and the security elephant
- Jai's cleanest taxonomy: black-swan events can be binary — “you're either screwed or you're not screwed” — and insurance is meant to cover those black-swan attacks and risks; “tranching is built for when you have a spectrum of outcomes,” which credit instruments inherently produce.
- Pressed by the hosts on exactly which incidents tranching covers, Jai concedes the category “needs to make that clearer”: it depends on each market's oracle. A bank-cash-balance oracle using Accountable plus RedStone indexes a narrower risk set; a Chainlink secondary-price feed can also capture hacks and admin-key mess-ups. His self-aware verdict: “maybe a non-answer, but it depends on the pool.”
- On his tweet that “DeFi security today is extremely cooked”: DeFi Dad noted that AI tools are being used to find zero-day-type exploits; Jai says “we're not going to be able to catch all of the bugs,” so systems must be built to live with failure — Royco's delayed-settlement design — plus an industry-wide push into formal verification, citing Vitalik's article on AI reducing its currently prohibitive cost.
- The T+1 exchange: DeFi Dad frames instant withdrawals as “a race to the exit... a terrible user experience,” and Jai extends it — “How many Aave depositors wish that there was a T+1 settlement inside of Aave today?... I would argue the vast majority” — saying this could become a more popular decision for teams. His human note: “everybody writing smart contracts these days... has difficulty sleeping.”
7. Royco Dusk, revealed: junior tranches as guaranteed liquidity → RWA credit
- Discussed publicly for the first time: issuers want to offer leverage, but “it's very difficult to extend credit to a lot of these RWAs” versus, say, an on-chain Bitcoin wrapper with visible liquidity. Dusk puts junior capital into an AMM — stablecoin on one side, senior tranche on the other — instead of the underlying. The AMM alone “isn't very valuable by itself”; the point is a junior-backed on-chain pool that lets lenders “extend credit very safely” to RWAs.
- The worked example, rough maths as told: a 9% credit asset with quarterly redemptions (“that really sucks”) becomes a ~6% senior with instant, DEX-style exit liquidity and a ~20% junior that holds the duration through its AMM position — arbitrageurs buy discounted seniors or hold to redemption, giving the senior dynamic real-time pricing.
- The wrap: the host says Royco's Boyco predecessor had, “I think,” billions at the time, and DeFi Dad said that “as someone who wants senior tranche exposure... this is the kind of product I'm hoping will grow.”
Full transcript
If we believe that the vast majority of yield programs are going to be RWAs, then what technologies are needed to connect these demographics of investors to these RWAs? What we identified is that our customer base is split into 2 groups. You have the institutional players, who are here to earn some rate above the risk-free rate and deliver a return to their LPs. On the other side, you have these retail degens—the DeFi degens that everybody knows about.
If you have an RWA that's earning between, let's say, 7% to 12%, that's not appealing to either one of these groups. It's too much risk for an institution and not enough return for a crypto-native degen. What if we were able to tranche it and turn an asset that was previously boring to both of these groups into an asset that's now interesting to both of them?
Maybe there's a stable, conservative 6% yield that's secured by a massive junior tranche, and you can sell that to an institution. Then there's a junior tranche that's high-yield, high-reward, and also high-risk that you can sell to these DeFi degens. All of these RWAs that we talk to love it because now they can unlock all of these different customers that previously they would have said no to: “Oh, too high risk,” or “too high or too little yield.” Now they can sell to them.
Jai, thanks for joining us again. How are you doing?
Awesome. Thank you guys for having me. Excited to be here.
It's so great to have you back on the show. The last time we spoke with you, Ryze Capital looked very different. Since then, you have launched, I believe, 8 markets under this new product called Ryze Capital Dawn. There are juniors and seniors in each of these markets, so it's a risk-tranching type of product.
1. What is Royco? A DeFi risk tranching protocol
It's something we talked about recently with the founder of Strata Markets. I think this is a great follow-up for folks who are interested in a sophisticated TradFi-like product, but one that's permissionless and brought on-chain through the power of smart contracts. Let's talk about what has changed. Talk to us about what you've been building at Ryze Capital. I'm curious how you landed on this risk-tranching product.
Great question. Let's zoom out and talk about what Ryze Capital is. Ryze Capital has always fundamentally been about delivering the tools to connect on-chain users with on-chain yield opportunities. That's always been our fundamental business. Prior iterations of this were focused on incentives, because prior to even the last year, the vast majority of yields on-chain—the vast majority of capital on-chain—was seeking incentive-based yield.
This crazy thing happened about a year ago where the amount of money being spent on incentives and these on-chain yield programs started shrinking. Our business started shrinking alongside it, and it caused us to look in the mirror and say, “What are we going to do about this?” Royco Capital was so heavily indexed on the incentive side of things that it was a really hard time, to be honest.
What we then realized was, where is this capital going? Where is it going to go? What we identified was that it's going to go into these organic yields, primarily off-chain yields, where investors and users don't need to underwrite smart-contract risk, but they get the visibility of all these on-chain interactions. They get to use these assets throughout DeFi.
We said, “These RWAs, as they're now being called, are what people are going to be allocating into.” That thesis has now come into play, where you have folks like Sky allocating the vast majority of their backing to these RWAs of sorts.
If we believe that the vast majority of yield programs are going to be RWAs, then what technologies are needed to connect these demographics of investors to these RWAs? What we identified is that our customer base is split into 2 groups. You have the institutional players, who are here to earn some rate above the risk-free rate and deliver a return to their LPs. On the other side, you have these retail degens—the DeFi degens that everybody knows about.
If you have an RWA that's earning between, let's say, 7% to 12%, that's not appealing to either one of these groups. It's too much risk for an institution and not enough return for a crypto-native degen. What if we were able to tranche it and turn an asset that was previously boring to both of these groups into an asset that's now interesting to both of them?
Maybe there's a stable, conservative 6% yield that's secured by a massive junior tranche, and you can sell that to an institution. Then there's a junior tranche that's high-yield, high-reward, and also high-risk that you can sell to these DeFi degens. All of these RWAs that we talk to love it because now they can unlock all of these different customers that previously they would have said no to: “Oh, too high risk,” or “too high or too little yield.” Now they can sell to them. Does that make sense?
Yeah, Jai, totally. It really feels like one of the big tailwinds for DeFi is this RWA explosion. I know there are people—maybe true DeFi OGs—who aren't in favor of it, but it's clear that this is where yields are being generated on-chain right now.
In preparation for this, I was looking through your X feed, and I saw you mention an article called “Tokenizing Trillions.” You said, “This is one of the most articulate explanations as to where we are going, both as an industry and what Royco is working towards.” That's a big statement, so clearly Royco is hitching its wagon to this RWA meta.
Talk a bit more at a high level about where you see this going as a movement within DeFi.
Great question. Let's look at the last few years of being an on-chain user. It sucked. All of the on-chain-native yields have basically dried up. You're left with smart-contract risk left and right, and that seems to only be getting worse. None of these DeFi protocols are innovating on the security side of things—not to the degree that they need to, at least.
You're stuck in a situation where the risk-to-reward of keeping your capital in any on-chain vehicle is very difficult—extremely difficult. But at the same time, what do we have? We have deep primitives. At this point, Morpho is very battle-tested. Pendle is very battle-tested. Uniswap is very battle-tested. These are excellent primitives—not necessarily protocols for yield generation, but primitives that you can take any token and use inside of.
My vision of what's going to happen here is that all of this capital we're seeing on-chain, currently earning very little, is going to slowly start migrating into RWAs at various levels of the stack. Maybe in Pendle, maybe in lending, or whatever. Everybody's going to be exposed to these RWAs because they're the only source of scalable and safe yield that can happen, generally.
Now you can use these RWAs inside all of these primitives, and that's when things get interesting. Before, in the off-chain world, if you had some sort of security earning some yield and wanted to fix the yield on it, that would take months of paperwork and finding counterparties. Now I can just use Pendle. That's it. So freaking cool.
Not only that, but now I can offer that to RWAs and issuers that might not even have the size to do a trade like that before. All of this is to say that I fundamentally believe RWAs are going to be the key to this next arc of on-chain financial growth and the growth of the entire DeFi space. It's going to be RWAs and using these RWAs in the primitives that we already have—the battle-tested primitives that we already have.
Yeah, this is a change that caught me off guard just in the last year: realizing that we've been so dependent on DeFi-native yields for so long, and that DeFi could actually serve as a distribution network for real-world yields. For example, T-bill yield, I think, is the most distributed real-world yield on-chain, and ultimately, stablecoins are real-world assets.
That RWA buzzword gets used a lot now in our space, and you just have to remind folks that this is the merging of DeFi and TradFi. This is what we all wanted all along, and we're just recognizing that we want better yields. We want yields that don't compress every 4-year crypto bear cycle.
2. What is Royco Dawn and what does it solve?
This is good. This is, again, where we were always headed. It's just that I think it's happened very abruptly. Anyway, talk to us more about this Ryze Co Dawn product. What is the problem—the elevator pitch that you're trying to solve for—and who is this built for?
Sure. At the end of the day, we have 2 primary customers. We have the RWA issuer, or the yield issuer, that we work with on one side, and then we have all of our users on the other side. Our job, at the end of the day, is to figure out how we connect these groups and make both of them extremely, extremely happy.
Dawn is the first step in connecting these groups. Can we tranche out the yields such that it makes sense for more users to go into these RWAs? It's an easy win for the RWA: now I'm unlocking more capital into my yield strategy, which means more revenues and more fees for me, yada yada yada. It's a win for the user because now the user is getting a risk-adjusted yield that suits their risk profile. This is a win for both sides.
We're going to be developing a lot of different technologies around how we connect these 2 sides of the market. To zoom out and take it back to that tokenizing-trillions piece, our goal is this: when an RWA comes along, it shouldn't need to deal with Pendle, then deal with Morpho, talk to all these curators, and run a whole on-chain LP strategy. That's going to become Ryze Co.
We're spending all of our time now talking to these RWA issuers about how we can help them with the full DeFi stack—how we can help them access this on-chain capital and pioneer their on-chain capital strategy. That's our real goal here: connecting that up with users.
3. What is the perfect asset to tranche?
Jai, I also want to ask you: in your mind, what is the perfect asset to tranche? We asked Strata this recently as well, and they said something really interesting about when this was tried 3 to 4 years ago. They were trying to tranche assets that were already overcollateralized, so there wasn't as much inherent risk in the assets. It seems to me like you want some element of risk. I don't know if that's true, but I'll let you answer: what's the perfect asset to tranche?
Yep, yep. There's a lot of different angles from which you could approach this question, but I'll tell you how we think about it internally. The assets we want to spend time on and present to our users are assets where we can unlock net-new deposits.
If we look at some overcollateralized lending position, who would give up some percentage of their yield to go into that senior tranche? Not that many people, because you're not transforming the risk so fundamentally. The risk is already extremely low.
Now, if you were to look at a hedge fund where the volatility is going up 30% and down 40%, that's craziness. But now I can go into a senior tranche where I'm not really seeing any of that volatility. Maybe that unlocks net-new deposits on the senior side that they could have gotten if they hadn't tranched.
We're really driven by this question: where do we believe we can unlock the most net-new deposits? Usually, yes, that's correlated to risk, but it's not exclusive to it.
I'll give you one example where it's not exclusive to risk. We're talking to all these different issuers, and one of the biggest problems they're having is figuring out how to instill trust in their new product. The biggest thing that we've seen is that they couldn't post a junior tranche themselves and signal to the market, "Hey, look, we actually believe in this. We're willing to be that first loss."
They themselves going and putting their own money on the line because they believe in their product tells the market a lot. There are all these different angles through which you can understand where we're unlocking net-new deposits. That's one. Obviously, unlocking new deposits just from a risk profile is another, and there are a handful of others.
Yeah, Nomatic and I were talking more recently about the yields available on Royco. Something I remember from the days of BarnBridge, trying to tranche according to risk and create this senior-versus-junior pool, is that there just weren't the kind of yields that needed to be tranched. Everyone was either senior or junior.
We talked about, for example, lending USDC to something like Aave. In that scenario, it just didn't make a whole lot of sense because there wasn't demand for anything but that most—
Basic.
Exactly. A basic USDC yield. Fast-forward to today, and I would argue that most DeFi products are giving you junior exposure. You're ultimately taking all the risk, and if it goes to hell—there's a smart-contract exploit, something fails like an oracle, or the yield just drops dramatically—you're all feeling that hit at once.
When you look at the risk that's on-chain, with exploits happening, especially with AI tools now being used to find zero-day-type exploits in DeFi protocols, it again begs the question: why would I want exposure to this? I'm earning T-bill yield on-chain, but I'm taking the risk of losing literally everything.
Someone had a funny tweet recently, something like, "The state of DeFi is that you can earn T-bill yield on-chain. The only risk you take is that you can lose it all once a year." You're earning 4% while risking it all. So anyway, the time is ripe now for this product to actually take off.
4. Screenshare and explanation of Royco’s live markets
Jai, I'm wondering, would it be possible to do a quick screen share? We want to dig more into real examples here with the market that you have live.
Yeah.
Let's do it.
We do have 2 markets outside Ethereum—1 on Avalanche and 1 on Arbitrum—but the thing that we follow is our users and what our users are asking for. There are 2 different types of users, as I mentioned before: our actual users, the ones participating in these markets, and the RWA issuers.
What we're finding is that both of them want to stay on Ethereum. All of the serious capital allocators that we talk to on a daily basis want to stay on Ethereum. They don't want to bridge their funds elsewhere and change the whole security profile of their assets.
Similar to the RWAs, they're just going to follow where people's assets are. You can't expect anything more. People's assets want to stay on Ethereum. Looking at our markets today, again, we only have 2 markets outside Ethereum, and I imagine that percentage will probably continue to stay the same.
Jai, could you go ahead and continue with this demo?
Cool. Yeah, this is our app. Over here, you can see 2 different things. First of all, we have a vault. This is an actively managed vault, and it's actively managed by a firm called Dialectic. They allocate between a bunch of different senior tranches.
You can think about this as a very diversified, very safe piece of collateral that you can basically treat similarly to a yield-bearing stablecoin, with additional yield layered on top. If we scroll down here, we can see the actual individual markets—the individual things being tranched.
We just started scaling this up to the public about 3 weeks ago. Prior to that, these had all been private markets. If we look at one of these markets in particular, we can look at APYUSD. APYUSD is a stablecoin that's backed by a lot of MicroStrategy credit instruments.
It's a pretty volatile—or rather, the credit instruments being issued are pretty volatile. If you look at similar players to APYUSD, you actually see a lot of volatility in their price because the credit instruments are pretty volatile.
Here you have a senior tranche that's earning 9.83%, which is about 2% less than the actual underlying yield source. That underlying yield source is 11.88%. So you're giving up 2% in yield, but in exchange for giving up 2% in yield, you're getting, at minimum, 15% in price protection—or, as we call it, coverage.
So this means if the asset drops from, let’s say, $1 to $0.85, the user is still secure. In this case, we actually have a surplus of juniors. We actually have 41.48% protection, which means the asset can draw down to $0.60 and the senior is still untouched.
So this senior becomes pretty interesting. Meanwhile, that junior—the one underwriting that risk—is adding another risk premium right now: 2.92%. This is the lowest it’s been over the last couple of weeks because we’ve seen a massive inflow on the junior side of things. So now you see the senior yield going up to basically get the markets back into calibration.
5. Observation period: Royco's first stress test with apyUSD
This is the gist of it. If we dive into one of these markets, you can actually see all of the data around this. You can see the yields.
Okay, so if you’re listening to the episode, you might not be aware of this, but we recorded the podcast here with Jai a few weeks ago. Then, just by chance, there was an event that kicked off an observation period on the platform related to the Apex markets.
Anyways, we’re back to ask Jai a few relevant questions. If you’re watching the podcast and you’re thinking, “Why are they in different clothes?” it’s because we’re recording this after the fact. So, just a few things to set this up: APYUSD is a yield-bearing asset that is ultimately backed by stretch. They hold a large amount of stretch, and I’ll let Jai tell the story.
APYUSD, the yield-bearing asset that is tranched through Royco, I believe the best way to say it is that it depegged and triggered this observation period. Again, that’s all part of determining whether or not juniors would ultimately pay seniors and compensate for some sort of loss scenario. So, Jai, can you take it from there? Is that enough to get us started and talk about what you’re seeing here?
Yep, totally. To zoom out, the APYUSD basket has different credit strategies backing it. It holds stretch on its balance sheet. It holds sat on its balance sheet. All of which have drawn down versus their all-time high, and that means that users who are sitting inside of APYUSD are now facing some losses. Folks going in and looping this are also facing some losses.
When you look at our tranches and how they’ve reacted during this time, it’s pretty interesting. If you look at our senior tranche right here—I’m screen sharing—you can see the senior tranche normally appreciating during all this time since the market went live. Then what happened here is that it kickstarted an observation period.
Why did it kickstart an observation period? Because the NAV value drew down. It detected that the value of APYUSD had decreased, so it was going to kickstart this observation period. During this time, you can see that the senior price, as opposed to decreasing as it would if you were holding APYUSD, is staying flat. Why is it staying flat? Because juniors are absorbing those losses. They’re absorbing those losses for the seniors.
You can see that, for a brief moment here, it came out of the observation period. The NAV actually recovered for a brief moment, and then it went back into the observation period. You can see here that yield has been flat on the senior, when in reality, if you compare it to the underlying, yield has actually been positive for the senior because they haven’t faced these drawdowns. That’s what the senior tranche looks like right now. Does that make sense? Maybe we could dive into the junior tranche.
6. How seniors stay protected while juniors absorb losses
Yeah, can you remind us what protection seniors are ultimately guaranteed here? If we’re looking at the screen share, what are you signing up for as a senior in terms of that minimum coverage?
At minimum, it’s 15%, which means APYUSD could draw down 15% and you’re still covered. In this case, there’s a surplus of juniors because juniors were really excited about this opportunity. So, you’re actually covered 31%, which means APYUSD’s NAV value could draw down 31% and the user in the senior tranche is still safe. Did that answer your question?
It does. Do you recall, or are you able to see anywhere on screen, what the junior yield was prior to the depeg or prior to this observation period kicking off?
Let’s hop into the junior tranche right here, and we can zoom out to a month. That should be enough. You can see here that it was 14%, ranging from 29% to 15%, 13%, it looks like. So, it was pretty aggressive on the junior side of things.
If we zoom out to the share price of the junior, you can see it was really attractive. It started, I would say, at $1 here and went all the way up to nearly $1.02 over a pretty short duration. Then it activated into observation mode.
Just as a refresher, these juniors—the share price has fallen, and you can see here that the juniors are down about 15% as it currently stands. But the goal of the observation period is, “Hey guys, let’s wait. Let’s wait for this period of time.” It was set to 30 days, and there are 21 days remaining. Let’s wait before the juniors get slashed.
7. What could end the 21-day observation period?
Now the juniors have this 21-day timer to recover. There are 2 things that can end this period: the 21-day timer, or they run out of coverage for the seniors. The protocol will never hurt the seniors, so they’ll let the seniors out as the juniors start to run out of coverage. One of these 2 things will happen, but until one of those things happens, everybody has their eyes on this clock. Everybody’s monitoring the underlying NAV value, and in the junior tranche, they’re hoping that it can recover during this time and that the share price goes back to where it was.
8. Can you deposit or withdraw during observation period?
When the observation period kicks off, does that halt any withdrawals or deposits? I was wondering about deposits, too. I don’t know if there would be any reason for someone to be depositing during that period. It seems pretty high risk, but is there any mechanism at play there?
Yep. Withdrawals for the junior are halted during this time. Withdrawals for the senior can only happen up to the amount of surplus.
9. Can seniors lose money in a Royco loss event?
If you look at how Royco is responding to this versus some of the other folks in our peer group, it’s because these losses are not being realized. We’re effectively freezing certain parts of the market during this observation period, which means that the juniors are not realizing these losses right away.
Why is that super valuable? If you go look at our peer groups, they’re marking these losses as they’re coming in and enabling folks to withdraw and realize these losses. If you look at the junior tranche performance again in this peer group, the Royco junior tranches are significantly outperforming everybody else.
Even if we were to go and realize our losses today, they basically bought the bottom. Those juniors are all constantly buying the bottom, and that’s basically screwing over a lot of the junior tranches in our peer group.
The only question I would have is, is there a scenario where the whole junior cohort needs to be slashed and some of this bleeds into the senior tranche?
No. Here’s how you can think about it. Right now, there’s 30% coverage for those juniors, and this will continue to get consumed. The seniors don’t get out when that reaches 0%. We let the seniors out when that reaches 5%. It depends on the market, but with a little bit of a surplus.
The idea here is that the seniors can get out as soon as that happens. It’s like a break-glass situation, but they get out with a little bit of a surplus. Realistically, outside of a crazy volatility event where this thing draws down 80% in a second, the seniors should be able to get out with that surplus, which enables them to unwind their position and come out safely.
10. How Royco tries to restore markets to healthy status
Another detail that I recognized when this observation period kicked off is that the protocol stops any yield from flowing to seniors, right? You’re allocating all of that to the junior tranche. Assuming that the underlying doesn’t go to 0, you’re hopefully building up a bit of a buffer.
Again, I’m not under the illusion that there are going to be 0 losses by doing that, but you are, I think, lessening the pain of any sort of slashing event, right?
Exactly. That’s the goal here. In a recovery state, it doesn’t make sense to continue paying out yield to the senior tranche. In a recovery state, you want the system to go back to normal, and that should be the top priority.
11. Estimating losses if 21-day period runs out for apyUSD
It doesn’t make sense to continue paying out yield to the senior just because the senior signed up for some benchmark rate, and now you’re forced to slash the junior, A, for underperformance of the strategy, and B, because they signed up for this benchmark rate. The idea here is that every part of the system is trying to restore the market to a healthy status.
Okay. While we hope that this returns to peg, let’s just say we run through the next 21-plus days and it has not recovered. What is the outcome of all of this? What do seniors anticipate walking away from this with?
Let’s pretend I put in $100 of some stablecoin into this to begin with as a senior, and then let’s pretend I’m someone who put in about $100 into the junior tranche.
Are you able to forecast what the senior would walk away with versus what the junior would?
Yeah, we can walk through it at current numbers. Who knows what the NAV price is going to be once the observation period is over, but let's assume that the observation period ended right now. In this case, the senior is walking away with their full value: 1.0008. They can walk away with that, and they aren't really stressed.
Meanwhile, the junior tranche is walking away with the share price as well. How is this share price being calculated? You can see that the senior tranche would have drawn down 5.81%. It has these losses at $172,000 worth of losses. Those $172,000 worth of losses are what the junior is absorbing.
So, if you fundamentally do the math on how much junior capital is here and what the surplus is, you can see that the junior has drawn down by this much, and those are the losses that they would be incurring today. You deposited a dollar. It depends on when you deposited, but you can do the math on that drawdown since.
And then remind us: what is that withdrawal denominated in? Are you walking away with APYUSD, or is it in USDC?
12. Design for juniors to not get wiped out
You're walking away with more APYUSD, such that, if you're a senior, you're now getting whatever your principal was, plus some payout of APYUSD from the junior. If you're a junior, now you're just walking away with a little bit less APYUSD.
Am I understanding this correctly? This is a really interesting design because I was imagining the juniors getting fully wrecked, but are you actually—am I looking at this right? You still walk away with 85 cents on your dollar?
That's correct.
Wow, okay, cool. Yeah, I hadn't gone this far into the weeds, and I was of the mind that you were just wiped out and completely lost all your capital, and it all went to the senior for protection. Very interesting. Have you been talking to any of the users who are in this situation right now? It seems like a very orderly transition for something like this. We're not used to that in DeFi, really. You wake up and you're totally dead, usually.
So, first of all, in terms of getting wiped out, that is the norm. That's the norm with our peer group on the tranching side of things as well: these juniors are getting completely owned. In contrast, with our juniors, we hope that they're looked after. In chatting with them, everybody's just got their eyes on that clock, pretty much. They aren't sweating too much quite yet because there's still 21 days remaining.
Sailor can do a lot in 21 days to restore both stretch and saddle to the peg. The big question here, though, is whether the juniors are going to have to break glass before them, or whether the seniors are going to have to break glass before them. That break-glass situation here—if we scroll down here, you can see we have this minimum coverage and this protected exit threshold.
So, we're still very far above it. We're at 31%. This would need to draw down significantly. We would need to have a significant drawdown to even get to that protected exit threshold, that break-glass situation, that “Hey, let's liquidate everything” situation. So, they aren't sweating here, but I would say everybody's keeping an eye on this.
By the way, I think the nature of what's happened here is a little more complicated than probably other markets you might be dealing with. For example, let's pretend that you have a yield-bearing asset. It's been tranched into juniors and seniors on Royco, and let's pretend that there is some sort of exploit that happened and there's a loss—a 50% loss.
To me, that's a more black-and-white situation where you ultimately are looking at the juniors probably taking a larger loss there, just because there's not as much capital to pay out. The seniors are getting whatever protection you offer, but there's not a deep depeg you're dealing with. It's just a very straightforward loss in the underlying.
That's correct. The way I like to think about this is that it's a binary outcome: you're either screwed or you're not screwed. There's no in-between. Am I partially screwed? Maybe, if that is a not-super-bad black swan event. That's what insurance is great for. Insurance is meant to cover you against these black swan attacks and these black swan risks.
Tranching is built for when you have a spectrum of outcomes. It's not built for these black swan events. When you're going into a credit instrument, you will inherently have a wide spectrum of outcomes that aren't black swan and that you're just underwriting as a participant in that market. That's where tranching succeeds. That's where tranching thrives: when there's that spectrum. So, you're spot-on with that assessment.
13. What is protected? Tranching vs insurance
Okay, so we'll probably return to the remainder of the original conversation we recorded, but I really appreciate Jai being able to come back and answer some hard questions about what exactly is going on with this current observation period.
Jai, I want to go back to what is protected, and I want listeners to come away from this crystal clear. The reason is that I'm still confused about what risk tranching is actually covering and what incidents. If the price of something drops like it is, does coverage extend to exploits or OPSEC-related issues, or is this primarily smart-contract and strategy issues? Can you delineate the boundaries? Sometimes I feel like I'm being told that risk tranching covers everything. It's the greatest thing, but there have to be some limitations here, right? Maybe just explain those boundaries.
It's a great question, and I think it's something that we need to improve on as a risk-tranching category. We need to make that clearer. So, let's talk about what this actually looks like today.
When a market is deployed on Royco, it specifies an oracle. Similar to a lending protocol—lending protocols have oracles to determine, “Hey, what is the price of this asset?”—we also have oracles. These oracles can be set up in many different ways. They can be set up to look at the cash balance inside a bank account by using an Accountable plus RedStone oracle, or maybe they're going and looking at the secondary price of the asset using Chainlink.
Both of these types of oracles will be indexing different types of risks. If you're looking at secondary prices, that's going to start to look at whether this thing has been hacked or whether it's covering admin-key mess-ups. All of that stuff. Versus maybe if we're just looking at the backing, it's looking at a narrower set of risks that are actually occurring here, albeit at the trade-off that it's a little bit more secure to be looking at that.
On a perp pool, we show users, “Hey, look, here's what the oracle that's being used is. It's using a secondary price feed. It's using—hey, we're actually looking at the cash balance in this account.” So, I would make maybe a non-answer, but it depends on the pool.
14. Is security in DeFi cooked? How we move forward
You also recently posted on Twitter that DeFi security today is extremely cooked. I'm wondering what you think the industry is still getting wrong.
There's a lot that the industry is getting wrong. I do not think that we as an industry are spending nearly enough money or time on security as we need to. I think that is causing capital to flee and developers to flee as well. I think there's very little innovation happening on-chain in a purely on-chain-centric mode of innovation because people are scared. And they're scared for the right reasons.
So, what needs to be done to make these systems more secure?
I think, first of all, we need to start thinking about security very differently here. In a world where we have mythos and these crazy AI models, we're not going to be able to catch all of the bugs, right? It's just a matter of fact: as an industry, we're not going to be able to. So we need to build systems where we can live with that, right? That's why we have our delayed-settlement system, right? It's so that way we can live with that. If there—God forbid—if there is an issue, it's okay, right? That's the first thing I'd say.
The second thing is that I think we need an industry-wide investment into formal verification, right? Formal verification is something we take super seriously, right? It's basically proving, “Hey, look, the code is functioning as it's meant to function” by using math. Vitalik just had a really great article on formal verification and all of its merits, and how AI is going to decrease the cost of formal verification, because right now it's extremely expensive, right? This is what I think we really need to be focused on as an industry: how do we decrease that cost of formal verification and basically decrease the barrier to entry so everybody can write smart contracts and feel safe because it's been proven by math to be safe?
I think there's a whole level up that we need to get to with just opsec before we go anywhere else. I've been having a lot of conversations with teams that are doing this right now about hardening their protocols and their own admins on that side of things, but you're not wrong. There's this massive elephant in the room that needs to be addressed as well, and it's even scarier to me.
15. Royco’s decision to introduced delayed settlement
When you talked about the T+1 settlement, that was radical to me. When you announced that, I was somewhat at odds with it, just thinking, “Wait, what? T+1 settlement? Why are they doing this? What's the reasoning?” The reasoning is what you just called out: Nomadic. It's about the fact that there's a big issue, a huge vulnerability, to our whole industry right now, which goes back to opsec.
All the exploits are going back to some sort of key management, something unrelated to a smart-contract exploit. While we're hopefully figuring this out, I do think it's important to have some sort of—call it a circuit breaker, or something to trigger a protection if the worst-case scenario happens. A lot of DeFi is set up in a way where, if the worst happens, it's then a race to the exit, and that is a terrible user experience. It's awful. It's like, “If it goes to hell, don't worry, you can instantly withdraw—but by the way, everyone else withdraws, too, so you're left holding the losses, holding the bags.”
Am I making sense? I thought that what you guys are doing with the T+1 settlement for withdrawals had to have been some reaction to what happened with Aave, but maybe I'm connecting the wrong dots there.
Yeah, I mean, look, everybody writing smart contracts these days—anybody working on-chain—has difficulty sleeping, right?
Everybody has their own battle scars from many months of doing this, and one of the things I frequently talk about with other Royco contributors is how we can make it so we can actually sleep well at night, right? I want to be able to sleep well at night, and it's going to mean making these trade-offs. It's not going to be, “Hey, look, we can maintain atomic, instant systems,” right?
To go back to Nomadic's point earlier that a lot of these are opsec-originated, I agree with that, but I would take it a step further: that is not a solvable problem in its entirety, right? You can't have a binary outcome saying, “Okay, this system is secure; this system's not secure.” There will always be some spectrum of risk that an LP will be underwriting on any one of these opportunities, right?
So then the question is, if you're always underwriting some amount of risk and there's some trust involved in that, how do we limit the risk? How do we limit the exposure to the rest of the broader industry? That's why I really like DeFi Dad's point: let's rewind what happened over these last 3 months. How many Aave depositors wish that there was a T+1 settlement inside of Aave today, right? How many wish that they could go back and add it 3 months ago? I would argue the vast majority of them, right?
That makes me think that this is the right thing, and it makes me think that this is going to be a more popular decision for teams to make if they want to continue to innovate at the frontier and attract the attention and, basically, the trust of on-chain users.
I totally agree with this. You've just injected time back into the equation. The problem with some of this stuff is that you can't choose when something's going to be exploited, right? You can't choose the time of day. What if it happens at 3:00 a.m.? We know that all the money drains within seconds or minutes, right? So regardless of what you do, if you don't have some sort of time lock—essentially what this is emulating in a way—you're just screwed, right?
16. Royco Dusk: Extend credit to RWAs with AMM-backed LP
And, dude, I totally empathize with protocol founders. There is a happy medium in there with your comment about sleeping at night. But I want to get to something else that I saw.
I think there's a person named Shiv potentially on your team. They're at least talking like they are. They put out a tweet recently that said, “Just got off the phone with a rockstar design partner for Royco Dust. This is going to be massive.” What caught me there was, “Oh, interesting. What's Royco Dust?” I have no idea, so I'm wondering what you can share. We've already talked about Royco Dawn, and then there's this very probably aptly named Royco Dust product. What is that?
Great question. We haven't talked about this publicly yet. This will be the first time we're talking about it publicly. Essentially, what we're starting to see is that a large segment of the issuers that we're talking to—these yield issuers—want to be able to come on-chain and attract all of these users, but also offer leverage, right? They find it very important to offer leverage.
They're at a crossroads here. Nobody wants to underwrite these things. It's easy to underwrite an on-chain Bitcoin wrapper because there's a bunch of on-chain liquidity. You can see all of the trust assumptions and everything that you're underwriting, and then you can easily extend credit to it. It's very difficult to extend credit to a lot of these RWAs.
So Dusk is our first step at making it really easy to extend credit to these RWAs. How are we going to do that? It's actually really cool.
What it looks like is that our junior tranches, instead of being allocated into the underlying, are actually being allocated into an AMM—an AMM where there's a stablecoin on one side and a senior tranche on the other side. Now we can take an RWA with a 3-month duration, right? You can go and throw it in this AMM, right? And now you can have liquidity provided by that junior tranche, guaranteed by that junior tranche, at any given time. The senior tranche could go and interact with the AMM and buy and sell and get out of it at a discount, however they'd like, right?
This isn't very valuable by itself. We don't really care about this by itself. Why it's valuable is that now you have an on-chain liquidity pool that we can use to extend credit to these RWAs, and we can extend credit very safely because there's an entire on-chain liquidity pool that we know is going to be there, since our junior tranche is providing these guarantees, right?
We think that this can be very powerful. Again, it's another tool to help scale and make both sides really happy: our users and these issuers. It's another tool to connect them now with credit and leverage.
17. How seniors will get instant liquidity on Dusk
In the end, if you're a senior or a junior in one of the markets, just quickly summarize for us what we would look to do with Royco Dusk. If I'm a senior or junior, either one of them will benefit from this and potentially have options there. I'm trying to map it out on a screen.
For sure. Let's talk about an asset right now. Let's talk about A credit, for example, okay? A credit—let's say you're earning 9% today. You have quarterly redemptions. That really sucks, quarterly redemptions, right? Because now somebody who's going in, looping and whatever, it's just a pain in the butt. There's no liquidity. I'm stuck in that position for some time, or I need to sell that position at a discount. Whatever—it sucks, right?
The idea here is that you can take 8% or 9%, let's say. I can go get a senior tranche that's earning 6%, okay? And I can go and get a junior tranche that's earning, let's say, 20%. These are all rough maths, right?
So you have a senior that's earning 6%. All of its capital is in ACRED, okay? You have a junior that's earning 20%; its capital isn't in ACRED. Instead, it's in the AMM, providing liquidity for USDC and the senior tranche of A credit.
Now the senior tranche wants out. I want to close out my leverage position. I want to go and do whatever, right? I can just sell that senior tranche like I do on a normal DEX, right? And I know that liquidity is going to be there because it's being provided by that junior tranche.
Now that junior tranche is going to have an increased amount of senior tranches in its AMM portfolio, which means either somebody's going to go and arbitrage it, because it's buying back at a discount, right? Or they're just going to hold it until redemption.
Right? Anybody can go and do that. So this is really cool because now you have this dynamic pricing of the senior tranche, and you can see those real-time quotes and real-time prices as things are going on. To summarize, you have the senior tranche—less yield—but now you have instant liquidity that you know is going to be there. Your junior tranche holds the duration but gets paid a higher rate of return for holding that duration, and it's holding that duration by holding that AMM position.
18. Why RWAs are the future of onchain yield
Yeah, it makes total sense. I think one of the drawbacks to this setup is that you do need the ability to easily exit, and I think, to your point, you're ultimately providing that. You're going to have juniors who are going to want to be able to potentially buy a senior position at a discount. So we'll have to have you back when this is live.
19. Closing
We would love to do a screen-sharing walkthrough of all the game theory behind that and how we can think about it as users. But Jai, I think this is probably a great place for us to wrap up. First, I want to remind our listeners that they can learn more about Royco by going to royco.org. They can follow Royco Protocol on Twitter and follow your personal handle, Jai Bhavnani. We'll put all of that into the show notes so you can go learn more.
Jai, it's so great to see you. It's really cool to see where you have all pivoted. I mean, you were building a really compelling product before. I think it was called Boyco. Well, there was Royco, which was more of an all-encompassing farming platform, but then you were also involved with Boyco, which had, I think, billions at the time on it.
Anyways, times have changed, market conditions have changed, and I do think that the market conditions are absolutely ripe for this type of product. Again, as someone who wants senior tranche exposure and wants that protection, this is the kind of product I'm hoping will grow, and that there will be that much more liquidity and that many more yields that you guys provide on the platform. But I want to give you the final word here before we go.
Yeah, awesome. Thank you guys for having me. This was a great chat.