# How tranching works A Covenant Market accepts deposits of a specific Base Asset and splits them into two fungible ERC‑20 tranches against the same collateral pool. This page walks through the split, the loss waterfall, redemption mechanics, and a simple worked example. Pricing and rate-setting are handled by the Latent Swap AMM and described in [The Latent Swap AMM](/protocol-mechanism/latent-swap-amm.md). ## 1. The split A Liquidity Provider deposits the Base Asset into a Covenant Market and receives one of two claims: * a **senior tranche**, the **Yield Coin**, with first call on the collateral pool; or * a **junior tranche**, the **Leverage Coin**, with leveraged exposure to the residual. Each Covenant Market is designed around a **target LTV**. At the target, the value of the collateral pool splits cleanly between the two tranches: $$V\_B = V\_Y + V\_L$$ where: * $$V\_B$$ = Base Asset NAV (mark-to-market value of the collateral pool); * $$V\_Y$$ = Yield Coin NAV (par debt outstanding to senior holders, also called the notional); * $$V\_L$$ = Leverage Coin NAV (residual claim on collateral at target LTV). For a market with an 80% target LTV, $100 of Base Asset NAV splits into $80 of Yield Coin NAV (senior debt at par) and $20 of Leverage Coin NAV (junior equity, levered 5x on the underlying). At the target, each tranche's market price equals its NAV (no discount, no premium). When the market is away from target LTV, the [Latent Swap AMM](/protocol-mechanism/latent-swap-amm.md) prices the tranches above or below NAV. The Yield Coin trades at a discount to NAV when leverage demand is high (the discount is the implied funding rate), and at a premium when leverage demand is low. Leverage Coin pricing moves correspondingly. The simple split identity above is the anchor; the AMM provides the continuous off-target pricing. The split is permissionless. Either tranche can be minted directly through the Latent Swap AMM, or both tranches can be minted simultaneously against fresh Base Asset collateral (a "pair-mint"). Both tranches are fully collateralized against the deposited Base Asset at all times. A Covenant Market is parameterized by: 1. a specific Base Asset; 2. a price oracle (denominating the Base Asset in a quote unit); 3. a debt duration parameter `D` (used in the Perpetual Debt mechanism); 4. a min and max market price `Pa`, `Pb` (concentrating liquidity in the Latent Swap AMM); and 5. a target LTV (the design point at which $$V\_B = V\_Y + V\_L$$ and tranche prices equal their NAVs). These parameters are fixed at deployment and cannot be changed for the life of the market. ## 2. The loss waterfall Yield Coin holders are first in the waterfall and protected up to the depth of the Leverage Coin buffer. Leverage Coin holders absorb losses on the collateral first (i.e., declines in the mark-to-market value of the Base Asset), in exchange for amplified exposure on the upside. If the Base Asset's mark-to-market value falls, the loss is allocated to Leverage Coin holders pro rata until the Leverage Coin's claim is exhausted. Only after that does any further loss flow to Yield Coin holders. There is no liquidation event for any individual position. Risk is repriced continuously by the Latent Swap AMM rather than enforced through forced unwinds. ## 3. Funding flows from junior to senior Funding flows continuously from Leverage Coin holders to Yield Coin holders at the rate implied by the Yield Coin's market price. There is no separate cash payment. Instead, **funding accrues as a continuous transfer of NAV between the two tranches**: * the Yield Coin's NAV (notional) grows at the implied rate `r = -ln(P / D)`, where `P` is the Yield Coin's market price and `D` is the debt duration parameter; * the same amount is removed from the Leverage Coin's residual claim on the collateral pool. When the implied rate is positive (Yield Coin trading below par), NAV transfers from the Leverage Coin to the Yield Coin. When the implied rate is negative (Yield Coin trading above par), the transfer reverses: the Yield Coin's NAV decretes and NAV flows back to the Leverage Coin. The total Base Asset NAV does not change as a result of funding; only the split between the two tranches does. See [Perpetual Debt](/protocol-mechanism/perpetual-debt.md) for the full accrual mechanism. ## 4. Redemption Both tranches are redeemable to the Base Asset at any time: * **Single-tranche redemption** swaps a Yield Coin or a Leverage Coin into the Base Asset through the Latent Swap AMM at the prevailing market price. * **Pair redemption** burns matched Yield Coin and Leverage Coin notional simultaneously and returns the underlying Base Asset with no AMM slippage. This is the path used by leverage-and-yield-seeking flows that want to unwind cleanly. Redemption never requires permission and is not subject to a queue or unbonding period at the Covenant level. (The Base Asset itself may have its own redemption window, which passes through to redemption back to the asset that originated the Base Asset.) ## 5. A worked example Consider a Covenant Market with $100 of Base Asset collateral, an 80% LTV target, and a 5% implied funding rate: * Yield Coin notional: **$80** * Leverage Coin claim: **$20** * Effective leverage on the Leverage Coin: **1 / (1 - 0.8) = 5x** If the Base Asset stays flat for one year and produces no native yield, the Yield Coin's notional accretes at the implied 5% rate, growing from $80 to roughly $84. The Leverage Coin's residual claim falls from $20 to roughly $16. The $4 transfer is the funding paid by Leverage Coin holders to Yield Coin holders, realized as dilution rather than as a cash payment. If instead the Base Asset is yield-bearing, paying 10% per year, the collateral grows from $100 to $110. After Yield Coin accrual to $84, the Leverage Coin's claim is $26, a 30% return on the $20 deposit. This is the leveraged carry case: 5x effective leverage on a 10% underlying yield, less funding paid to senior, lands the Leverage Coin holder at roughly 30% net. If the Base Asset moves down 10%, collateral falls to $90. The full $10 loss is absorbed by the Leverage Coin, whose claim becomes $10, a 50% loss on the $20 deposit. The Yield Coin's $80 notional is unaffected. ## 6. The market clears continuously The Latent Swap AMM sets the Yield Coin price, the Leverage Coin price, and the implied funding rate as a continuous function of the market's LTV. As leverage demand rises, Yield Coin prices fall, the implied rate rises, and senior capital is drawn in. As leverage demand falls, Yield Coin prices rise, the implied rate compresses, and junior capital is drawn in. There is no governance vote, no utilization curve, and no per-position margin call. The mechanism is described in detail in [The Latent Swap AMM](/protocol-mechanism/latent-swap-amm.md). --- # Agent Instructions: Querying This Documentation If you need additional information that is not directly available in this page, you can query the documentation dynamically by asking a question. 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