What Happens in an Asset Default on Tinlake?
Today we’re going to explore a common question about Tinlake and Real World Asset (RWA) financing: what happens when a borrower defaults on a loan?
Unlike fully crypto-native (and typically overcollateralized) lending, RWAs can’t be instantly liquidated via the blockchain alone. So how does Tinlake handle a default? What happens in this case — both on-chain and off-chain?
As is the case in traditional finance, we should expect defaults to happen sooner or later. In fact, in most asset pools, a reasonable percentage is expected to be written off — and this expectation is built into Tinlake’s infrastructure.
Junior and Senior : TIN and DROP
Let’s start with Tinlake’s two tranche model. On Tinlake, RWA pools have a junior and senior tranche — with separate tokens for each.
TIN tokens represent an investment in the junior tranche, and DROP tokens an investment in the senior tranche. In the event of a default, the junior tranche (TIN) takes losses first — and earns a higher, variable yield. The senior tranche (DROP) is protected by the junior tranche as a result — and it earns a lower, fixed yield.
The DROP and TIN yields should reflect the risk taken on by investors.
Depending on what percentage of the pool the junior tranche is (a.k.a. TIN Buffer) and the amount of the default, a default could affect only TIN returns or affect both TIN and DROP returns negatively.
In the case of a healthy TIN buffer and a small amount of assets defaulting, DROP returns are likely to not be impacted at all. The securitization and structure of the pool should protect the senior tranche fully here.
What does a default look like on Tinlake? There are two main components:
- On-chain technical process
- Off-chain legal process
On-chain technical process
The TIN write off schedule will be adjusted and the asset’s NFT will be repriced. The TIN tranche value will be reduced by whatever amount the asset default is. This also reduces the TIN buffer and, more importantly, reduces TIN price and yield. This impact would be visible on chain and in future graphs.
In the waterfall, proceeds are distributed from top (senior tranche) to bottom (junior tranche). This implicitly means that losses/defaults are allocated from bottom to top, meaning they are borne by the junior tranche that protects the senior tranche.
Therefore, the junior tranche, or TIN, is also sometimes referred to as a first loss piece. If the TIN tranche absorbs all the losses, DROP value would not be impacted at all. Had the asset default been larger than the value of the TIN tranche, the value of the DROP tranche would have decreased and DROP return would drop accordingly.
Off-chain legal process
This process looks very different for different assets, and generally, in the real world, the write-off policy doesn’t mean a liquidation policy. It’s much more about managing an asset default.
This looks different across asset classes. For example, a real estate issuer might aim to buy out and replace any non-performing loan with a performing loan, and then deal with collections on their own balance sheet.
The issuer might have servicers with special servicing functions for defaulted loans who can perform the collections and go all the way to foreclosure if needed. Once a loan is in default, the issuer might engage them in the special servicing capacity.
There is also a fairly robust market for non-performing real estate loans where non-performing loan buyers could buy non-performing loans at a discount.
For an inventory-based issuer, in the event of a default, they could move to take possession of the inventory purchased. The issuer could then liquidate the inventory assets via their network of e-commerce sellers and liquidators.
After such liquidation or actions, the proceeds would then be distributed to the tokenholders as the issuer or liquidator pays back the NFT partially or fully. All in all, the two tranche model allows the investors to earn the appropriate returns for their risk appetite.
