2factor finance — Primer

In this primer we cover the core concepts behind 2factor finance using a series of animated diagrams. We begin with a high-level overview and then deconstruct how the system works from the bottom up.

1. Overview

At a high level, 2factor finance does two things:

  • Tranches — the volatility of BTC into stable and leveraged derivatives.
  • Balances — demand for stability and leverage.
1.1  Tranching

In this system tranching refers to the process of partitioning an underlying asset's volatility into two perpetual derivatives — one stable, one leveraged.

The protocol reorganizes the volatility of an input asset (BTC) into senior and junior perpetual tranches.

  • Sr∞ — insulated from underlying volatility
  • Jr∞ — benefits from magnified volatility

Holding Sr∞ and Jr∞ together, in the right ratio, is equivalent to holding the underlying (BTC) while fees are turned off; because volatility is conserved in the system.

1.2  Balancing

Demand for stability and volatility differ in nature, so the balancing mechanism uses a bidirectional funding rate to keep the two collateral sets in equilibrium.

To balance demand for stability and leverage, the protocol carries a bidirectional funding rate.

When demand for Jr∞ is high, holders of Sr∞ receive a yield — incentivizing new demand for Sr∞ tokens and vice versa.

1.3  The Sections Below

The sections below deconstruct how tranching and balancing work — from fixed-term tranches, to perpetual tranches via rotation, to the bidirectional funding rate that keeps the system balanced.

2. Fixed-term Tranching

In this section we'll explain fixed-term tranching.

Tranching is the process of reorganizing an asset's volatility into two or more derivative assets with different volatility exposure.

The volatility of an asset, Ai can be separated into senior and junior fixed-term tranches simply and predictably:

  • Sri — is affected by volatility last
  • Jri — is affected by volatility first

At maturity both tranches mature into claims on the underlying asset (BTC). Holding both [Sri, Jri] is equivalent to holding the underlying asset.

2.1  What's Special About This?

Fixed-term tranching simplifies the process of converting a medium risk asset into two derivative assets: one that is safe and one that's extra risky.

  • Safe Asset — The senior tranche (Sri) can be held as a safe asset because it is only affected by volatility after its matching junior (Jri) has been depleted.
  • Risky Asset — The Junior tranche (Jri) offers magnified volatility because all volatility accrues to it until it has been fully depleted.

3. Perpetual Tranching

Fixed-term tranching is a powerful building block. Combined with rotation, fixed-term tranches can be used to create perpetual tranches that reorganize volatility indefinitely.

Perpetual Tranching is the process of reorganizing volatility into two or more derivative assets with different volatility profiles; indefinitely.

An input asset's volatility, A, can be separated into senior and junior tranches perpetually, by bundling multiple fixed-term tranches that are evenly offset by time.

And then systematically rotating maturing tranches out (left), in exchange for fresh tranches in (right):

  • The Perpetual Senior (Sr∞) — is a proportional claim on a rotating basket of Sri tranches — it can be held as a safe asset.
  • The Perpetual Junior (Jr∞) — is a proportional claim on a rotating basket of Jri tranches — it can be held for magnified exposure.
3.1  Proportional Redemption

At any time, users can redeem the perpetual senior or junior tokens for underlying collateral on-chain.

Example: Let's say Alice owns 1% of the Jr∞ (or Sr∞) token supply; and wants to redeem all of it for underlying collateral. Upon redemption she would receive 1% of each fixed-term tranche in the collateral set, as well as 1% of any raw underlying collateral in the set:

Jr∞100 → [Jr0100+Jr1100+Jr2100+Jr3100+Raw100]

Proportional redemption prevents bank-run scenarios because the composition of collateral remains the same before and after any given redemption.

3.2  Volatility Multiple

The perpetual tranching diagram above shows fixed-term Sri and Jri tranches rotating into Sr∞ and Jr∞. In practice, each collateral set can also include a chunk of raw underlying that doesn't rotate; the proportion of fixed-term tranches versus raw underlying is what determines the perpetual's volatility multiple:

Example: Let's say BTC-Jr is targeting 1.33x volatility. Because the fixed-term Jri tranche carries roughly 2x BTC exposure while raw BTC carries 1x, 1/3 of the collateral should be fresh fixed-term Jri tranches and the remaining 2/3 should be raw BTC.

3.3  What's Special About This?

Fixed-term tranching is great for temporarily reorganizing volatility, but fixed-term tranches aren't fungible across vintages because different vintages have experienced different market conditions over time. By bundling multiple vintages into rotating baskets of Sri's and Jri's we can solve for this problem in a simple and highly durable way.

4. Rotation

Perpetual tranches stay perpetual through a weekly rotation process, where maturing fixed-term tranches are continuously replaced with fresh ones.

Rotation is the process of withdrawing maturing tranches and replacing them with fresh tranches. This process is automated and occurs weekly.

At the time of rotation (in the case of BTC), the junior perpetual contract initiates a process that:

  • Mints fresh (Sr/Jr) tranches using assets in the BTC-Jr collateral set and moves the new seniors to the BTC-Sr collateral set.
  • Withdraws the maturing Sr's from the BTC-Sr collateral set and merges them with maturing Jr's in the BTC-Jr collateral set, storing as BTC.

In the case where the BTC balance in the Jr∞ collateral set does not cover the entire rollover, it rotates as much as possible.

5. Rebalancing

Rebalancing is a process of periodic value transfer between the Sr∞ and Jr∞ collateral sets that aims to:

  • Ensure there's sufficient capital in the Jr∞ collateral set to complete rotations
  • Keep volatility multiples reasonably close to target
5.1  Bidirectional Funding Rate

To help the system maintain balance, there is a bidirectional funding rate mechanism that periodically transfers value from the overcapitalized collateral set to the undercapitalized collateral set. This funding rate, k, is a function of how much the current ratio, r, has deviated from the target ratio rt:

rt=target ratio
r=current ratio
k=funding rate=f(r, rt)

6. Liquidity & Fees

2factor supports single-sided entry and exit for BTC-Sr and BTC-Jr — the BTC-collateralized perpetual senior (Sr∞) and perpetual junior (Jr∞) tokens.

Users mint or redeem either side directly, and the protocol prices liquidity according to system state — analogous to a swap pool.

6.1  Pool Bias & Fee Curve

Liquidity is deepest at target. As the system drifts, fees become directional — minting the over-supplied side and redeeming the under-supplied side both carry a premium, discouraging flows that worsen imbalance.

7. System Configuration & Operating Dynamics

2factor's operating profile is determined by a small set of configuration parameters. These parameters define the relationship between BTC-Sr protection, BTC-Jr leverage, system liquidity, and downside behavior.

At launch, 2factor is expected to use a conservative configuration:

  • Fixed-term Sr/Jr bond ratio: 50:50
  • Perpetual Sr∞:Jr∞ collateral target: 1:3
  • Jr∞ collateral composition: 1/3 fixed-term Jr tranches and 2/3 raw cbBTC
  • Target BTC-Jr leverage: 1.33x