2factor finance

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.

› describe tranching

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

BTC

Sr_∞

Jr_∞

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.

› describe balancing

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.

In the diagram above, the arrows denote a magnitude of funding rate. This magnitude corresponds with deviations from equilibrium (the dotted line).

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.

› describe tranching --fixed

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, A_i can be separated into senior and junior fixed-term tranches simply and predictably:

›› $\begin{matrix} A \end{matrix} \to [{Sr}_{i} & {Jr}_{i}]$

[Sr_i, Jr_i]

Sr_i — is affected by volatility last
Jr_i — is affected by volatility first

At maturity both tranches mature into claims on the underlying asset (BTC). Holding both [Sr_i, Jr_i] 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 (Sr_i) can be held as a safe asset because it is only affected by volatility after its matching junior (Jr_i) has been depleted.
Risky Asset — The Junior tranche (Jr_i) offers magnified volatility because all volatility accrues to it until it has been fully depleted.

Much of traditional finance works by some variation of this, but the methods used are complex, opaque, and difficult to implement without administrative oversight. Read on to learn about perpetual tranching.

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.

› describe tranching --perpetual

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.

›› $[\begin{matrix} A_{0} \\ A_{1} \\ A_{2} \\ A_{3} \end{matrix}] \to [\begin{matrix} {Jr}_{0} & {Sr}_{0} \\ {Jr}_{1} & {Sr}_{1} \\ {Jr}_{2} & {Sr}_{2} \\ {Jr}_{3} & {Sr}_{3} \end{matrix}] \to \begin{matrix} [ & {Jr}_{0} & {Jr}_{1} & {Jr}_{2} & {Jr}_{3} & ] \\ [ & {Sr}_{0} & {Sr}_{1} & {Sr}_{2} & {Sr}_{3} & ] \end{matrix}$

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

Sr_∞

Jr_∞

The Perpetual Senior (Sr_∞) — is a proportional claim on a rotating basket of Sr_i tranches — it can be held as a safe asset.
The Perpetual Junior (Jr_∞) — is a proportional claim on a rotating basket of Jr_i 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:

$\frac{{Jr}_{\infty}}{100} \to [\frac{{Jr}_{0}}{100} + \frac{{Jr}_{1}}{100} + \frac{{Jr}_{2}}{100} + \frac{{Jr}_{3}}{100} + \frac{{Raw}_{}}{100}]$

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 Sr_i and Jr_i 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 Jr_i tranche carries roughly 2x BTC exposure (it absorbs the first-loss volatility of a 50:50 Sr/Jr pair) while raw BTC carries 1x, 1/3 of the collateral should be fresh fixed-term Jr_i 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. This makes them less perennially liquid. By bundling multiple vintages into rotating baskets of Sr_i's and Jr_i'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.

› describe 2factor --rotation

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 (left arrows above).
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 (right arrows above).

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

Demand for stability (Sr_∞ tokens) and volatility (Jr_∞ tokens) come from different places. For this reason, the TVL of Jr_∞ and Sr_∞ collateral sets can grow out of balance.

5.1 Bidirectional Funding Rate

› describe 2factor --rebalancing

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.

When demand for Jr_∞ is high, holders of Sr_∞ receive a yield — incentivizing new demand for Sr_∞ tokens and vice versa. This has the added benefit of incentivizing users to hold whichever position there's less relative demand for; further encouraging balance.

This funding rate, k, is a function of how much the current ratio, r, has deviated from the target ratio r_t:

\begin{array}{l} r_{t} = target ratio \\ r = current ratio \\ k = funding rate = f (\frac{r}{r_{t}}) \end{array}

Example: let's say the system targets a 2:1 (Jr_∞:Sr_∞) ratio of collateral TVL. But at present there's excess demand for holding the Jr_∞ vs the Sr_∞ and the current TVL ratio is 3:1. In this case the protocol looks at the deviation ratio ((3:1) / (2:1)) and computes an amount to transfer that directionally pushes the system towards the target ratio; based on this deviation.

5.2 Calculating the Funding Rate

To calculate the funding rate, we just need to recognize there's some balance Δb that can be subtracted from one collateral set and added to the other; such that the current ratio, r, equals the target ratio r_t:

\begin{array}{l} \frac{S_{r \infty} - ∆ b}{J_{r \infty} + ∆ b} = r_{t} \end{array}

From here, solving for Δb gives us:

\begin{array}{l} ∆ b = \frac{S_{r \infty} - r_{t} J_{r \infty}}{r_{t} + 1} \end{array}

To avoid overcorrection, Δb, is divided by a smoothing constant c. This gives the actual amount settled in a particular daily rebalancing action, b:

\begin{matrix} b = \frac{∆ b}{c} \end{matrix}

Extrapolating to a 30-day funding rate (in the case where holders of Jr_∞ are paying holders of Sr_∞) gives us k:

\begin{matrix} k = \prod_{i = 1}^{30} (1 + \frac{b_{i}}{{S r}_{\infty, i}}) \end{matrix}

Rebalancing occurs daily, so the 30-day funding rate, k, is presented as though no other market actions take place; and each day's balance change affects the next day's deviation deterministically. Both the rebalancing frequency and the funding rate curve are configurable by governance.

5.3 Rebalancing ∝ Volatility Multiple

The volatility multiple of Jr_∞ is an equilibrium target. For example, if the Jr_∞ targets the multiple 1.2xBTC, holding the Jr_∞ is like holding 1.2xBTC at equilibrium. However this volatility multiple can fluctuate based on market forces. Recall that 2factor finance targets a specific ratio of Sr_∞:Jr_∞ collateral. When the system deviates from this target ratio, the volatility multiple temporarily changes. Broadly:

When current_ratio > target_ratio — the volatility multiplier is temporarily lower than its target
When current_ratio < target_ratio — the volatility multiplier is temporarily higher than its target

The rebalancing mechanism, described above, automatically corrects for these deviations. When the system rebalances back into equilibrium, the multiplier returns to target.

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, where flows that restore balance receive better pricing than flows that worsen it.

6.1 Pool Bias & Fee Curve

› describe 2factor --fee-bias

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.

The arrow shows the direction and magnitude of the bias. At target, none. Away from target, minting the over-supplied side and redeeming the under-supplied side both pay a premium — two ways of describing the same balance-worsening flow.

This diagram shares its visual grammar with the funding rate animation in §1.2. The two mechanisms serve the same goal — restoring the system toward its target ratio — but they differ in posture. Fees are defensive: they discourage flows that worsen imbalance by making them more expensive. The funding rate is proactive: it actively pays holders of the under-supplied side via asset transfer between the two collateral pools.

The target is not a 50:50 inventory balance; it is configured to preserve the intended relationship between BTC-Sr and BTC-Jr — first-loss protection on the Sr side, target volatility multiple on the Jr side. Directional fees protect both characteristics by making deviations self-correcting.

The exact curve shape is a configuration choice. A more aggressive curve protects the system by discouraging imbalance quickly, but can make user pricing more sensitive to temporary deviations. A smoother curve provides a gentler user experience, but allows the system to spend more time away from target.

6.2 Liquidity & Sr-Side Market Efficiency

In an efficient market, BTC-Sr should trade around a market-clearing yield. When BTC-Sr offers yield above comparable opportunities, yield-seeking capital flows in to mint; when it offers yield below, holders redeem. Combined with directional fees that favor balance-restoring flows, this creates a stabilizing loop — capital naturally migrates toward the side that needs it.

This is the same dynamic a swap pool relies on: in a cbBTC/USDC pool, any deviation from BTC's market rate compels arbitrageurs to take the spread, restoring the price. The practical consequence is that, in an efficient market, large BTC-Sr positions can be built progressively rather than in single blocks — as capital flows in, restoring flows keep per-trade slippage modest along the path.

Several distinct initiatives can fill the role of yield-driven balance restoration:

Market makers — discretionary participants who mint and redeem BTC-Sr based on its yield relative to their required return.
Yield-product integrations — protocols and venues that route stable deposits into BTC-Sr as a backend yield source, sizing exposure to incoming demand.
Elastic senior vaults — programmatic vaults that scale BTC-Sr positions up or down in response to the yield signal, providing always-on yield-seeking flow.

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. This section describes the expected launch configuration — with cbBTC as the underlying — and the operating dynamics that follow from it.

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

These parameters define the initial operating dynamics of BTC-Sr and BTC-Jr.

7.1 First-Loss Protection

› describe 2factor --bond-ratio

Parameter	Fixed-term Sr/Jr bond ratio
Description	Initial size relationship between senior and junior fixed-term tranches
Operating dynamic	The fixed-term bond ratio determines the degree of first-loss protection for BTC-Sr holders.
Launch configuration	50:50 — BTC-Sr begins to take losses only after ~50% BTC drawdown over the tranche period (roughly 4-sigma on a 10-year lookback)

Each fixed-term tranche pair begins with a 50:50 Sr/Jr bond ratio. The senior side and junior side are initially equal in size; the junior tranche absorbs losses first, and the senior tranche is impaired only after the junior tranche has been fully depleted.

At a simplified fixed-term level:

Sr impairment threshold ≈ J / (S + J)

With a 50:50 bond ratio:

J / (S + J) = 50 / 100 = 50%

So BTC-Sr is not impaired unless the underlying BTC collateral falls by roughly 50% over the relevant tranche period.

For a 28-day fixed-term tranche, this is an extreme downside scenario. Under 2factor's launch assumptions, a 50% BTC decline without recovery over a 28-day period corresponds to roughly a 4-sigma drawdown based on a 10-year historical lookback, as detailed in the whitepaper appendix.

Importantly, this is not the point where BTC-Sr is wiped out. It is the point where BTC-Sr first begins to take losses.

If BTC falls by 50%, the junior side has absorbed the full first-loss buffer and BTC-Sr begins to be impaired. If BTC falls beyond 50%, additional losses pass through to BTC-Sr. BTC-Sr would only lose all value if the underlying collateral itself went to zero.

On the recovery side, the same waterfall runs in reverse. BTC-Sr is restored first as the underlying recovers; only after BTC-Sr has been made whole does further upward movement propagate to the fixed-term Jr tranche.

7.2 Capital Efficiency

› describe 2factor --collateral-ratio

Parameter	Sr_∞:Jr_∞ collateral target ratio
Description	Target size relationship between senior and junior perpetual collateral pools
Operating dynamic	The Sr_∞:Jr_∞ collateral target ratio determines the proportional cost of leverage for BTC-Jr holders relative to BTC-Sr yield.
Launch configuration	1:3 — BTC-Sr yield translates to roughly 1/3 cost for BTC-Jr (e.g. 9% Sr ≈ 3% Jr)

The perpetual system targets a 1:3 Sr_∞:Jr_∞ collateral ratio. At target, the Jr_∞ collateral set is three times the size of the Sr_∞ collateral set.

This ratio matters for both yield and leverage. If BTC-Sr earns a yield of x%, the corresponding cost to BTC-Jr is approximately x/3 %, because the same total payment is spread across a Jr_∞ collateral base that is three times larger than the Sr_∞ collateral base.

For example:

If BTC-Sr earns 6%, BTC-Jr pays approximately 2%.
If BTC-Sr earns 9%, BTC-Jr pays approximately 3%.
If BTC-Sr earns 12%, BTC-Jr pays approximately 4%.

This is one of the core efficiency advantages of the system. BTC-Sr can receive a meaningful yield while BTC-Jr pays a comparatively modest cost of leverage.

7.3 Durable Leverage

› describe 2factor --collateral-composition

Parameter	Jr_∞ collateral composition
Description	Mix of leveraged tranche and raw underlying collateral in the BTC-Jr collateral set
Operating dynamic	The Jr_∞ collateral composition determines BTC-Jr's target leverage and its downside reset behavior.
Launch configuration	1/3 fixed-term Jr + 2/3 raw cbBTC — 1.33× target leverage with built-in downside reset (no liquidation)

At launch, the Jr_∞ collateral set is expected to hold:

1/3 fixed-term Jr tranches
2/3 raw cbBTC

This composition explains the 1.33x target leverage. The fixed-term Jr tranche carries approximately 2x BTC exposure because it absorbs the first-loss volatility of a 50:50 Sr/Jr tranche pair; raw cbBTC carries 1x BTC exposure. The blended exposure of the Jr_∞ collateral set is:

(1/3 × 2.0x) + (2/3 × 1.0x) = 1.33x

BTC-Jr therefore targets moderate leverage by combining a leveraged tranche component with raw BTC collateral. This is different from a conventional 2x or 3x leverage product — BTC-Jr does not put the entire collateral set into a fully leveraged position.

The same composition determines BTC-Jr's downside behavior. Only the fixed-term Jr portion can be fully depleted by tranche-period losses; the raw cbBTC portion tracks BTC but is not itself a tranche that can be wiped out.

With a 50:50 fixed-term Sr/Jr bond ratio, the fixed-term Jr buffer is exhausted after roughly a 50% BTC drawdown over the tranche period. At that point, BTC-Jr's leveraged component has been wiped out, but BTC-Jr itself has not been liquidated — its remaining raw cbBTC continues to track BTC. BTC-Sr begins taking impairment beyond this point; it would only lose all value if the underlying collateral itself went to zero.

This creates a built-in downside reset. Before the fixed-term Jr component is exhausted, BTC-Jr behaves like a moderately levered BTC asset. After exhaustion, its remaining exposure snaps back toward 1x and continues to participate in any subsequent BTC recovery.

Over subsequent tranche periods, rotations bring fresh fixed-term Jr tranches into the collateral set, gradually recomposing it back toward the 1/3 + 2/3 target and restoring BTC-Jr's leverage.

This is very different from conventional margin leverage. In a margin structure, a severe drawdown can liquidate the entire position. In BTC-Jr, the leveraged component can be exhausted, but the raw cbBTC component remains.

This is the core durability property of BTC-Jr:

The leverage can compress, but the position is not liquidated.

7.4 Minting & Redemption Fee Curve

› describe 2factor --fee-curve

Parameter	Fee curve shape
Description	Sensitivity of pricing to system imbalance
Operating dynamic	The fee curve shape determines how aggressively the system enforces its target ratio.
Launch configuration	Coming soon

7.5 Configuration Tradeoffs

The launch configuration is one point on a tradeoff surface. Two axes stand out.

Fixed-term Jr allocation. A higher allocation increases BTC-Jr's target leverage, but reduces the raw cbBTC remaining after a severe drawdown — more capital efficient, less durable. A lower allocation has the opposite effect.

Sr_∞:Jr_∞ collateral ratio. A larger Jr_∞ collateral base reduces the proportional cost of BTC-Sr yield for BTC-Jr, but requires more junior-side capital to support the same senior demand. A smaller Jr_∞ base is more capital efficient from the senior side, but raises the proportional cost of BTC-Sr yield for BTC-Jr.

The expected launch configuration targets the middle of these tradeoffs: enough junior exposure to make BTC-Jr meaningfully more capital efficient than spot BTC, but enough raw cbBTC to keep the leverage durable across market cycles.