How does it work? Quite simple! Imagine that you have one Bitcoin (assume the price is $6,000) and issue 2 TVSs backed by it – Senior TVS, and Junior TVS. Each TVS can have a value claim of 50% of market price of Bitcoin, or 50% x 6,000 = $3,000, and minimum $3,000. So far, they are same, right? Yes, and here innovation would step in, if there’s no additional feature for each TVS (be it Senior or Junior) to claim value share of Bitcoin, a higher level TVS’s claim must be satisfied first (in this case Senior is the most and only senior tranche). So, it means that before Junior TVS can make a claim, Senior’s must be satisfied first.
In such a simple setup, see below what happens: When the price declines, Junior tranche loses first. However, when price starts increasing afterwards, Junior is compensated by magnified return. At the same time Senior one does not decline below its minimum value, unless the value of underlying is completely wiped out, but still earns positive return when Bitcoin goes up.
Return: $3,150 / $3,000 = 5.00%
Return: $3,150 / $3,000 = 5.00%
Return: $3,000 / $3,150 = -4.76%
Return: $2,700 / $3,150 = -14.29%
Return: $3,250 / $3,000 = 8.33%
Return: $3,250 / $2,700 = 20.37%