Domen Zavrl is an entrepreneur and cryptology specialist who has earned two PhDs, one in Applied Macroeconomics and one in System Dynamics. This article will look at structured finance and the options it opens up from the investor’s perspective.
For hundreds of years, financial innovation has been a mainstay of economies, with loans made since ancient times and the trading of various assets a driving force in managing financial risk and generating returns on capital throughout history. The attached PDF takes a closer look at the origins of the modern stock market.
Traditionally, banks, corporations and governments alike turned to the financial markets to finance their operations. Investment products were kept simple, with an issuer and a purchaser, and usually no change of ownership. The purchaser would hold onto their investment until maturity, collecting a share of the profits or interest in exchange for their investment.
As times moved on, both purchasers and issuers found themselves in situations were factors such as performance, duration and liquidity impacted their attitudes towards investment risk and return. Market players needed additional tools and protections to enhance their business or investment. This increased emphasis on managing opportunity and risk via financial engineering eventually led to the categorization of investment products under structured finance.
During the 1980s, in response to economic uncertainties created by oil shocks, capital market volatility, interest rates and economic downturns, financial engineering evolved to meet changes in investor demand, enabling them to mitigate various risks. By the 1990s, the sector saw growth of a variety of new structured products, including asset swaps, credit default swaps and total return swaps. Today, financial markets are extremely complex, with numerous investment products available that were simply unimaginable until relatively recently. The attached video takes a closer look at what asset swaps entail.
Structured finance is a flexible financial engineering tool that is currently popular among investors. There are many issuers and purchasers in the marketplace, transacting on a variety of different structured financial products. Although in the past, products yielding such attractive returns were the remit of large institutions and ultra-high-net-worth individuals, today they are available to a much broader investor base, presenting increased opportunities for profit.
Structured finance typically requires the completion of one or a series of discretionary transactions. It is typically not offered by traditional lenders and is almost always non-transferrable.
When a traditional bank loan is insufficient to meet a business’s operational needs, business owners may turn to structured financial products such as collateralised bond obligations, collateralised debt obligations, credit default swaps, collateralised mortgage obligations, or hybrid securities combining elements of debt and equity securities.
Securitisation is the process through which financial instruments are created by combining financial assets, typically resulting in such instruments as credit-linked notes, asset-backed securities and collateralised debt obligations. Various tiers of these repackaged financial products are then sold to investors. Much like structured finance, securitisation promotes liquidity and is commonly used to develop structured financial products used by qualified businesses and their customers.
A prime example of securitisation and its risk-transferring capabilities are mortgage-backed securities. Mortgages may be grouped into a single large pool, giving the issuer the ability to divide that pool into pieces based on the default risk inherent to each mortgage before selling off the smaller pieces to investors.
Structured financing and securitisation are often used by corporations and governments to manage risk, expand business reach, develop financial markets and design new funding instruments for the advancement and evolution of complex emerging markets. They can be used to transform cashflows, reshaping the liquidity of financial portfolios by transferring risk from sellers to buyers. The attached infographic contains some interesting statistics about US investment trends in 2023.