Structured products in Traditional finance
US Securities and Exchange Commission defines structured securities as “securities whose cash flow characteristics depend upon one or more indices or that have embedded forwards or options or securities where an investor's investment return and the issuer's payment obligations are contingent on, or highly sensitive to, changes in the value of underlying assets, indices, interest rates or cash flows”. That is a bit of mouthful. I’ll do my best to explain the concept of structured assets at least better than SEC.
Structured assets, a relatively recent phenomenon in the finance industry, offer retail investors a convenient way to access derivatives. These securities are usually linked to interest and other products which can vary from FX to debt securities. Think of it this way. Structured products are similar to bonds in that an investor will get coupon payments and the principal value at maturity. However, in the case of structured securities payments are non-traditional which means that the performance of these assets is linked to the underlying assets. Bond investors depend on the issuer’s cash flow; investors of structured products depend on the performance of the underlying securities which is typically an index or a basket of other securities.
Let’s take collateralized mortgage obligation (CMO), a notorious security believed to be one of the reasons behind the financial crisis of 2007-2008. CMO is issued by a legal entity called “special purpose entity” formed for that narrow scope – to originate and distribute CMOs to investors. So, investors buying CMOs from the special purpose entity (SPE) receive payment from the SPE on predefined criteria. However, the cash flow doesn’t come from the issuer himself but from the mortgages in the CMO pool. The mortgages in this case are collateral which comprise of tranches, specified fractions of mortgages with the same risk and reward profile.
To understand structured products better we have to understand the idea of tranching. Tranches are simply slices of the product which are the deal’s capital structure. Tranches with a first lien on the underlying assets are senior tranches. These are relatively safer investments. More risk-averse financial institutions, such as pension funds and insurance companies invest in senior tranches. Tranches with a second lien or no lien are referred to as junior tranches. These are the riskier slices of investments. Investors seeking higher yields, such as hedge funds tend to invest in junior tranches.
But as they say, there is no free lunch in finance. Tranches bear risks according to their return profile. Typically, the more senior tranches are paid first, and if there are any funds left, they’ll be distributed to the most subordinated tranches. If there is any loss in the underlying assets, it is first absorbed by junior tranches.
The next will be about Struct Finance, the protocol aiming to bring structured products to DeFi.
