Structured finance products are a broad category of financial instruments that provide investors with exposure to underlying assets, typically by investing in a small amount. These products may offer high returns but also come with high risks and costs.
The products can be based on market indices, currencies, commodities, interest rates or a combination of these. They can also incorporate embedded derivatives such as options and futures.
Guaranteed Deposits
A deposit is a sum of money that a customer keeps in his or her bank account. A deposit guarantee scheme protects the deposits of all depositors, regardless of their citizenship or place of residence.
The European Union has harmonised deposit-guarantee schemes since 1994. This is in response to the financial crisis, which showed that bank failures did not stop at national borders.
Directive 94/19/EC requires all Member States to have a deposit guarantee scheme for at least 90% of the deposited amount, up to 20,000 euros per person. The new directive, Directive 2014/49/EU, maintains this level but increases the maximum compensation to EUR 100,000.
Depositors are informed when a bank becomes insolvent and the deposit guarantee scheme is triggered. This is done through public information, such as press releases and the bank’s website.
Credit Default Swaps (CDSs)
Credit Default Swaps (CDSs) are derivative contracts that allow buyers to shift the risk of default on debt securities. They’re often used to protect against the default of high-risk government bonds, corporate debt and sovereign debt.
CDSs can be bought and sold by banks, insurance companies and others in the financial industry. They can be purchased for hedging, arbitrage and speculation.
The CDS market was a major contributor to the global financial crisis of 2008-2010. The market’s opacity allowed some firms to hold more risk than they could handle and others to be falsely confident that they were protected from the risks they held.
The CDS market is now more transparent and more competitive than it was before the financial crisis. This increased transparency will help regulators better understand how risk is being transferred among counterparties and monitor concentrations of risk before they become systemic concerns.
Collateralized Debt Obligations (CDOs)
CDOs are securities that are backed by a pool of loans and other assets. They can include mortgage-backed securities, credit card debt, auto loans and corporate bonds.
The financial products are sold on a secondary market and can be bought by insurance companies, banks, pension funds, investment managers and hedge funds. They typically offer a higher interest rate than traditional bonds, but they also carry more risk.
They are grouped into tranches according to the risk appetite of investors. These can be senior, mezzanine and junior.
Generally, the most senior tranche has the highest credit rating and is first in line to be paid from the loan pool. The mezzanine and junior tranches are less rated, but they offer higher rates.
The financial innovations that led to CDOs helped the economy in the past, but they also created a mess in the 2000s. They grew too complex for many buyers and caused the Great Recession.
Hybrid Securities
Hybrid Securities are a type of financial instrument which combines features of shares and corporate bonds. They are considered to be somewhere in between debt and equity, or ‘in the debt-equity continuum’ as credit rating agencies call it.
Examples of hybrid securities include convertible bonds, preference shares and capital notes. These securities provide the investor with a fixed return, like bonds do, but also pay dividends and can be exchanged for ordinary shares.
Preference shares are hybrid securities that pay dividends at a set rate before shareholders receive dividend payments from the underlying stock (ordinary shares). These are usually issued by companies with a high preference for paying dividends to preference shareholders and ranking them ahead of holders of ordinary shares for the payment of dividends in case of bankruptcy or winding up of the company.
The main risk associated with hybrid securities is subordination risk – they are generally ranked 2-3 notches below the senior debt of the same issuer, and are thus deemed to be less likely to recover if the issuer fails. This can result in the issuer being unable to repay a large part of their outstanding hybrids or even being wound up altogether.
