What is Structured Finance?
This brief article defines structured finance (SF) in the way that SF encompasses all advanced private and public financial arrangements that serve to efficiently refinance and hedge any profitable economic activity beyond the scope of conventional forms of on-balance sheet securities (debt, bonds, equity) in the effort to lower cost of capital and to mitigate agency costs of market impediments on liquidity. In particular, most structured investments (i) combine traditional asset classes with contingent claims, such as risk transfer derivatives and/or derivative claims on commodities, currencies or receivables from other reference assets, or (ii) replicate traditional asset classes through synthetication. Structured finance is invoked by financial and non-financial institutions in both banking and capital markets if established forms of external finance are either (i) unavailable (or depleted) for a particular financing need, or (ii) traditional sources of funds are too expensive for issuers to mobilize sufficient fund for what would otherwise be an unattractive investment based on the issuer’s desired cost of capital.
Structured finance offers the issuers enormous flexibility in terms of maturity structure, security design and asset types, which allows issuers to provide enhanced return at a customized degree of diversification commensurate to an individual investor’s appetite for risk. Hence, structured finance contributes to a more complete capital market by offering any mean-variance trade-off along the efficient frontier of optimal diversification at lower transaction cost. However, the increasing complexity of the structured finance market, and the ever growing range of products being made available to investors, invariably create challenges in terms of efficient assembly, management and dissemination of information.