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### Overview and scope
- Synthetic risk transfers (SRTs) are a form of securitization banks use to manage credit risk and optimize capital.
- Over $1 trillion in assets have been synthetically securitized globally since 2016.
- European issuers historically dominated; U.S. issuance accelerated in 2022–23 and is projected to continue throughout 2024–25.
- Through SRT securitization, banks buy credit protection on an underlying pool of loans (underlying or reference pools), transfer credit risk to investors, and, subject to regulation, can reduce regulatory capital requirements.
- The note provides a broad view of the SRT market, updates on regulation, discusses benefits and vulnerabilities, and suggests measures to mitigate systemic risks.

### Key market statistics and participants
- Since 2016, SRT volume of underlying loans protected increased about fourfold between 2016 and 2022 (from a low base).
- Annual SRT issuance surpassed $200 billion in protected loan pools since 2022.
- The average size of an SRT deal has fluctuated around $2.0 - $2.5 billion per transaction.
- SRTs have been structured for over $1 trillion worth of loans globally since 2016.
- The average life of SRTs typically ranges from 3 to 5 years.
- Credit funds and asset managers have accounted for close to 60 percent of the global investor pool in recent years.
- The top 10 investors hold over 75 percent of banks’ outstanding SRT exposure.
- The number of SRT investors is limited, exposing banks to rollover risk if investors withdraw.

### Geographical and asset-pool trends
- Principal data sources: Structured Credit Investor (SCI) and IACPM Synthetic Securitization Global Bank Data Report 2016–2024.
- European and U.K. GSIBs predominated early issuance; Canada and the United States significantly increased issuance in 2022–2024.
- The U.S. market received a substantial boost after Federal Reserve guidance on Regulation Q.
- Most SRT issuance has been collateralized by corporate and SME loans; asset pools expanded to include:
  - residential real estate (RRE) loans,
  - auto loans,
  - other consumer loans,
  - subscription lines.
- SCI data collected between November 2005 and December 2024 for issuers; excludes multilateral agencies.

### Common SRT structures and mechanics
- Most widely used structures:
  - credit-linked notes (CLNs) issued directly by the bank (“bank direct-issued CLN”),
  - CLNs issued through a special purpose vehicle (“SPV-issued CLN”).
- SPV-issued CLNs (funded transactions):
  - Bank transfers credit risk to an SPV via CDS or financial guarantee.
  - SPV issues CLNs to investors, funds collateral account; collateral invested in short-dated government securities, US Treasury bills, or money market instruments.
  - Investors pay upfront corresponding to maximum loss; receive periodic interest composed of credit protection premium plus investment income.
  - Reference portfolio split into tranches: first loss (junior/equity), mezzanine (protected tranche), senior.
  - Bank typically retains the senior tranche (often more than 80 percent) and the first loss tranche (1 or 2 percent).
  - On credit event, SPV liquidates collateral; CLN principal written down; protection payments end after mezzanine wiped out or at end of life.
  - Typical attachment/detachment points vary by regulatory framework and can introduce nonlinear dynamics.
- Bank direct-issued CLNs:
  - Bank issues CLN with embedded CDS to investor; proceeds owned by bank (not held at third-party custodian).
  - Generates counterparty risk for investors tied to the bank’s creditworthiness; CLNs are unsecured obligations of the bank unless specific protections exist.
  - Bank makes periodic payments typically SOFR plus a spread; covered losses lead to principal write-downs and bank retains corresponding proceeds if written down.

### SRT features, variations, and tranche thresholds
- Blind reference loan pools: investors see only high-level characteristics; anecdotal use by European and US GSIBs.
- Unfunded SRTs: protection providers do not make upfront payments; protection providers typically include insurance companies, pension funds, or multilateral development banks in Europe; bank remains exposed to counterparty credit risk.
- Replenishment period: allows adding new loans to portfolio subject to eligibility; risk of asset-quality deterioration for investors.
- Jurisdictional tranche thresholds:
  - Europe (ESRB example): first loss tranche typically covers 1 percent of portfolio losses, mezzanine tranche covers 7 percent, senior tranche covers remaining losses.
  - United States: mezzanine tranche threshold commonly 12.5 percent (Simplified Supervisory Formula Approach); attachment point for retained tranche commonly 12.5 percent to achieve a 20 percent risk weight for retained senior tranche.

### Drivers of growth and recent developments
- Post-Global Financial Crisis regulatory reforms (risk retention, transparency) increased securitization resilience and shifted market to more standardized structures.
- ECB guidance and streamlined approval (beginning 2014–2015) supported SRT market expansion.
- Canadian and U.S. issuance in size after 2022 accelerated overall issuance.
- Reports cited issuance activity including a 2025 issuance of over $30 billion (as noted in source).

### Regulatory framework and capital treatment (Basel III and related)
- Basel III recalibration introduced a more risk-sensitive hierarchy reducing mechanistic reliance on external credit ratings.
- Originating banks may exclude securitized exposures from RWA only if they demonstrate significant credit risk transfer (SRT) to third parties; instruments cannot contain hidden structural features that limit risk transfer.
- Early termination options are prohibited except for non-credit-related events (CRE40.25).
- Transactions meeting STC criteria can be subject to alternative capital treatment (CRE40.66 to CRE40.165).
- In the EU, Regulation (EU) 2021/557 extended STS framework to include synthetic securitizations with specific criteria.
- IOSCO (2012) recommended originator risk retention to align incentives.

### Example capital relief and illustrative numerical estimates (selected figures preserved exactly)
- Example setup: $100 notional residential mortgage portfolio, assumed 10.5 percent minimum Tier 1 capital requirement and 50 percent RWA.
  - Regulatory capital requirement without SRT: $5.8 (Row I).
  - Regulatory capital requirement with SRT: $2.7 (Row Y).
  - Post-SRT transactions, estimates suggest banks could obtain capital relief of 55 to 80 percent of pre-SRT RWA.
- Residential Mortgage Loans (United States example) selected rows:
  - A Notional Value: 100
  - B RWA ratio (%): 50%
  - C = A * B RWA (US$ m): 50
  - D T1 Ratio Requirement (%): 10.5%
  - F Allowance for Credit Losses (US$ m): 0.5
  - G = C * D + F Required Capital (US$ m): 5.8
  - J First-Loss Tranche (%): 0.5%
  - K First-Loss Tranche (US$ m): 0.5
  - L RWA ratio (%) for first-loss tranche: 1250%
  - M = K * L RWA (US$ m): 6.3
  - N Mezzanine Tranche (%): 4.5%
  - O Mezzanine Tranche (US$ m): 4.5
  - P RWA ratio (%) for mezzanine tranche: 0.0%
  - Q RWA (US$ m) for mezzanine: 0.0
  - R Senior Tranche (%): 95.0%
  - S Senior Tranche (US$ m): 95.0
  - T RWA ratio (%) for senior tranche: 20.0%
  - U S Senior RWA (US$ m): 19.0
  - V Total SRT RWA (US$ m): 25.3
  - W = V / A SRT RWA Ratio (%): 25.3%
  - Y = V * X Required Capital (US$ m) with SRT: 2.7
  - Z Loss Absorption from External Investors/Mezzanine Tranche (US$ m): 4.5
  - AA = Y + Z Effective Loss Buffer (US$ m): 7.2
  - BB = G - Y Capital relief for Bank (US$ m): 3.1
  - CC = BB / G Capital relief (%): 53.9%
  - DD = AA - I Increase in Effective Loss Buffer (US$ m): 1.4
  - CC = DD / I Increase in Effective Loss Buffer (%): 24%
  - EE Assumed cost of capital for SRT (%): 8.2%
  - FF SOFR / €STR (%): 4.35
  - GG Management costs (bps): 10
  - HH = EE - FF - GG Implied CLN Spread over Benchmark Rate (bps): 383
  - II Implied yearly CLN cost of protection to maturity: -0.2
  - JJ = DD - HH Increase in Effective Loss Buffer (US$ m): 1.2
  - KK = JJ / I Increase in Effective Loss Buffer (%): 21%
- Other selected asset-type results (preserved exactly):
  - Corporate and Auto Loans:
    - G Required Capital (US$ m): 12.0
    - Y Required Capital with SRT (US$ m): 3.8
    - BB Capital relief for Bank (US$ m): 8.2
    - CC Capital relief (%): 68.3%
    - AA Effective Loss Buffer (US$ m): 14.8
    - DD Increase in Effective Loss Buffer (US$ m): 2.8
    - CC Increase in Effective Loss Buffer (%): 23%
    - EE Assumed cost of capital for SRT (%): 8.5%
    - FF SOFR / €STR (%): 4.35
    - GG Management costs (bps): 10
    - HH Implied CLN Spread over Benchmark Rate (bps): 413
    - II Implied yearly CLN cost of protection to maturity: -0.5
    - JJ Increase in Effective Loss Buffer (US$ m): 2.3
    - KK Increase in Effective Loss Buffer (%): 19%
  - High Volatility Commercial Real Estate (HVCRE) Loans:
    - G Required Capital (US$ m): 20.8
    - Y Required Capital with SRT (US$ m): 8.2
    - BB Capital relief for Bank (US$ m): 12.5
    - CC Capital relief (%): 60.5%
    - AA Effective Loss Buffer (US$ m): 5.2
    - DD Increase in Effective Loss Buffer (US$ m): 4.5
    - CC Increase in Effective Loss Buffer (%): 21%
    - EE Assumed cost of capital for SRT (%): 3.2%
    - FF SOFR / €STR (%): 4.35
    - GG Management costs (bps): 10
    - HH Implied CLN Spread over Benchmark Rate (bps): 88
    - II Implied yearly CLN cost of protection to maturity: -1.5
    - JJ Increase in Effective Loss Buffer (US$ m): 2.9
    - KK Increase in Effective Loss Buffer (%): 14%
  - Europe Reference Corporate Loans:
    - G Required Capital (US$ m): 7.3
    - Y Required Capital with SRT (US$ m): 1.4
    - BB Capital relief for Bank (US$ m): 5.8
    - CC Capital relief (%): 80.2%
    - AA Effective Loss Buffer (US$ m): 9.9
    - DD Increase in Effective Loss Buffer (US$ m): 2.7
    - CC Increase in Effective Loss Buffer (%): 37%
    - EE Assumed cost of capital for SRT (%): 8.5%
    - FF SOFR / €STR (%): 2.45
    - GG Management costs (bps): 10
    - HH Implied CLN Spread over Benchmark Rate (bps): 605
    - II Implied yearly CLN cost of protection to maturity: -0.5
    - JJ Increase in Effective Loss Buffer (US$ m): 2.1
    - KK Increase in Effective Loss Buffer (%): 29%
- Notes: estimates do not assume downward adjustment in allowance for credit losses from structural protection; example is an upper bound; investor protection is not equivalent to equity capital because investors can finance CLNs through leverage.

### Benefits of SRTs (banks, investors, economy)
- For banks:
  - Potential capital relief (subject to regulatory approval); a few banks reported capital relief ranging from 15 bps to 28 bps of their CET1 ratio in 2024.
  - Manage credit risk concentrations without removing loans from balance sheet.
  - Increase liquidity for direct bank-issued CLN structures because banks keep cash proceeds.
  - Can fund stock repurchases, dividends, interest payments, or reduce subordinated debt depending on capital management.
- For investors:
  - Access to loan categories not easily accessible through public markets.
  - Attractive yields compared to other asset classes.
  - Shorter durations relative to underlying loan tenors; bespoke, negotiable exposures.
- For the broader economy:
  - Support more efficient risk allocation relative to 100 percent risk retention.
  - Create conditions for additional bank lending, thereby supporting growth.

### Vulnerabilities, systemic concerns, and empirical indicators
- Key systemic concerns:
  - SRTs can increase system leverage by transferring bank-originated credit risk to less regulated investors that can use more leverage.
  - Transferring credit risk to leveraged, less regulated investors increases interconnectedness and complicates system-wide risk assessment.
  - Regulatory arbitrage opportunities and private/opaque transaction nature hinder true exposure evaluation.
  - Banks often provide leverage to investors; some credit risk effectively remains within banking system.
  - Maturity mismatches: SRT maturities (3 to 5 years typically) are often shorter than underlying loan maturities, raising rollover risk if investor withdrawal forces replacement of protection.
  - Rapid replacement of protection could raise funding costs and liquidity pressures for banks.
  - Competition and attractive returns may attract more risk-tolerant investors, potentially weakening underwriting and increasing system vulnerability to credit shocks.
- Specific vulnerabilities highlighted:
  1. Interconnectedness
    - Investors often borrow from banks to enhance returns; risk transferred out of banking system can partially circle back via financing relationships.
    - Unfunded SRTs expose banks to counterparty credit risk if investors fail to provide protection after credit events.
  2. Leverage and liquidity mismatches
    - SRTs reduce bank risk-based capital while loans remain on balance sheet, increasing leverage.
    - Credit funds were the largest investors in SRTs, with over half of synthetic securitization trade flows between 2016 and 2024.
    - ESRB notes instances where originating banks may provide financing for protection sellers to subscribe to CLNs, potentially undermining capital adequacy.
    - Open-ended investment vehicles face liquidity mismatches because CLNs are illiquid; ESRB estimates a large portion of Euro-area investors in CLNs are open-ended vehicles.
  3. Opacity
    - Lack of transparency and limited disclosure hinder monitoring of interconnectedness and leverage.
    - FRB, ECB reviews indicate regulators may lack full visibility into SRT leverage providers and financing exposures.
    - BCBS (July 2025) highlighted need for granular, timely, and high-frequency data to monitor linkages between banks and nonbank financial intermediaries.
- Concentration statistics (survey examples preserved exactly):
  - Single largest investor holds 31 percent outstanding exposures.
  - Top three investors hold 49 percent.
  - Top ten investors hold 76 percent.
  - Single largest issuing bank accounts for 22 percent of the market.
  - Top three banks account for 53 percent.
  - Top 10 banks account for 95 percent.
  - Large French, Spanish, and German banks accounted for about two-thirds of SRT exposures originated in the EU in Q2 2024 (survey of 14 European banks).
- Market cyclicality example:
  - SRT issuance declined by an estimated 30 percent in 2020 compared to 2019.

### Operational, modeling, and origination risks
- SRTs, even if meeting STC/ST S criteria, remain complex and generate legal, operational, and model risks.
- Risks from limited issuer experience include mis-specified contracts that fail to provide expected protection and underestimation of tail risks via overreliance on quantitative models.
- ECB (2025) called for banks to integrate SRT-related risks into internal capital planning, risk management processes, and stress testing.
- Ineffective risk transfer channels include banks providing financing to investors intended to absorb credit risk and thinly capitalized protection sellers.

### Measures to mitigate risks (policy recommendations and supervisory actions)
- Integrate SRT-related risks into supervisory tools and banks’ internal processes:
  - Require banks to incorporate SRT-related risks into internal governance, continuous monitoring, and reporting of counterparties.
  - Include SRT risks in internal capital planning and stress testing.
- Strengthen disclosure and reporting:
  - Enhanced disclosure to enable market discipline and allow authorities to monitor underwriting practices, default risk of underlying pools, and structural features.
  - Address data gaps needed to monitor interconnectedness, leverage concentrations, and financial stability risks.
  - Improve granularity of reported SRT exposure amounts (Pillar 3 disclosures may lack sufficient detail).
- Enhance international cooperation:
  - Improve cross-border and cross-sectoral supervisory cooperation, data sharing arrangements, and harmonized regulatory approaches to reduce regulatory arbitrage.
  - Relevant standard-setting bodies should analyze and address regulatory arbitrage opportunities if material.

### Investor concentration, hedge funds, and leverage dynamics (appendices)
- Hedge fund borrowing and leverage:
  - Aggregate AUM in sample: total assets under management exceeding $5 trillion (sample) versus $8.5 trillion estimate in 2024 Global Monitoring Report on Non-Bank Financial Intermediation (FSB).
  - Leverage for CLN investments often comes via repurchase agreements.
  - Broker-dealer arms of banks provide leverage but may lack full visibility into clients’ total exposure.
  - Estimated share of hedge fund portfolios liquidatable in less than 30 days has fallen sharply (figure series 2014–2023: 7, 12, 17, 22, 27, 32, 58, 63, 68, 73, 78, 83).
  - Chart markers include 0.4, 0.6, 0.8, 1 on vertical scale.
- Structural drivers:
  - Tougher U.S. requirements compared to European banks reportedly led to differences in SRT deal structures and lower coupons on U.S. trades, potentially driving investors to use leverage on U.S. trades.
- Risks and spillovers:
  - A spike in margin calls on repurchase agreements could trigger asset sales across liquid markets as hedge funds raise liquidity.
  - Such margin-call spikes could be triggered by concerns about valuation of SRT underlying securities after a sharp increase in defaults.

*Source: INTRODUCTION, Sections I and supporting appendices of the IMF Working Paper "Recycling Risk: Synthetic Risk Transfers" (excerpts from the provided PDF content).*

### INTRODUCTION __________________________________________________________________________________ 4

### INTRODUCTION

### Overview and scope
- Synthetic risk transfers (SRTs) are a form of securitization banks use to manage credit risk and optimize capital.
- Over $1 trillion in assets have been synthetically securitized globally since 2016.
- European issuers have historically dominated the SRT market; U.S. issuance accelerated in 2022–23 and this trend is projected to continue throughout 2024–25.
- Through SRT securitization, banks buy credit protection on an underlying pool of loans (underlying or reference pools), transfer credit risk to investors, and, subject to regulation, can reduce regulatory capital requirements.
- The note provides a broad view of the SRT market, updates on regulation, discusses benefits and vulnerabilities, and suggests measures to mitigate systemic risks.

### Key market statistics and features
- Since 2016, SRT volume of underlying loans protected has increased about fourfold between 2016 and 2022 (from a low base).
- Annual SRT issuance surpassed $200 billion in protected loan pools since 2022.
- The average size of an SRT deal has fluctuated around $2.0 - $2.5 billion per transaction.
- SRTs have been structured for over $1 trillion worth of loans globally since 2016.
- The average life of SRTs typically ranges from 3 to 5 years, depending on structure and underlying pool characteristics.

### Market participants and concentration risks
- Credit funds and asset managers have accounted for close to 60 percent of the global investor pool in recent years.
- The top 10 investors hold over 75 percent of banks’ outstanding SRT exposure.
- The number of SRT investors is limited and market concentration exposes banks to rollover risk if investors withdraw.

### Drivers of growth and recent developments
- Post-Global Financial Crisis regulatory reforms enhanced risk retention and regulatory standards, supporting securitization market resilience and extending to most SRTs.
- The SRT market expanded significantly after improved guidance and a more streamlined approval process introduced by the European Central Bank beginning in 2014–2015.
- Canadian and U.S. banks began to issue in size after 2022, contributing to the acceleration in SRT issuance.
- Reports cited in the source note issuance activity including a note of 2025 issuance of over $30 billion.

### Structural and systemic concerns highlighted
- SRTs can increase overall financial system leverage by transferring bank-originated credit risk to less regulated investors (e.g., hedge funds) that can use more leverage.
- Transferring credit risk to more leveraged, less regulated investors increases interconnectedness across financial institutions and complicates system-wide risk assessment.
- Regulatory arbitrage opportunities across sectors and the private/opaque nature of many SRT transactions hinder evaluation of true exposures.
- Banks often provide leverage to investors, meaning some credit risk remains within the banking system.
- Mismatches in maturities: SRT maturities are often much shorter than maturities of underlying loan portfolios, raising the risk that sudden investor withdrawal increases banks’ capital needs as risk-weighted assets rise and capital ratios fall.
- If SRT protection must be replaced quickly, banks could face higher funding costs and liquidity pressures.
- Competition for deals and attractive returns can attract more risk-tolerant investors, which may lead to deteriorated credit standards or higher leverage and riskier deal structures, potentially weakening underwriting and making the system more vulnerable to credit shocks.

### Conditional benefits and supervisory priorities
- When appropriate safeguards exist, SRTs can help banks manage risks and capital requirements, diversify exposures, and support lending capacity.
- SRTs can improve investors’ risk-return frontier by offering alternative risk profiles and diversification benefits.
- Realizing benefits depends on continued close monitoring by regulators and market participants to:
  - Ensure risks are transferred effectively.
  - Preserve incentives for sound origination standards.
  - Contain financial system leverage.
  - Establish proper reporting and disclosure so transactions are sufficiently transparent to supervisors and market participants, fostering market discipline.

*Source: INTRODUCTION and Section I (Synthetic Credit Risk Transfers: Market Trends and Structures) of the IMF Working Paper "Recycling Risk: Synthetic Risk Transfers."*

### 2. Geographical Breakdown by

### 2. Geographical Breakdown by Asset Pool (SCI)

### Geographical issuance trends
- Sources: Structured Credit Investor (SCI) and IACPM Synthetic Securitization Global Bank Data Report 2016–2024, International Association of Credit Portfolio Managers (IACPM).
- SRT issuers include globally systemically important banks (GSIBs), non-GSIBs, international organizations, and multilateral development banks.
- European and U.K. GSIBs have been the predominant issuers in the initial stages of the SRT market.
- In 2022 and 2023, other regions, particularly Canada and the United States, significantly increased their issuance.
- The market in the U.S. received substantial boost after guidance on Regulation Q was issued by the Federal Reserve.
- Data coverage notes:
  - SRT deal-level data is extremely limited, as transactions are private. Aggregate annual data on loan pool sizes, asset types, and geographic region are available from IACPM; pre-transaction data from SCI; post-transaction exposure data for banks subject to Basel III, Pillar 3 disclosures.
  - SCI data collected between November 2005 and December 2024 for issuers; excludes multilateral agencies.

### Asset pools and evolution
- Most SRT issuance has traditionally been and continues to be collateralized by corporate and small- and medium-enterprise (SME) loans.
- In recent years, asset pools have expanded to include:
  - residential real estate (RRE) loans,
  - auto loans,
  - other consumer loans,
  - subscription lines.
- Panel description (2016–2024): relative shares across years show Corporate and SME, Auto Loans, RRE, Consumer, Other as categories (visual timeline from 2016 to 2024 in source).

### Structures — overview
- Focus on the most widely used SRT structures:
  - credit-linked notes (CLNs) issued directly by the bank (“bank direct-issued CLN”),
  - CLNs issued through a special purpose vehicle (“SPV-issued CLN”).
- SPV-issued CLNs have been most utilized by European banks according to the European Systemic Risk Board (ESRB).
- Other SRT structures exist (bilateral CDS, financial guarantees), but are used less often than bank direct-issued and SPV-issued CLNs.

### SPV-issued CLNs — mechanics and key parameters
- Under SPV-issued CLNs:
  - The bank transfers credit risk associated with a pool of loans (not the assets themselves) to an SPV via a credit default swap (CDS) or financial guarantee.
  - The SPV issues CLNs to investors and uses proceeds to fund a collateral account that supports credit protection for the bank (funded transaction).
  - Investors buy CLNs, receive premium payments from the SPV, and take on credit risk of the underlying assets.
- Tranching and typical retention:
  - Reference portfolio is split into tranches of different seniority: first loss (junior/equity), mezzanine (protected tranche), senior.
  - The bank typically retains the senior tranche accounting for most of the reference pool (often more than 80 percent) and the first loss tranche, which accounts for a small part of the reference loan pool (1 or 2 percent).
- Protection agreement:
  - Bank enters into credit protection agreement (CDS or financial guarantee) with the SPV to buy credit protection on the mezzanine tranche; bank pays the SPV a periodic fee.
  - Each tranche has an attachment and detachment point; these vary according to the regulatory framework and can introduce nonlinear dynamics to the SRT structure.
- Funded transaction mechanics:
  - Investors purchase CLNs and pay cash up front corresponding to the maximum loss the SPV could be responsible for.
  - Cash transferred to a third-party custodian bank to be held as collateral for state-contingent credit protection payments.
  - SPV invests cash proceeds in highly liquid investments such as short-dated government securities, US Treasury bills, or money market instruments.
  - SPV makes periodic interest payments to CLN investors comprised of a spread funded by the credit protection premium paid by the bank plus investment income from the upfront collateral.
- Credit event and loss allocation:
  - On a credit event (bank notifies SPV), SPV liquidates collateral to make credit protection payments to the bank.
  - Principal balance of the CLN is written down by the amount of credit losses, transferring loss to investors.
  - Credit events typically include bankruptcy, restructuring, or failure to pay as defined by the deal terms.
  - After credit event, SPV continues to pay investors based on a smaller notional; protection payments end after losses wipe out the mezzanine tranche or at end of transaction life.
- Maturity and early amortization:
  - At maturity of mezzanine tranche or upon early amortization, remaining collateral is liquidated after protection payments; remaining proceeds returned to investors as principal redemptions.
  - Early amortization can occur if SRT includes call options for bank termination before maturity.

### Bank direct-issued CLNs — mechanics and investor exposures
- Under bank direct-issued CLNs:
  - Bank issues CLN with embedded CDS to investor to transfer credit risk associated with the underlying reference loan pool.
  - The embedded CDS specifies amount of credit protection to which the bank is entitled.
- Proceeds and counterparty risk:
  - Bank receives cash proceeds from CLNs, including value of purchased credit protection; proceeds are owned by the bank rather than held at a third-party custodian.
  - This mitigates counterparty risk faced by the bank but generates counterparty risk for investors tied to the bank’s creditworthiness.
  - Bank direct-issued CLNs are unsecured obligations of the bank and can become senior unsecured claims against the issuing bank if the bank fails, unless specific protections are included.
- Payments and loss treatment:
  - Principal and interest payments are based on reference pools’ performance and calculated as if a CDS were in place under a 2002 ISDA Master Agreement and Schedule between the bank and a hypothetical counterparty.
  - Bank makes periodic payments to investor, typically SOFR plus a spread equivalent to the premium under a CDS.
  - If covered losses occur, principal balance of the CLN is written down by corresponding amount; the bank keeps the corresponding amount of the proceeds from the CLNs.
  - If CLNs are not written down, the bank makes principal payments to investors.

### Additional SRT features and variations
- Blind reference loan pools:
  - Bank does not reveal loan-level borrower details; investor has access only to high-level characteristics (industry distribution, credit ratings, geographic exposure).
  - Investors face higher uncertainty and rely on the bank’s standards and risk management practices.
  - Anecdotal evidence suggests European and US GSIBs have issued SRTs with blind reference pools; no public market share estimate available.
- Unfunded SRTs:
  - Transactions not secured by financial collateral; investor (protection provider) does not make upfront payments and only compensates bank if a credit event occurs.
  - Protection providers are considered to have high enough credit quality to mitigate counterparty risk and are subject to eligibility criteria in Europe.
  - Protection providers typically include insurance companies, pension funds, or multilateral development banks in Europe.
  - The bank originating the SRT remains exposed to counterparty credit risk.
- Replenishment period:
  - SRTs with replenishment allow adding new loans to the portfolio as old loans mature, subject to eligibility criteria.
  - Risk for investor: potential asset quality deterioration if lower-quality loans are added or risk profile changes.

### Typical tranche thresholds (jurisdictional examples)
- Europe (ESRB example): first loss tranche typically covers one percent of portfolio losses, mezzanine tranche covers 7 percent of portfolio losses, and the senior tranche covers the remaining losses.
- United States: threshold for the mezzanine tranche for US banks is set to cover 12.5 percent of losses under the Simplified Supervisory Formula Approach; the attachment point for the retained tranche (mezzanine) is typically set at the point that achieves the optimum level of capital relief for the issuer bank (a 20 percent risk weight). This is commonly 12.5 percent, the point where the underlying loan exposures are subject to a 100 percent risk weighting (corporate exposures, consumer exposures other than first-lien residential mortgages).

### Establishing an SRT Program (Box 1.1) — key decision factors and process
- Banks consider numerous factors before establishing an SRT program to manage risk and claim capital relief:
  - Identifying core loan assets as reference loans and assessing investor appeal.
  - Assessing cost of alternative funding options (including selling part of loan portfolio).
  - Estimating cost of different SRT structures.
  - Estimating potential capital relief.
  - Understanding regulatory framework in different jurisdictions.
  - Identifying and maintaining investor relationships.
  - Determining length of SRT program and ability to continue issuing SRTs.
  - Having a team with deep securitization and structured finance experience.
  - Having adequate risk management frameworks and reporting capabilities to model risks and provide data to investors.
- Establishment timeline and process:
  - Establishing an SRT program could take a few months to implement.
  - Banks inform relevant authorities and request regulatory approval as needed.
  - Negotiation/documentation covers asset pools, collateral, funding arrangements, reporting, and credit default event definitions.
  - Hypothetical process steps include: set objective and strategy; select asset pool; select structure; develop operational infrastructure; start SRT program; identify and engage potential investors; documentation and non-disclosure agreement; data review; preliminary bids; investor due diligence; final bids; allocation and pricing; settlement.

### Comparing High Yield Structured Products (Box 1.2) — SRT mezzanine vs CLO BB
- Market context and 2024 issuance:
  - CLO issuance in 2024 reached an estimated record level of $250 billion, of which an estimated $8 billion were CLO BB tranches.
  - Estimated protected tranches through SRT were $30 billion (from over $200 billion in reference pools).
- Structural and investor differences:
  - SRT mezzanine tranches (Reg Cap) and BB-rated CLO tranches target high-risk investors with attractive yields and diversified corporate credit exposure.
  - SRT mezzanine tranches are bespoke, privately negotiated, have limited secondary market liquidity, and carry higher counterparty credit risk for investors—especially for direct bank-issued CLNs.
  - CLO BB tranches benefit from loan diversification, active portfolio management by CLO managers, greater liquidity, more standardized disclosure practices, and rating agency coverage.
- Performance and stress behavior:
  - SRT mezzanine tranches performed better than CLO BB tranches during the COVID-19 pandemic.
  - CLO BB tranches experienced more stress than SRTs during COVID; CLO BB tranches faced downgrade risks as rating agencies reassessed underlying leveraged loans.
  - Regulatory flexibility and capital relief measures (e.g., in the United States, CARES Act loan modification flexibility) helped banks manage credit exposures during the pandemic.

### Regulatory Framework and Capital Relief — introduction
- Post-Global Financial Crisis reforms by BCBS, IOSCO, and other standard setters addressed securitization vulnerabilities including misaligned incentives, opacity, and excessive risk-taking.
- Key reforms introduced to the securitization market aimed to reduce systemic instability (beginning of broader discussion in source).

*Source: IMF Working Papers "Recycling Risk: Synthetic Risk Transfers", sections and figures extracted from the provided PDF content.*

### 1. Higher Capital Requirement: The Basel III revisions introduced a recalibration of the capital

### 1. Higher Capital Requirement: The Basel III revisions introduced a recalibration of the capital

### Basel III recalibration and capital treatment for securitization
- Recalibration introduced a more risk-sensitive hierarchy of approaches that reduced mechanistic reliance on external credit ratings.
- Capital requirements were significantly increased for highly complex, opaque, or low-quality securitizations to address pre-crisis underestimation of risk and regulatory arbitrage.
- Under the Basel securitization framework, originating banks may exclude securitized exposures from RWA only if they demonstrate significant credit risk transfer (SRT) to third parties.
  - Instruments used to transfer credit risk cannot contain hidden structural features that limit risk transfer (e.g., retained indirect control, clauses allowing credit quality improvement, increased protection costs, or performance-based triggers).
  - Early termination options are prohibited, except for non-credit-related events such as clean-up calls or regulatory changes that do not weaken risk transfer (CRE40.25).
  - Ongoing due diligence requirement: banks must maintain a comprehensive understanding of risks associated with the underlying pool.
- Transactions meeting STC criteria can be subject to alternative capital treatment (CRE40.66 to CRE40.165).
- In the EU, Regulation (EU) 2021/557 extended the Simple, Transparent, and Standardized (STS) framework to include synthetic securitizations with specific criteria.

### Risk retention (“Skin in the Game”)
- IOSCO (2012) recommended that securitization originators retain a portion of the credit risk of the underlying assets to align incentives across the securitization value chain.
- Retention encourages higher underwriting standards, thorough asset screening, and more diligent credit risk monitoring by originators and investors.

### Standardization and transparency (STC / STS)
- IOSCO and BCBS developed criteria for identifying simple, transparent, and comparable (STC) securitizations that qualify for more favorable capital treatment.
- STC/ST S criteria ensure investors have sufficient information on underlying assets, transaction structure, and parties to facilitate comparison and risk understanding.
- Post-GFC regulations shifted the market toward more standardized and transparent structures and encouraged banks to explore alternative capital relief mechanisms, increasing prominence of SRT.

### Investors’ regulatory frameworks and incentives
- Major investors in SRTs include credit funds, asset managers, pension funds, and insurers; these operate under distinct regulatory frameworks.
  - Investment funds (including credit funds and hedge funds): increasing regulatory/supervisory scope post-GFC; requirements include liquidity risk management, some leverage and concentration limits, and transparency; not subject to risk-based capital requirements (ultimate risk borne by end investors).
  - Institutional investors (pension funds, insurers): regulations prioritize long-term stability and protection of beneficiaries; capital requirements often simpler and less risk sensitive than Basel, creating incentives to take higher credit risk through SRTs.

### Example estimates of capital relief and loss buffer benefits from SRT structures
- Example setup: $100 notional residential mortgage portfolio, assumed 10.5 percent minimum Tier 1 capital requirement and 50 percent RWA.
  - Regulatory capital requirement without SRT: $5.8 (Row I).
  - Regulatory capital requirement with SRT: $2.7 (Row Y).
  - Result: $5.8 versus $2.7 for the same loan pool under the SRT structure in the example.
- Post-SRT transactions, estimates suggest banks could obtain capital relief of 55 to 80 percent of pre-SRT RWA.
- Table 1 illustrative figures (selected rows and columns aggregated from asset types):
  - Residential Mortgage Loans (United States example):
    - A Notional Value: 100
    - B RWA ratio (%): 50%
    - C = A * B RWA (US$ m): 50
    - D T1 Ratio Requirement (%): 10.5%
    - E Allowance for Credit Losses (%): 0.5%
    - F Allowance for Credit Losses (US$ m): 0.5
    - G = C * D + F Required Capital (US$ m): 5.8
    - J First-Loss Tranche (%): 0.5%
    - K First-Loss Tranche (US$ m): 0.5
    - L RWA ratio (%) for first-loss tranche: 1250%
    - M = K * L RWA (US$ m): 6.3
    - N Mezzanine Tranche (%): 4.5%
    - O Mezzanine Tranche (US$ m): 4.5
    - P RWA ratio (%) for mezzanine tranche: 0.0%
    - Q RWA (US$ m) for mezzanine: 0.0
    - R Senior Tranche (%): 95.0%
    - S Senior Tranche (US$ m): 95.0
    - T RWA ratio (%) for senior tranche: 20.0%
    - U S Senior RWA (US$ m): 19.0
    - V Total SRT RWA (US$ m): 25.3
    - W = V / A SRT RWA Ratio (%): 25.3%
    - Y = V * X Required Capital (US$ m) with SRT: 2.7
    - Z Loss Absorption from External Investors/Mezzanine Tranche (US$ m): 4.5
    - AA = Y + Z Effective Loss Buffer (US$ m): 7.2
    - BB = G - Y Capital relief for Bank (US$ m): 3.1
    - CC = BB / G Capital relief (%): 53.9%
    - DD = AA - I Increase in Effective Loss Buffer (US$ m): 1.4
    - CC = DD / I Increase in Effective Loss Buffer (%): 24%
    - EE Assumed cost of capital for SRT (%): 8.2%
    - FF SOFR / €STR (%): 4.35
    - GG Management costs (bps): 10
    - HH = EE - FF - GG Implied CLN Spread over Benchmark Rate (bps): 383
    - II Implied yearly CLN cost of protection to maturity: -0.2
    - JJ = DD - HH Increase in Effective Loss Buffer (US$ m): 1.2
    - KK = JJ / I Increase in Effective Loss Buffer (%): 21%
  - Corporate and Auto Loans (selected results):
    - G Required Capital (US$ m): 12.0
    - Y Required Capital with SRT (US$ m): 3.8
    - BB Capital relief for Bank (US$ m): 8.2
    - CC Capital relief (%): 68.3%
    - AA Effective Loss Buffer (US$ m): 14.8
    - DD Increase in Effective Loss Buffer (US$ m): 2.8
    - CC Increase in Effective Loss Buffer (%): 23%
    - EE Assumed cost of capital for SRT (%): 8.5%
    - FF SOFR / €STR (%): 4.35
    - GG Management costs (bps): 10
    - HH Implied CLN Spread over Benchmark Rate (bps): 413
    - II Implied yearly CLN cost of protection to maturity: -0.5
    - JJ Increase in Effective Loss Buffer (US$ m): 2.3
    - KK Increase in Effective Loss Buffer (%): 19%
  - High Volatility Commercial Real Estate (HVCRE) Loans (selected results):
    - G Required Capital (US$ m): 20.8
    - Y Required Capital with SRT (US$ m): 8.2
    - BB Capital relief for Bank (US$ m): 12.5
    - CC Capital relief (%): 60.5%
    - AA Effective Loss Buffer (US$ m): 5.2
    - DD Increase in Effective Loss Buffer (US$ m): 4.5
    - CC Increase in Effective Loss Buffer (%): 21%
    - EE Assumed cost of capital for SRT (%): 3.2%
    - FF SOFR / €STR (%): 4.35
    - GG Management costs (bps): 10
    - HH Implied CLN Spread over Benchmark Rate (bps): 88
    - II Implied yearly CLN cost of protection to maturity: -1.5
    - JJ Increase in Effective Loss Buffer (US$ m): 2.9
    - KK Increase in Effective Loss Buffer (%): 14%
  - Europe Reference Corporate Loans (selected results):
    - G Required Capital (US$ m): 7.3
    - Y Required Capital with SRT (US$ m): 1.4
    - BB Capital relief for Bank (US$ m): 5.8
    - CC Capital relief (%): 80.2%
    - AA Effective Loss Buffer (US$ m): 9.9
    - DD Increase in Effective Loss Buffer (US$ m): 2.7
    - CC Increase in Effective Loss Buffer (%): 37%
    - EE Assumed cost of capital for SRT (%): 8.5%
    - FF SOFR / €STR (%): 2.45
    - GG Management costs (bps): 10
    - HH Implied CLN Spread over Benchmark Rate (bps): 605
    - II Implied yearly CLN cost of protection to maturity: -0.5
    - JJ Increase in Effective Loss Buffer (US$ m): 2.1
    - KK Increase in Effective Loss Buffer (%): 29%

- Notes on table and estimates:
  - Estimates do not assume downward adjustment in the allowance for credit losses from structural protection from SRTs that could result in lower provision expenses and higher net income and retained earnings for the bank.
  - Assumed cost of capital for SRT (EE) is based on “Bank Strategies for Risk Transfer and Capital Relief (Santander 2023).” HVCRE proxied with cost of capital for SRT of a C&I Loan. Costs vary by deal specifics and can scale up with CLN years to maturity.
  - The example represents an upper bound: effective loss buffer will decline by the annual cost of the CLN (Row JJ). Investor protection is not equivalent to equity capital because investors can finance their CLNs through leverage (Appendix 3).

### Benefits of SRTs
- For banks:
  - Allow banks to claim capital relief, subject to regulatory approval, potentially increasing lending capacity.
  - A few banks reported capital relief ranging from 15 bps to 28 bps of their Common Equity Tier 1 capital (CET1) ratio in 2024.
  - Help manage credit risk by reducing sector, single-name, and geographic loan concentrations.
  - Allow banks to maintain customer relationships and avoid crystallizing mark-to-market losses since underlying loans remain on balance sheet.
  - Increase liquidity for direct bank-issued CLN structures because banks keep cash proceeds.
  - Can fund stock repurchases, dividends, interest payments, or reduce subordinated debt depending on capital management strategy.
- For investors:
  - Offer access to loan categories not easily accessible through public markets or direct lending.
  - Offer attractive yields compared to other asset classes (Box 1.2).
  - Offer shorter durations when underlying loans have longer tenors (see risk of rollover in Vulnerabilities).
  - Enable customization and negotiation of risk exposure across creditors or industries.
- For the broader economy:
  - Support more efficient risk allocation relative to 100 percent risk retention by originating banks.
  - Create conditions for additional bank lending, thereby supporting growth.

### Vulnerabilities and risks of SRTs
- Overall: Risks currently contained due to post-GFC reforms and modest overall SRT market size, but rapid growth could create significant vulnerabilities warranting close monitoring (Figure 1, panel 3).
- Key vulnerabilities:
  1. Interconnectedness
    - Investors often borrow from banks and other financial institutions to enhance returns, increasing interlinkages.
    - ESRB reports risk transferred out of the banking system through SRTs can partially circle back to banking sector via financing relationships.
    - Unfunded SRT structures expose banks to counterparty credit risk if investors fail to provide protection after credit events.
  2. Leverage and liquidity mismatches
    - SRTs reduce bank risk-based capital while loans remain on balance sheet, increasing leverage.
    - Transfer of risk to less regulated institutions (e.g., hedge funds) can increase system leverage; concentrated, leveraged investor positions raise herd-behavior risks.
    - Credit funds (including hedge funds and asset managers) were the largest investors in SRTs, with over half of synthetic securitization trade flows between 2016 and 2024.
    - Hedge funds and some credit funds holding SRT CLNs use leverage mainly sourced from banks; exposures remain unknown.
    - ESRB notes instances where originating banks may provide financing for protection sellers to subscribe to CLNs, effectively funding own capital relief and potentially undermining capital adequacy; supervisors may make such transactions ineligible for SRT status in Europe.
    - Open-ended investment vehicles and some hedge funds face liquidity mismatches because CLNs are illiquid; ESRB estimates a large portion of Euro-area investors in CLNs are open-ended investment vehicles.
  3. Opacity
    - Lack of transparency and limited disclosure requirements hinder monitoring of system-wide interconnectedness and leverage risks.
    - FRB and ECB reviews indicate regulators may lack full visibility into SRT leverage providers, SRT financing exposures, and leverage risk management practices.
    - BCBS (July 2025) highlighted the need for granular, timely, and high-frequency data to better understand and monitor linkages between banks and nonbank financial intermediaries and assess sensitivity to adverse market conditions.

*IMF WORKING PAPERS Recycling Risk: Synthetic Risk Transfers — content excerpt*

### 1. Investor Breakdown 2. SRTs and Hedge Fund’s Credit Derivative

### 1. Investor Breakdown 2. SRTs and Hedge Fund’s Credit Derivative

### Maturity mismatches and investor concentration
- SRT structures typically have shorter maturities than the underlying portfolio; the average maturity for SRT deals ranges from 3 to 5 years, with longer maturity depending on the reference loan pool.
- Banks expect to create new SRT structures once previous ones mature; high dependence on SRTs or a sudden freeze in the SRT market during stress could leave banks vulnerable to lost protection and procyclical capital requirements.
- Nonbank financial institutions are noted to be significantly more procyclical than banks, contracting credit provision more sharply during stress.
- Example: SRT issuance declined by an estimated 30 percent in 2020 compared to 2019, as banks reduced SRT issuance during the COVID-19 pandemic.
- Investor concentration (survey cited for Europe):
  - Single largest investor holds 31 percent outstanding exposures.
  - Top three investors hold 49 percent.
  - Top ten investors hold 76 percent.
- Issuer concentration (Europe):
  - Single largest issuing bank accounts for 22 percent of the market.
  - Top three banks account for 53 percent.
  - Top 10 banks account for 95 percent.
- Geographic concentration: Large French, Spanish, and German banks accounted for about two-thirds of SRT exposures originated in the EU in the second quarter of 2024 (survey of 14 European banks).

### Complexity and operational/model/legal risk
- Despite meeting criteria for simple and comparable securitizations, SRTs remain complex and generate substantial legal challenges and heightened operational and model risks.
- Risks from limited issuer experience:
  - Issuers with limited securitization infrastructure may fail to design contracts that provide expected credit protection or to monitor risks during the life of transactions.
  - Overreliance on quantitative models can lead to underestimation of tail risks by banks and investors.
- Regulatory response:
  - Bank regulators have called for adequate risk management and reporting of securitization activities, including SRTs.
  - In 2025, the ECB called for banks to integrate SRT-related risks into internal capital planning, risk management processes, and stress testing.

### Potential for ineffective risk transfer and origination standards
- Ineffective risk transfer can produce misleading reductions in RWAs and overstated capital ratios, undermining market confidence.
- Channels for ineffective transfer:
  - Banks providing financing to the investor intended to absorb credit risk.
  - Investors that are thinly capitalized or less regulated and unable to cover losses when structures are not prefunded.
- Origination standards risk:
  - Potential decline in loan origination standards, especially for SRT blind pool deals and SRTs with riskier underlying loans.
  - Leveraged loans, while still a small component, have increased their participation in underlying pools (leveraged loans have increased over the past five years; underlying pools include CRE and Leveraged Loans).
- Monitoring needs:
  - Assess effective risk transfer, investor leverage, and blind pool opacity.
  - Ensure regulatory capital reductions only reflect full credit risk transfer, including under stressed conditions.

### Measures to mitigate potential risks (policy recommendations and supervisory actions)
- Integrate SRT-related risks into existing supervisory tools and banks’ internal processes:
  - Require banks to incorporate SRT-related risks into internal governance, continuous monitoring, and reporting of counterparties.
  - Include SRT risks in internal capital planning and stress testing.
- Strengthen disclosure and reporting:
  - Enhanced disclosure to help market discipline and allow authorities to monitor underwriting practices, default risk of underlying pools, and structural features of SRT transactions.
  - Address significant gaps in data availability needed to monitor interconnectedness, leverage concentrations, and financial stability risks.
  - Improve granularity of reported SRT exposure amounts (Pillar 3 disclosures currently lack sufficient detail in some cases).
- Enhance international cooperation:
  - Improve cross-border and cross-sectoral supervisory cooperation, data sharing arrangements, and harmonized regulatory approaches to reduce regulatory arbitrage.
  - Relevant standard-setting bodies should analyze and address regulatory arbitrage opportunities if material.

### Appendix 1 — Additional SRT market trends (issuer composition and incentives)
- European and U.K. GSIBs have been predominant SRT issuers since inception; raising equity has been more expensive and dilutive for these banks due to lower ROE and low price-to-book ratios compared to U.S. banks.
- Shifts in issuer composition:
  - Between 2022 and 2024, there were an average of 40 banks issuing SRTs.
  - In 2023, issuing banks in Europe had total assets between $50 billion and $300 billion; in the United States, issuers were below $100 billion.
- Incentives:
  - Higher costs of equity for European non-GSIBs compared to U.S. non-GSIBs contributed to demand for SRTs for capital optimization, particularly during higher SRT issuance periods (2022–2023).
  - GSIBs with higher cost of equity tend to have greater SRT exposure (positive correlation between retained SRT exposure and cost of equity).
- Bank asset size range referenced in charts: $17 billion to $3.8 trillion.
- Observed patterns:
  - Lower CET1 ratios for non-GSIB entrants in the U.S. compared to European non-GSIBs in 2023; compared to 2022, likely reflecting preference for SRTs to boost capital ahead of proposed regulatory changes.

### Appendix 2 — Regulatory treatment of SRTs across jurisdictions (key rules and comparisons)
- European Union (CRR Articles 243 and 244, from 2013):
  - Conditions for recognizing SRTs in traditional and synthetic securitization to allow originator to reduce capital requirements require a genuine transfer of significant credit risk to third parties.
  - Retention limits: bank must retain no more than 50 percent of the risk-weighted exposure amounts (RWEA) of mezzanine tranches or no more than 20 percent of the riskiest positions (those subject to deduction from Common Equity Tier 1 capital or a 1250 percent risk weight).
  - National competent authorities may grant SRT permissions on a case-by-case basis, provided capital reductions reflect commensurate transfer of credit risk.
- United States:
  - Framework primarily governed by Regulation Q and Dodd-Frank risk retention rules.
  - On September 28, 2023, the Federal Reserve issued guidance (FAQ) effectively endorsing capital relief benefits of SRT transactions, spurring renewed interest and growth in the U.S. SRT market.
- United Kingdom:
  - SRT framework initially mirrored the EU's CRR; post-Brexit PRA has begun adapting the framework for U.K. specifics.
  - The PRA provided explicit permission for banks to use unfunded credit protection in SRTs (insurance-provided contracts or guarantees), classified as “complex features” that require discussion with the regulator but not pre-approval. (Supervisory Statement 9/13 “Securitisation—Significant Risk Transfer”, Bank of England, July 2025).
- Table A.2 highlights (regulatory comparison, United States vs EU):
  - United States:
    - Require use of collateral, eligible guarantees, or eligible credit derivatives to mitigate risk.
    - No termination of protection; no credit enhancement; and no increase in the cost of protection or yield payable due to deterioration in credit quality of underlying exposures/assets.
    - Directly issued credit-linked notes are not recognized as synthetic securitizations and require a Federal Reserve reservation of authority to review specific transactions.
    - Insurance companies are not considered eligible guarantors for providing credit protection to banks.
  - European Union:
    - Significant risk transfer demonstrated through a quantitative SRT test or with permission from national competent authorities.
    - Securitization documentation must reflect the economic substance of the transaction.
    - Credit protection conditions: no termination of protection; no credit enhancement; no increase in cost of protection or yield payable; no materiality thresholds that prevent protection from being triggered if a credit event occurs.
    - Legal opinion required confirming credit protection enforceability in all relevant jurisdictions.
    - Documents must specify arm’s-length conditions between the bank and the investor.

### Appendix 3 — SRTs and hedge funds (vulnerabilities)
- Hedge fund borrowing (balance sheet leverage) has risen sharply; the ratio of total borrowing to net asset value has reached record highs.
- Much of hedge fund leverage is related to other trading strategies (notably the U.S. Treasury market basis trade), but a small and fast-growing portion may be used to amplify returns on SRT investments, particularly in the United States.
- Structural drivers:
  - Tougher U.S. requirements compared to European banks reportedly led to differences in SRT deal structures and lower coupons on U.S. trades, potentially driving investors to use leverage on U.S. trades to chase yields comparable to double-digit returns available on similar investments in Europe.

*Source: IMF Working Paper — Recycling Risk: Synthetic Risk Transfers (excerpts from 1. Investor Breakdown 2. SRTs and Hedge Fund’s Credit Derivative).*

### 1. Hedge Fund Borrowing by Source

### 1. Hedge Fund Borrowing by Source

### Sample and data
- Data sources: Securities Exchange Commission, and IMF Staff calculations.
- Sample coverage: About two thirds of the hedge funds in the sample are domiciled outside of the United States.
- Aggregate AUM in sample: total assets under management exceeding $5 trillion, versus a $8.5 trillion estimate in the 2024 Global Monitoring Report on Non-Bank Financial Intermediation of the Financial Stability Board.
- Note: This calculation excludes any derivative exposures that can have embedded leverage.
- Definition: Repo = repurchase agreements.

### Borrowing channels and leverage mechanics
- The leverage on the CLNs often comes in the form of repurchase agreements, which account for a growing share of hedge funds’ overall borrowing.
- Broker-dealer risk management: broker dealer arms of banks that provide leverage to the investors in CLNs typically examine their counterparties’ leverage, but individual broker-dealers often do not have full visibility into their clients’ total exposure.
- As a result, haircuts and other lending conditions can be less effective in constraining overall leverage.
- Opacity and illiquidity concerns: These issues could be more prevalent in the opaque and illiquid SRT market, where there are additional concerns about the mismatch between shorter-term repurchase agreements and longer dated, less liquid CLNs.

### Liquidity mismatches and investor protection
- Hedge funds are better protected than other commingled investment vehicles—including regulated investment funds—when facing investor redemption pressure due to stricter liquidity terms and the more active use of investor gates.
- Despite stronger investor liquidity terms, hedge fund portfolios have become increasingly illiquid in aggregate.
- The estimated share of hedge fund portfolios that could be liquidated in less than 30 days has fallen sharply (Figure A.3).
- Increasing investment in less liquid credit derivative instruments, including CLNs, may have contributed to the deterioration in the liquidity mismatches of the more credit-focused hedge funds.

### Risks, spillovers, and triggers
- A spike in margin calls on repurchase agreements could lead to spillovers into other, more liquid markets as hedge fund investors sell other assets to raise liquidity.
- Such a spike in margin calls could be triggered by concerns about the valuation of the underlying securities of a SRT following a sharp increase of defaults, for example.

### Charted indicators and numeric points (as presented)
- Years shown: 2014, 2015, 2016, 2017, 2018, 2019, 2020, 2021, 2022, 2023.
- Charted borrowing types: Unsecured; Other secured borrowing; Secured reverse repo; Secured prime broker.
- Charted series: Ratio of total borrowing to net asset value (right axis).
- Charted liquidity indicators (years 2014–2023): 7, 12, 17, 22, 27, 32, 58, 63, 68, 73, 78, 83 (presented in the figure alongside years).
- Charted small numeric markers visible: 0.4, 0.6, 0.8, 1 (vertical scale markers in figure).

*Source: IMF Working Papers — Recycling Risk: Synthetic Risk Transfers, Working Paper No. WP/2025/200.*

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_Source: https://www.imf.org/-/media/files/publications/wp/2025/english/wpiea2025200-source-pdf.pdf_