Asset-Backed Security (ABS): What It Is, How Different Types Work

What Is an Asset-Backed Security (ABS)? 

An asset-backed security (ABS) is a type of financial investment that is collateralized by an

underlying pool of assets—usually ones that generate a cash flow from debt, such as loans,
leases, credit card balances, or receivables. It takes the form of a bond or note,
paying income at a fixed rate for a set amount of time, until maturity.

For income-oriented investors, asset-backed securities can be an alternative to other debt

instruments, like corporate bonds or bond funds.1

KEY TAKEAWAYS

 Asset-backed securities (ABSs) are financial securities backed by income-

generating assets such as credit card receivables, home equity loans, student loans,
and auto loans.
 ABSs are created when a company sells its loans or other debts to an issuer, a
financial institution that then packages them into a portfolio to sell to investors.
 Pooling assets into an ABS is a process called securitization.
 ABSs appeal to income-oriented investors, as they pay a steady stream of interest,
like bonds.
 Mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs) can
be considered types of ABS.2

Understanding Asset-Backed Securities (ABSs) 

Asset-backed securities allow their issuers to raise cash, which can be used for lending or
other investment purposes. The underlying assets of an ABS are often  illiquid and can’t be
sold on their own. So, pooling assets together and creating a financial instrument out of them
—a process called securitization—allows the issuer to make illiquid assets marketable to
investors. It also allows them to get shakier assets off their books, thus alleviating their credit
risk.1

The underlying assets of these pools may be home equity loans, automobile loans, credit
card receivables, student loans, or other expected cash flows. ABS issuers can be as
creative as they desire. For example, asset-backed securities have been built based on cash
flows from movie revenues, royalty payments, aircraft landing slots, toll roads, and solar
photovoltaics. Just about any cash-producing vehicle or situation can be securitized into an
ABS.

For investors, buying an ABS affords the opportunity of a revenue stream. The ABS allows
them to participate in a wide variety of income-generating assets, sometimes (as noted
above) exotic ones that aren’t available in any other investment.

How an Asset-Backed Security Works 

Assume that Company X is in the business of making automobile loans. If a person wants to
borrow money to buy a car, Company X gives that person the cash, and the person is
obligated to repay the loan with a certain amount of interest. Perhaps Company X makes so
many loans that it starts to run out of cash. Company X can then package its current loans
and sell them to Investment Firm X, thus receiving the cash, which it can then use to make
more loans.

Investment Firm X will then sort the purchased loans into different groups called tranches.
These tranches contain loans with similar characteristics, such as maturity, interest rate, and
expected delinquency rate. Next, Investment Firm X will issue securities based on each

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tranche it creates. Similar to bonds, each ABS has a rating indicating its degree of riskiness
—that is, the likelihood that the underlying loans will go into default.

Individual investors then purchase these securities and receive the cash flows from the
underlying pool of auto loans, minus an administrative fee that Investment Firm X keeps for
itself.

Special Considerations 

An ABS will usually have three tranch classes: A, B, and C. The senior tranche, A, is almost
always the largest tranche and is structured to have an investment-grade rating to make it
attractive to investors.

The B tranche has lower credit quality and thus has a higher yield than the senior tranche.
The C tranche has a lower credit rating than the B tranche and might have such poor credit
quality that it can’t be sold to investors. In this case, the issuer would keep the C tranche and
absorb the losses.3

Types of Asset-Backed Securities 

Theoretically, an asset-based security can be created out of almost anything that generates
an income stream, from mobile home loans to utility bills. But certain types are more
common. Among the most typical ABS types are:

Collateralized Debt Obligation (CDO) 

A CDO is an ABS issued by a special purpose vehicle (SPV). The SPV is a business entity
or trust formed specifically to issue that ABS. There are a variety of subsets of CDOs,
including:

 Collateralized loan obligations (CLOs) are CDOs made up of bank loans.

 Collateralized bond obligations (CBOs) are composed of bonds or other CDOs.
 Structured finance-backed CDOs have underlying assets of ABS, residential or
commercial mortgages, or real estate investment trust (REIT) debt. 
 Cash CDOs are backed by cash-market debt instruments, while other credit
derivatives support synthetic CDOs.
 Collateralized mortgage obligations (CMOs)  are composed of mortgages—or, more
precisely, mortgage-backed securities (MBSs), which hold portfolios of mortgages
(see below).4

Though a CDO is essentially structured the same as an ABS, some consider it a separate
type of investment vehicle. In general, CDOs own a wider and more diverse range of assets
—including other asset-based securities or CDOs.5

Home Equity ABS 

Home equity loans are one of the largest ABS categories. Though similar to mortgages,
home equity loans are often taken out by borrowers who have less-than-stellar credit scores
or few assets—the reason why they didn’t qualify for a mortgage. These are amortizing loans
—that is, payment goes toward satisfying a specific sum and consists of three categories:
interest, principal, and prepayments.

A  mortgage-backed security (MBS)  is sometimes considered a type of ABS but is more

often classified as a separate variety of investment, especially in the United States. Both
operate in essentially the same way; the difference lies in the underlying assets in
the  portfolio.

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Mortgage-backed securities are formed by pooling together mortgages exclusively, while
asset-backed securities consist of any other type of loan or debt instrument (including, rather
confusingly, home equity loans).  MBSs actually predate ABSs.6

Auto Loan ABS 

Car financing is another large category of ABS. The cash flows of an auto loan ABS include
monthly interest payments, principal payments, and prepayments (though the last is rarer,
for an auto loan ABS is much lower than a home equity loan ABS). This is another
amortizing loan.7

Credit Card Receivables ABS 

Credit card receivables—the amount due on credit card balances—are a type of non-

amortizing ABS: They go to a revolving line of credit, rather than toward the same set sum.
Thus, they don’t have fixed payment amounts, while new loans and changes can be added
to the composition of the pool. The cash flows of credit card receivables include interest,
principal payments, and annual fees.8

There is usually a lockup period for credit card receivables where no principal will be paid. If
the principal is paid within the lockup period, then new loans will be added to the ABS with
the principal payment that makes the pool of credit card receivables staying unchanged.
After the lockup period, the principal payment is passed on to ABS investors.9

Student Loan ABS 

ABSs can be collateralized by either government student loans, guaranteed by the U.S.
Department of Education, or private student loans. The former have had a better repayment
record and a lower risk of default.10

What is an example of an asset-backed security (ABS)?

A collateralized debt obligation (CDO)  is an example of an asset-based security (ABS). It is

like a loan or bond, one backed by a portfolio of debt instruments—bank loans, mortgages,
credit card receivables, aircraft leases, smaller bonds, and sometimes even other ABSs or
CDOs. This portfolio acts as collateral for the interest generated by the CDO, which is
reaped by the institutional investors who purchase it.

What is asset backing?

Asset backing refers to the total value of a company’s shares in relation to its assets.
Specifically, it refers to the total value of all the assets that a company has, divided by
the number of outstanding shares that the company has issued.

In terms of investments, asset backing refers to a security with value deriving from a single
asset or a pool of assets; these holdings act as collateral for the security—“backing” it, in
effect.

What does ABS stand for in accounting?

In the business world, ABS stands for accounting and billing system.

What is the difference between MBS and ABS?

An asset-based security (ABS) is similar to a mortgage-backed security (MBS). Both are
securities that, like bonds, pay a fixed rate of interest derived from an underlying pool of
income-generating assets—usually debts or loans. The main difference is that an MBS, as

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its name implies, consists of a package of mortgages (real estate loans). In contrast, an ABS
is usually backed by other sorts of financing—student loans, auto loans, or credit card debt.6

Some financial sources use ABS as a generic term, encompassing any sort of securitized
investment based on underlying asset pools—in which case, an MBS is a kind of ABS.
Others consider ABSs and MBSs to be separate investment vehicles.

How does asset securitization work?

Asset securitization begins when a lender (or any company with loans) or a firm with income-
producing assets earmarks a bunch of these assets, then arranges to sell the lot to an
investment bank or other financial institution. This institution often pools these assets with
comparable ones from other sellers, then establishes a special purpose vehicle  (SPV)—an
entity set up specifically to acquire the assets, package them, and issue them as a single
security.

The issuer then sells these securities to investors, usually institutional investors (hedge
funds, mutual funds, pension plans, etc.). The investors receive fixed- or floating-rate
payments from a trustee account funded by the cash flows generated by the portfolio of
assets.

Sometimes the issuer divides the original asset portfolio into slices, called tranches. Each
tranche is sold separately and bears a different degree of risk, indicated by a different  credit
rating.

The Bottom Line 

Asset-backed securities (ABSs) are pools of loans that are packaged together into an
investable security, which can in turn be bought by investors—predominantly large
institutions like hedge funds, insurance companies, and pension funds. ABSs provide a
method of diversification from typical bond mutual funds or individual bonds themselves.
Most importantly, they are income-generating assets, typically with a higher return than a
normal corporate bond, all depending on the credit rating assigned to the ABS.

The underlying assets of an ABS could consist of auto loans, credit card receivables, and
even more exotic investments, such as utility bills and toll roads. Such categories of ABS are
referred to by different names such as collateralized debt obligations (CDOs), which are
broken down into further subcategories, such as collateralized loan obligations (CLOs).
However, by far, the most popular and therefore liquid ABS are mortgage-backed securities
(MBSs), which provide an income stream from mortgage payments.

For the investor, ABSs provide an income stream in line with the credit rating of the security,
and they offer an alternative to standard bond mutual funds.

Mortgage-Backed Securities (MBS) Definition: Types of Investment

What Is a Mortgage-Backed Security (MBS)? 

Mortgage-backed securities (MBS) are investment products similar to bonds. Each MBS
consists of a bundle of home loans and other real estate debt bought from the banks that
issued them. Investors in mortgage-backed securities receive periodic payments similar to
bond coupon payments.

KEY TAKEAWAYS

 Mortgage-backed securities (MBS) turn a bank into an intermediary between the

homebuyer and the investment industry.

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  The bank handles the loans and then sells them at a discount to be packaged as
MBSs to investors as a type of collateralized bond.
 For the investor, an MBS is as safe as the mortgage loans that back it up.

Understanding Mortgage-Backed Securities

Understanding Mortgage-Backed Security (MBS) 

Mortgage-backed securities (MBS) are variations of asset-backed securities that are formed

by pooling together mortgages exclusively. The investor who buys a mortgage-backed
security is essentially lending money to home buyers. An MBS can be bought and sold
through a broker. The minimum investment varies between issuers.

As became glaringly obvious in the subprime mortgage meltdown of 2007-2008, a mortgage-

backed security is only as sound as the mortgages that back it up. An MBS may also be
called a mortgage-related security or a mortgage pass-through.

Essentially, the mortgage-backed security turns the bank into an intermediary between the
homebuyer and the investment industry. A bank can grant mortgages to its customers and
then sell them at a discount for inclusion in an MBS. The bank records the sale as a plus on
its balance sheet and loses nothing if the homebuyer defaults sometime down the road.

This process works for all concerned as everyone does what they're supposed to do. That is,
the bank keeps to reasonable standards for granting mortgages; the homeowner keeps
paying on time, and the credit rating agencies that review MBS perform due diligence.

In order to be sold on the markets today, an MBS must be issued by a government-

sponsored enterprise (GSE) or a private financial company. The mortgages must have
originated from a regulated and authorized financial institution. And the MBS must have
received one of the top two ratings issued by an accredited credit rating agency.

 
Mortgage-backed securities loaded up with subprime loans played a central role in the
financial crisis that began in 2007 and wiped out trillions of dollars in wealth.1

Types of Mortgage-Backed Securities 

There are two common types of MBSs: pass-throughs and collateralized mortgage
obligations (CMO).

1. Pass-throughs: Pass-throughs are structured as trusts in which mortgage payments

are collected and passed through to investors. They typically have stated maturities
of five, 15, or 30 years. The life of a pass-through may be less than the stated
maturity depending on the principal payments on the mortgages that make up the
pass-through.
2. Collateralized mortgage obligations (CMO): CMOs consist of multiple pools of
securities which are known as slices, or tranches. The tranches are given credit
ratings which determine the rates that are returned to investors.

History of MBS 

Mortgage-backed securities were introduced after the passage of the Housing and Urban
Development Act in 1968. The act created the Government National Mortgage Association ,
or Ginnie Mae, which was split off from Fannie Mae.

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The new body allowed banks to sell their mortgages to third parties so that they would have
more capital to lend out and originate new loans. This in turn made it possible for institutional
funds to buy up and package many loans into an MBS.

Ginnie Mae introduced the first mortgage-backed securities for the retail housing market in
1970. The first private MBS was introduced by Bank of America in 1977.2

MBS and the Financial Crisis of 2007/2008 

Mortgage-backed securities played a central role in the financial crisis that began in 2007

and went on to wipe out trillions of dollars in wealth, bring down  Lehman Brothers, and roil
the world financial markets.1

In retrospect, it seems inevitable that the rapid increase in home prices and the growing
demand for MBS would encourage banks to lower their lending standards and drive
consumers to jump into the market at any cost.

The Crisis 

That was the beginning of the subprime MBS. With Freddie Mac and Fannie

Mae aggressively supporting the mortgage market, the quality of all mortgage-backed
securities declined, and their ratings became meaningless. Then, in 2006, housing prices
peaked.3

Subprime borrowers started to default, which is the failure to repay a loan. As a result, the
housing market began its long collapse. More people began walking away from their
mortgages because their homes were worth less than their loans. Even the conventional
mortgages underpinning the MBS market saw steep declines in value. The avalanche of
non-payments meant that many MBSs and collateralized debt obligations (CDOs) based on
pools of mortgages were vastly overvalued.

The losses piled up as institutional investors and banks tried and failed to unload bad MBS
investments. Credit tightened, causing many banks and financial institutions to teeter on the
brink of insolvency. Lending was disrupted to the point that the entire economy was at risk of
collapse.

The Bailout 

The U.S. Treasury stepped in with Congress to authorize a $700 billion financial system
bailout intended to ease the credit crunch. Also, the Federal Reserve bought $4.5 trillion in
MBS over a period of years while the Troubled Asset Relief Program (TARP) injected capital
directly into banks.

Some of the measures of the bailout included the following:

 Nearly $250 billion to stabilize the banking Industry nearly

 $27 billion o stabilize the credit markets
 $80 billion to support the U.S. auto industry
 Almost $70 billion to bail out the insurance giant, AIG for the American International
Group
 $46 billion was allocated to help struggling families avoid home foreclosure, which is
when a mortgage lender or bank seizes a borrower's home due to nonpayment of
the loan

On Oct. 3, 2010, the authority to initiate new financial commitments ceased, essentially
ending any new bailouts under the TARP program.

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Also, in 2010, Congress authorized the Dodd-Frank Wall Street Reform and Consumer
Protection Act. The Dodd-Frank Act reduced the initial amount of the $700 billion authorized
for the TARP program to $475 billion.4

Advantages and Disadvantages of MBS 

Attractive Yield 

For investors, mortgage-backed securities have some advantages over other securities.
They pay a fixed interest rate that is usually higher than U.S. government bonds. Moreover,
they typically offer monthly payouts, whereas bonds offer a single lump-sum payout at
maturity.

Safe Investments 

Mortgage-backed securities are also considered relatively low-risk. If an MBS is guaranteed

by the federal government, investors do not have to absorb the costs of a borrower's default.
Moreover, they also offer diversification from the markets of corporate and government
securities.

Prepayment Risk 

If borrowers fail to repay their loans, the investor may ultimately lose money. Also, if
borrowers pay off their loans early or refinance their loans, that can also have a negative
impact on expected returns.

Interest Rate Risk 

MBSs are also sensitive to changes in the interest rates on loans and mortgages. If interest
rates rise, fewer people will take out mortgages causing the overall value of the housing
market to decline.

MBS Pros and Cons 

Pros
 Fixed interest rate and monthly payouts.
 More diversification than single loans.

 Relatively low correlation with corporate bonds or the stock market.

Cons
 Returns may be affected by borrowers refinancing or paying off their loans early.
 If interest rates increase, the price of an MBS may drop.

Mortgage-Backed Securities Today 

Mortgage-backed securities are still bought and sold today. There is a market for them again
simply because people generally pay their mortgages if they can. The Fed still owns a huge
chunk of the market for MBSs, but it is gradually selling off its holdings.

Even CDOs have returned after falling out of favor for a few years post-crisis. The
assumption is that Wall Street has learned its lesson and will question the value of MBSs
rather than heedlessly buying them. Time will tell.

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What Are the Types of Mortgage-Backed Securities (MBS)?

There are two common types of MBSs: pass-throughs and collateralized mortgage
obligations (CMO).5 Pass-throughs are structured as trusts in which mortgage payments are
collected and passed through to investors. They typically have stated maturities of five, 15,
or 30 years. CMOs consist of multiple pools of securities which are known as slices, or
tranches. The tranches are given credit ratings which determine the rates that are returned
to investors.

What's the Relationship Between MBS and a Bank?

Essentially, the mortgage-backed security turns the bank into an intermediary between the
homebuyer and the investment industry. A bank can grant mortgages to its customers and
then sell them at a discount for inclusion in an MBS. The bank records the sale as a plus on
its balance sheet and loses nothing if the homebuyer defaults sometime down the road.

This process works for all concerned as long as everyone does what they're supposed to do.
That is, the bank keeps to reasonable standards for granting mortgages; the homeowner
keeps paying on time, and the credit rating agencies that review MBS perform due diligence.

What Is an Asset-Backed Security (ABS)?

An asset-backed security (ABS) is a type of financial investment that is collateralized by an

underlying pool of assets—usually ones that generate a cash flow from debt, such as loans,
leases, credit card balances, or receivables. It takes the form of a bond or note, paying
income at a fixed rate for a set amount of time, until maturity.6

For income-oriented investors, ABSs can be an alternative to other debt instruments, like
corporate bonds or bond funds. For issuers, ABSs allow them to raise cash which can be
used for lending or other investment purposes. 

The Bottom Line 

A mortgage-backed security is a type of investment vehicle composed of a large basket of

mortgages. As each homeowner pays off their loans, the loan payments provide a steady
income stream for investors who hold the MBS. These securities may be particularly
attractive to investors who seek exposure to the housing market, rather than ordinary
corporate or debt securities.

Securitization: Definition, Pros & Cons, Examples

What Is Securitization? 

Securitization is the pooling of assets in order to repackage them into interest-bearing

securities. The investors that purchase the repackaged securities receive the principal and
interest payments of the original assets.

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The securitization process begins when an issuer designs a marketable financial
instrument by merging or pooling various financial assets, such as multiple mortgages, into
one group. The issuer then sells this group of repackaged assets to investors. Securitization
offers opportunities for investors and frees up capital for originators, both of which
promote liquidity in the marketplace.

In theory, any financial asset can be securitized—that is, turned into a

tradeable, fungible item of monetary value. In essence, this is what all securities are.

However, securitization most often occurs with loans and other assets that
generate receivables such as different types of consumer or commercial debt. It can involve
the pooling of contractual debts such as auto loans and credit card debt obligations.

How Securitization Works 

In securitization, the company holding the assets—known as the originator—gathers the

data on the assets it would like to remove from its associated balance sheets. For example,
if it were a bank, it might be doing this with a variety of mortgages and personal loans it
doesn't want to service anymore. This gathered group of assets is now considered a
reference portfolio. The originator then sells the portfolio to an issuer who will create tradable
securities. Created securities represent a stake in the assets in the portfolio. Investors will
buy the created securities for a specified rate of return.

Often the reference portfolio—the new, securitized financial instrument—is divided into
different sections, called tranches. The tranches consist of the individual assets grouped by
various factors, such as the type of loans, their maturity date, their interest rates, and the
amount of remaining principal. As a result, each tranche carries different degrees of risk and
offer different yields. Higher levels of risk correlate to higher interest rates the less-qualified
borrowers of the underlying loans are charged, and the higher the risk, the higher the
potential rate of return.

Mortgage-backed security (MBS) is a perfect example of securitization. After combining

mortgages into one large portfolio, the issuer can divide the pool into smaller pieces based
on each mortgage's inherent risk of default. These smaller portions then sell to investors,
each packaged as a type of bond.

By buying into the security, investors effectively take the position of the lender. Securitization
allows the original lender or creditor to remove the associated assets from its balance
sheets. With less liability on their balance sheets, they can underwrite additional loans.
Investors profit as they earn a rate of return based on the associated principal and interest
payments being made on the underlying loans and obligations by the debtors or borrowers.

KEY TAKEAWAYS

 In securitization, an originator pools or groups debt into portfolios which they sell to
issuers.
 Issuers create marketable financial instruments by merging various financial assets
into tranches.
 Investors buy securitized products to earn a profit.
 Securitized instruments furnish investors with good income streams.
 Products with riskier underlying assets will pay a higher rate of return.

Benefits of Securitization 

The process of securitization creates liquidity by letting retail investorspurchase shares in

instruments that would normally be unavailable to them. For example, with an MBS an
investor can buy portions of mortgages and receive regular returns as interest and principal

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payments. Without the securitization of mortgages, small investors may not be able to afford
to buy into a large pool of mortgages.

Unlike some other investment vehicles, many loan-based securities are backed by tangible
goods. Should a debtor cease the loan repayments on, say, his car or his house, it can be
seized and liquidated to compensate those holding an interest in the debt.

Also, as the originator moves debt into the securitized portfolio it reduces the amount of
liability held on their balance sheet. With reduced liability, they are then able to underwrite
additional loans.

Pros
 Turns illiquid assets into liquid ones
 Frees up capital for the originator
 Provides income for investors
 Lets small investor play

Cons
 Investor assumes creditor role
 Risk of default on underlying loans
 Lack of transparency regarding assets
 Early repayment damages investor's returns

Drawbacks to Consider 

Of course, even though the securities are back by tangible assets, there is no guarantee that
the assets will maintain their value should a debtor cease payment. Securitization provides
creditors with a mechanism to lower their associated risk through the division of ownership of
the debt obligations. But that doesn't help much if the loan holders' default and little can be
realized through the sale of their assets.

Different securities—and the tranches of these securities—can carry different levels of risk
and offer the investor various yields. Investors must take care to understand the debt
underlying the product they are buying.

Even so, there can be a lack of transparency about the underlying assets. MBS played a
toxic and precipitating role in the financial crisis of 2007 to 2009. Leading up to the crisis the
quality of the loans underlying the products sold was misrepresented. Also, there was
misleading packaging—in many cases repackaging—of debt into further securitized
products. Tighter regulations regarding these securities have since been implemented. Still
—caveat emptor—or beware buyer.

A further risk for the investor is that the borrower may pay off the debt early. In the case of
home mortgages, if interest rates fall, they may refinance the debt. Early repayment will
reduce the returns the investor receives from interest on the underlying notes.

Real-World Examples of Securitization 

Charles Schwab offers investors three types of mortgage-backed securities called specialty
products. All the mortgages underlying these products are backed by government-sponsored
enterprises (GSEs). This secure backing makes these products among the better-quality
instruments of their kind. The MBSs include those offered by:

 Government National Mortgage Association (GNMA): The U.S. government

backs bonds guaranteed by Ginnie Mae. GNMA does not purchase, package, or sell
mortgages, but does guarantee their principal and interest payments.

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  Federal National Mortgage Association (FNMA): Fannie Mae purchases
mortgages from lenders, then packages them into bonds and resells them to
investors. These bonds are guaranteed solely by Fannie Mae and are not direct
obligations of the U.S. government. FNMA products carry credit risk.
 Federal Home Loan Mortgage Corporation (FHLMC): Freddie Mac purchases
mortgages from lenders, then packages them into bonds and resells them to
investors. These bonds are guaranteed solely by Freddie Mac and are not direct
obligations of the U.S. government. FHLMC products carry credit risk.1

What is Structured Finance?

Structured finance deals with financial lending instruments that work to mitigate serious
risks related to complex assets. For most, traditional tools such as mortgagesand small
loans are sufficient. However, borrowers with greater needs, such as corporations, seek
structured finance to deal with complex and unique financial instruments and
arrangements to satisfy substantial financial needs.

The term “structured finance” is often used to explain the bundling of receivables,
although it is more generally applicable to the offering of a structured system to help
borrowers – and lenders – accomplish their end goal. The primary goal is to facilitate
financing solutions that don’t involve free cash flow and to address different asset
classes across various industries, making less risky products available to clients that need
them.

The Matter of Securitization

Securitization is the core of structured finance. It is the method by which those in

structured finance create asset pools and ultimately form complex financial instruments
that are useful to corporations and investors with special needs.

The specific reasons why securitization is valuable include:

 Alternative funding formats for unique or complicated needs

 Reduction of focus on credit
 Managing risk through liquidity and interest rates
 Efficient use of capital available, to capitalize on the potential for greater earnings
or profit
 Less-costly funding options, which may be primarily important for borrowers
with a less-than-stellar credit rating
 Transfer of risk away from investors

Examples

For large corporations looking to borrow substantial sums, a collected group of assets
and financial transactions may be necessary. There are lending transactions that can’t be
done with a traditional financial instrument. Therefore, structured finance comes into
play.

Several structured finance products and combinations of products can be used to

accomplish the financing needs of large borrowers. Structured finance products include:

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  Syndicated loans
 Collateralized bond obligations (CBOs)
 Credit default swaps (CDSs)
 Hybrid securities
 Collateralized mortgage obligations
 Collateralized debt obligations (CDOs)

Summary

Structured finance and its products are important. It provides the scaffolding and space
for major borrowers needing a capital injection or alternative source of financing when
other, more traditional borrowing options won’t work.

Collateralized Loan Obligation (CLO) Structure, Benefits, and Risks

What Is a Collateralized Loan Obligation (CLO)? 

A collateralized loan obligation (CLO) is a single security backed by a pool of debt. The process of
pooling assets into a marketable security is called securitization. Collateralized loan obligations (CLO)
are often backed by corporate loans with low credit ratings or loans taken out by private equity firms to
conduct leveraged buyouts. A collateralized loan obligation is similar to a collateralized mortgage
obligation (CMO), except that the underlying debt is of a different type and character—a company loan
instead of a mortgage.

KEY TAKEAWAYS

 A collateralized loan obligation (CLO) is a single security backed by a pool of debt.

 CLOs are often corporate loans with low credit ratings or loans taken out by private equity
firms to conduct leveraged buyouts.
 With a CLO, the investor receives scheduled debt payments from the underlying loans,
assuming most of the risk if borrowers default.

Collateralized Loan Obligation (CLO)

How Collateralized Loan Obligations (CLOs) Work 

A CLO is a bundle of loans that are ranked below investment grade. They are usually first-lien bank
loans to businesses that are initially sold to a CLO manager and consolidated into bundles of 150 to
250 loans.1 To fund the purchase of new debt, the CLO manager sells stakes in the CLO to outside
investors in a structure called tranches.

With a CLO, the investor receives scheduled debt payments from the underlying loans, assuming most
of the risk in the event that borrowers default. In exchange for taking on the default risk, the investor  is
offered greater diversity and the potential for higher-than-average returns. A default is when a borrower
fails to make payments on a loan or mortgage for an extended period of time.

Each tranche is a piece of the CLO. The order of the tranches dictates who will be paid out first when
the underlying loan payments are made. It also dictates the risk associated with each investment since
investors who are paid last have a higher risk of default from the underlying loans. Investors who are
paid out first have lower overall risk, but they receive smaller interest payments, as a result. Investors
who are in later tranches may be paid last, but the interest payments are higher to compensate for the
risk.

A CLO is an actively managed instrument: managers can—and do—buy and sell individual bank loans
in the underlying collateral pool in an effort to score gains and minimize losses. In addition, most of a

12
CLO's debt is backed by high-quality collateral, making liquidation less likely, and making it better
equipped to withstand market volatility.2

Types of CLO Tranches 

There are two types of tranches: debt tranches and equity tranches. Debt tranches, also called
mezzanine tranches, are treated just like bonds and have credit ratings and coupon payments. These
debt tranches come first in terms of repayment, and there is also a pecking order within the debt
tranches.

Equity tranches do not have credit ratings and are paid out after all debt tranches. Equity tranches are
rarely paid a cash flow but do offer ownership in the CLO itself in the event of a sale. Because equity
tranche investors usually face higher risks, they often receive higher returns than debt tranche
investors.

Collateralized Debt Obligation (CDOs): What It Is, How It Works

What Is a Collateralized Debt Obligation (CDO)? 

A collateralized debt obligation (CDO) is a complex structured finance product that is backed

by a pool of loans and other assets and sold to institutional investors.

A CDO is a particular type of derivative because, as its name implies, its value

is derived  from another underlying asset. These assets become the collateral if the loan
defaults.

KEY TAKEAWAYS

 A collateralized debt obligation is a complex structured finance product that is

backed by a pool of loans and other assets.
 These underlying assets serve as collateral if the loan goes into default.
 The tranches of CDOs indicate the level of risk in the underlying loans, with senior
tranches having the lowest risk. 
 CDOs backed by risky subprime mortgages were one of the causes of the financial
crisis between 2007 and 2009.
 Though risky and not for all investors, CDOs are a viable tool for diversifying risk and
creating more liquid capital for investment banks.
2:02

A Primer On Collateralized Debt Obligation (CDOs)

Understanding Collateralized Debt Obligations (CDOs) 

The earliest CDOs were constructed in 1987 by the former investment bank Drexel Burnham
Lambert, where Michael Milken, then called the "junk bond king," reigned.1 The Drexel
bankers created these early CDOs by assembling portfolios of junk bonds, issued by
different companies. CDOs are called "collateralized" because the promised repayments of
the underlying assets are the collateral that gives the CDOs their value.

To create a CDO, investment banks gather cash flow-generating assets—such as

mortgages, bonds, and other types of debt—and repackage them into discrete classes, or
tranches based on the level of credit risk assumed by the investor.

These tranches of securities become the final investment products, bonds, whose names
can reflect their specific underlying assets. For example, mortgage-backed

13
securities(MBS)are comprised of mortgage loans, and asset-backed securities (ABS) contain
corporate debt, auto loans, or credit card debt.

Other types of CDOs include collateralized bond obligations (CBOs)—investment-grade

bonds that are backed by a pool of high-yield but lower-rated bonds, and collateralized loan
obligations (CLOs)—single securities that are backed by a pool of debt, that often contain
corporate loans with a low credit rating. 

Collateralized debt obligations are complicated, and numerous professionals have a hand in
creating them:

 Securities firms, who approve the selection of collateral, structure the notes into
tranches and sell them to investors
 CDO managers, who select the collateral and often manage the CDO portfolios
 Rating agencies, who assess the CDOs and assign them credit ratings
 Financial guarantors, who promise to reimburse investors for any losses on the CDO
tranches in exchange for premium payments
 Investors such as pension funds and hedge funds

Ultimately, other securities firms launched CDOs containing other assets that had more
predictable income streams. These included automobile loans, student loans, credit card
receivables, and aircraft leases. However, CDOs remained a niche product until 2003–2004,
during the U.S. housing boom. Issuers of CDOs turned their attention to subprime mortgage-
backed securities as a new source of collateral for CDOs.2

CDO Structure 

The tranches of CDOs are named to reflect their risk profiles; for example, senior debt,
mezzanine debt, and junior debt—pictured in the sample below along with their Standard
and Poor's (S&P) credit ratings . But the actual structure varies depending on the individual
product.

Investopedia / Sabrina Jiang

In the table, note that the higher the credit rating, the lower the coupon rate (rate of interest
the bond pays annually). If the loan defaults, the senior bondholders get paid first from the
collateralized pool of assets, followed by bondholders in the other tranches according to their
credit ratings; the lowest-rated credit is paid last.

The senior tranches are generally safest because they have the first claim on the collateral.
Although the senior debt is usually rated higher than the junior tranches, it offers lower
coupon rates. Conversely, the junior debt offers higher coupons (more interest) to
compensate for their greater risk of default; but because they are riskier, they generally
come with lower credit ratings.

14
 
Senior Debt = Higher credit rating, but lower interest rates. Junior Debt = Lower credit rating,
but higher interest rates.

CDOs and the Subprime Mortgage Crisis 

Collateralized debt obligations exploded in popularity in the early 2000s, when issuers began
to use securities backed by subprime mortgages as collateral. CDO sales rose almost
tenfold, from $30 billion in 2003 to $225 billion in 2006.3

A  subprime mortgage  is one held by a borrower with a low credit rating, which indicates that
they might be at a higher risk of default on their loan.
These subprime mortgages often had no or very low down payments, and many did not
require proof of income. To offset the risk lenders were taking on, they often used tools such
as adjustable-rate mortgages, in which the interest rate increased over the life of the loan.

There was little government regulation of this market, and ratings agencies were able to
make investing in these mortgage-backed securities look attractive and low-risk to
investors.4CDOs increased the demand for mortgage-backed securities, which increased
the number of subprime mortgages that lenders were willing and able to sell. Without the
demand from CDOs, lenders would not have been able to make so many loans to subprime
borrowers.5

Some banking executives and investors did realize that a number of the subprime mortgages
that backed their investments had been designed to fail. But the general consensus was that
as long real estate prices continued to go up, both investors and borrowers would be bailed
out.6However, prices did not continue to rise; the housing bubble burst and prices declined
steeply. Subprime borrowers found themselves underwater on homes that were worth less
than what they owed on their mortgages. This led to a high rate of defaults.7

The correction in the U.S. housing market triggered an implosion in the CDO market, which
was backed by these subprime mortgages. CDOs became one of the worst-performing
instruments in the subprime meltdown, which began in 2007 and peaked in 2009. The
bursting of the CDO bubble inflicted losses running into hundreds of billions of dollars for
some of the largest financial services institutions.8

These losses resulted in the investment banks either going bankrupt or being bailed out via
government intervention. This impacted the housing market, stock market, and other
financial institutions, and helped to escalate the global financial crisis, the Great Recession,
during this period.

Despite their role in the financial crisis, collateralized debt obligations are still an active area
of structured finance investing. CDOs and the even more infamous synthetic CDOs are still
in use, as ultimately they are a tool for shifting risk and freeing up capital—two of the
outcomes that investors depend on Wall Street to accomplish, and for which Wall Street has
always had an appetite.

Benefits of CDOs 

Like all types of assets, CDOs have benefits as well as drawbacks. Their role in the housing
bubble and the subprime mortgage crisis was the result of their main disadvantages:
complexity, which made them difficult to value accurately; and being vulnerable to repayment
risk, particularly from subprime borrowers.

However, there are also two main benefits:

 Diversification: Because the debt bundled in a CDO is spread over many

mortgages or other loans, investors are exposed to a range of risks. As long as not

15
 all the loans used as collateral are subprime loans, there is an element of
diversification in each CDO.
 Liquidity: A single bond or loan is a relatively illiquid asset for a bank to hold. A
CDO, however, turns those into liquid assets. Holding more liquid assets means
banks can expand their lending and generate more revenue.

How Are Collateralized Debt Obligations (CDO) Created?

To create a collateralized debt obligation (CDO), investment banks gather cash flow-
generating assets—such as mortgages, bonds, and other types of debt—and repackage
them into discrete classes, or tranches based on the level of credit risk assumed by the
investor. These tranches of securities become the final investment products, bonds, whose
names can reflect their specific underlying assets.

What Should the Different CDO Tranches Tell an Investor?

The tranches of a CDO reflect their risk profiles. For example, senior debt would have a
higher credit rating than mezzanine and junior debt. If the loan defaults, the senior
bondholders get paid first from the collateralized pool of assets, followed by bondholders in
the other tranches according to their credit ratings with the lowest-rated credit paid last. The
senior tranches are generally safest because they have the first claim on the collateral. 

What Is a Synthetic CDO?

A synthetic CDO is a type of collateralized debt obligation (CDO) that invests in noncash
assets that can offer extremely high yields to investors. However, they differ from traditional
CDOs, which typically invest in regular debt products such as bonds, mortgages, and loans,
in that they generate income by investing in noncash derivatives such as credit default
swaps (CDSs), options, and other contracts. Synthetic CDOs are typically divided into credit
tranches based on the level of credit risk assumed by the investor.

The Bottom Line 

A collateralized debt obligation (CDO) is a structured finance product that is backed by a

pool of loans and other assets. It can be held by a financial institution and sold to investors.
The tranches of a CDO tell investors what level of risk they are taking on, with senior having
the highest credit rating, then mezzanine, then junior. In the case of a default on the
underlying loan, senior bondholders are paid from the pool of collateral assets first and junior
bondholders last.

During the housing bubble in the early 2000s, CDOs held huge bundles of subprime
mortgages. When the housing bubble burst and subprime borrowers went into default at high
rates, the CDO market went into a meltdown. This caused many investment banks to either
go bankrupt or be bailed out by the government. Despite this, CDOs are still in use by
investment banks today.

What Is Warehousing in Investment Banking?

What Is Warehousing? 

Warehousing is an intermediate step in a collateralized debt obligation (CDO) transaction that involves

purchasing loans or bonds that will serve as collateral in a contemplated CDO transaction.
The warehousing period typically lasts three months, and it comes to an end upon closing of the
transaction when they are ultimately securitized and sold as part of the CDO.

KEY TAKEAWAYS

16
  Warehousing is the accumulation and custodianship of bonds or loans that will become
securitized through a CDO transaction.
 A collateralized debt obligation (CDO) is a complex structured-finance product that is backed
by a pool of loans and other interest-bearing assets.
 This intermediate step before the transaction is finalized typically lasts three months, during
which time the underwriting bank is subject to the risks involved in holding those assets.

Understanding Warehousing 

A CDO is a structured financial product that pools together cash flow-generating assets and repackages
this asset pool into discrete tranches that can be sold to investors. The pooled assets, comprising
mortgages, bond, and loans, are debt obligations that serve as collateral — hence the name
collateralized debt obligation. The tranches of a CDO vary substantially with their risk profile. Senior
tranches are relatively safer because they have priority on the collateral in the event of a default. The
senior tranches are rated higher by credit rating agencies but yield less, while the junior tranches
receive lower credit ratings and offer higher yields.

An investment bank carries out the warehousing of the assets in preparation of launching a CDO into
the market. The assets are stored in a warehouse account until the target amount is reached, at which
point the assets are transferred to the corporation or trust established for the CDO. The process of
warehousing exposes the bank to capital risk because the assets sit on its books. The bank may or may
not hedge this risk.

CDOs Gone Wild! 

In 2006 and 2007 Goldman Sachs, Merrill Lynch, Citigroup, UBS and others were actively
warehousing subprime loans for CDO deals that the market seemed to have an insatiable appetite for
— until it didn't. When cracks in the dam started appearing, demand for CDOs slowed, and when the
dam burst, holders of CDOs collectively lost hundreds of billions of dollars.

In a detailed chronicle of events laid out in a subcommittee report of the U.S. Senate, "Wall Street and
the Financial Crisis: Anatomy of a Financial Collapse," it was reported that Goldman "was acquiring
assets for several CDOs at once, [and] the CDO Desk generally had a substantial net long position in
subprime assets in its CDO warehouse accounts." In early 2007, the report continues, "Goldman
executives began to express concern about the risks posed by subprime mortgage-related assets in the
CDO warehouse accounts."

How Goldman subsequently handled these assets on its books and other dealings in CDOs is a topic for
another discussion, but suffice to say the bank ended up being charged with fraud and forced to pay
record fines. It happily took a taxpayer bailout and paid millions in bonuses to employees.

What Notching Debt Means to Credit Rating Agencies

What Is Notching? 

Notching is the practice by credit rating agencies to give different credit ratingsto the
particular obligations or debts of a single issuing entity or closely related entities.

Rating distinctions among obligations are made based on differences in their security or
priority of claim. With varying degrees of losses in the event of  default, obligations are
subject to being notched higher or lower. Thus, while company A may have an overall credit
rating of "AA," its rating on its junior debtmay be "A."

KEY TAKEAWAYS

 Notching is when a credit rating agency bumps up or down the credit rating on an
issuer's specific debts or obligations.

17
  This is different than a credit agency upgrading or downgrading the company or
issuer as a whole.
 Because certain types of debt—for instance, subordinated debts—are inherently
riskier than senior debts, the rating on junior debts can be notched lower.
 Similarly, those debts from the issuer that are senior and secured by collateral may
be notched higher.
 Debt notches are evaluated by comparing the individual credit ratings of two or more
bonds.

How Notching Works 

Companies are given credit scores by specialist credit rating agencies, which evaluate a
firm's creditworthiness and its ability to meet its debt payments and other obligations.
However, a company may also issue several types of debts (e.g., secured vs. unsecured) or
related types of obligations (such as preferred shares or convertible bonds). As a result, the
credit rating on those particular debts or obligations may differ somewhat from the issuing
company's overall credit rating due to unique risks or restrictions on those obligations.

Moody's Investors Service  ("Moody's) and Standard & Poor's Financial Services ("S&P") are
two major credit rating agencies that notch up or notch down instruments within the same
corporate family depending on placement in an obligor's capital structure and their level of
collateral.

The base from which an instrument is notched in either direction is an obligor's senior
unsecured debt (base = 0), or the corporate family rating (CFR). Notching also applies to the
structural subordination of debt issued by operating subsidiaries or holding companies,
according to S&P. As an example, the debt of a holding company of an enterprise could be
rated lower than the debt of the subsidiaries, the entities that directly own the enterprise's
assets and cash flows.

 
Notching is not a precise science and credit rating agencies may use different approaches to
determine the credit risk of bond and debt issuers. As a result, it is not uncommon for
different credit rating agencies to assign different credit ratings to the same issuer. 

Moody's Updated Notching Guidance 

In 2017, Moody's published an update to its 2007 notching methodology. This most recent
guidance indicated as "applicable in most cases" was as follows:12

 Senior secured debt: +1 or +2 notches above the base (0)

 Senior unsecured debt: 0
 Subordinated debt: -1 or -2
 Junior subordinated debt: -1 or -2
 Preferred stock: -2

In a small number of cases, Moody's will notch beyond the -2 to +2 range under one or more
of the following circumstances:

 An unbalanced capital structure results in a particular obligation comprising a very

small or large proportion of total debt.
 A legal regime is less predictable.
 There is extra complexity in the legal structure of a corporation.

Tranche Notching
Notching is not just used to evaluate the credit risk of bond and debt issuers. It is also used
to evaluate the credit risk of other types of financial instruments, such as structured finance

18
products, such as collateralized debt obligations (CDOs). CDOs are complex securities that
are backed by a pool of assets, such as mortgages or corporate bonds. The credit risk of a
CDO is determined by evaluating the credit risk of the assets that make up the pool. This
process is known as "tranche notching," and it involves assigning different credit ratings to
different  tranches  (or slices) of the CDO based on the level of subordination of the tranches.
Tranches that are more highly subordinated (i.e., ranked lower in the repayment hierarchy)
are considered to be more risky and are assigned lower credit ratings. Tranches that are
more senior (i.e., ranked higher in the repayment hierarchy) are considered to be less risky
and are assigned higher credit ratings.

Example of Notching 

Imagine that ABC Company has issued two corporate bonds: Bond A and Bond B. Bond A is
a senior bond, which means that it has a higher priority for repayment in the event of default
compared to Bond B. Bond B is a junior bond, which means that it has a lower priority for
repayment.

ABC Company's creditworthiness is evaluated by a credit rating agency, which determines

that the company has a strong financial profile and is likely to be able to make timely interest
and principal payments on both Bond A and Bond B. As a result, the credit rating agency
assigns ABC Company an A credit rating and assigns both Bond A and Bond B an A credit
rating as well.

However, over time, ABC Company's financial performance begins to deteriorate. It takes on
more debt and its profits decline, which raises concerns about its ability to meet its financial
obligations. As a result, the credit rating agency conducts a review of ABC Company's
creditworthiness and decides to downgrade the company's overall credit rating from A to
BBB.

In this case, the credit rating agency would use notching to express the difference in credit
risk between Bond A and Bond B. Since Bond A is a senior bond, it is considered to be less
risky than Bond B and is assigned a BBB+ credit rating. Bond B, on the other hand, is
considered to be more risky and is assigned a BBB- credit rating. The difference in credit risk
between Bond A and Bond B is expressed as two notches, with Bond A having a higher
credit rating (and a lower notch) than Bond B.

19
Bond Notches.
Image by Sabrina Jiang © Investopedia 2021

What Is a Notch in Bond Rating?

In bond trading, a notch is a measure of the difference in credit risk between two bonds,
usually issued by the same issuer. It is calculated by taking the difference in the credit
ratings of the two bonds and expressing it in terms of notches. For example, if one bond has
a credit rating of A- and another bond has a credit rating of BBB+, the difference in credit risk
between the two bonds would be expressed as one notch.

Why Is Notching Important?

Notching is important because it helps investors to make informed decisions about the
creditworthiness of the various bonds and debt instruments issued by the same issuers by
using easy to understand ratings, grades, or scores. By understanding the likelihood of
default, investors can determine the level of risk they are willing to take on when investing in
a particular bond or debt issuer. This is especially important for investors who are
considering purchasing high-yield bonds, as these bonds are generally considered to be
more risky than investment-grade bonds. Notching can also be used by bond and debt
issuers to determine their own creditworthiness, as it can help them to identify any areas
where they may need to improve their financial health in order to attract investors.

What Is a Notch Downgrade?

A notch downgrade is a decrease in the credit rating of a particular bond from a debt issuer.
It is expressed in terms of notches, with each notch representing a difference in credit risk.
For example, if a bond issuer's credit rating is downgraded from A- to BBB+, the downgrade
would be expressed as one notch.

20
A notch downgrade can occur when the creditworthiness of the bond or debt issuer
deteriorates. This can be due to a variety of factors, including declining financial
performance, increased debt levels, or changes in market conditions that affect the issuer's
ability to meet its financial obligations. A notch downgrade can have significant implications
for the issuer, as it may make it more difficult for the issuer to access funding in the future
and may also lead to an increase in the issuer's borrowing costs. It can also have negative
consequences for investors in the issuer's bonds, as a downgrade may indicate an
increased risk of default and may lead to a decrease in the value of the bonds.

What Is Subordination-Based Notching?

Subordination-based notching is a method of rating the credit risk of bond or debt issuers
based on the level of subordination of the issuer's debts. Subordination refers to the ranking
of debts in terms of priority for repayment in the event that the issuer becomes bankrupt or is
unable to meet its financial obligations. Debts that are ranked higher in the subordination
hierarchy are considered to be more senior and are more likely to be repaid in the event of
default.

Subordination-based notching is used to determine the credit rating of an issuer by taking

into account the level of subordination of the issuer's debts. For example, an issuer with
highly subordinated debts (i.e., debts that are ranked lower in the subordination hierarchy)
may be assigned a lower credit rating than an issuer with more senior debts. This is because
the issuer with highly subordinated debts is considered to be at a higher risk of default, as it
is less likely to have the financial resources available to meet its obligations. Subordination-
based notching is often used in the evaluation of structured finance instruments, such
as collateralized debt obligations (CDOs).

The Bottom Line 

Notching is the process of rating the credit risk of the various bonds from the same debt
issuer, such as a company or a government, using discrete rating levels, or notches. So, if a
company issues several bonds, not every one may receive the same credit rating based on
its relative riskiness, terms, features, subordination, and clauses. It is used to determine the
likelihood that the issuer will default on its debt obligations. Notching can be used to
determine the credit rating of an issuer, which is a measure of the issuer's ability to make
timely interest and principal payments. Notching can also be used to determine the risk
premium that investors should demand for taking on the risk of investing in the bond or debt
issuer.

What are the 4 structured products?

a. Structured Deposits
 Baskets of stocks.
 Single or multiple stock market indices and exchange traded funds.
 Currencies.
 Interest rates.

In review: structured products law in Luxembourg

Legal and regulatory framework

i Prospectus Regulation
Structured products issuers and distributors will inevitably need to have regard to the
provisions of the Prospectus Regulation. 9 This Regulation embeds the principles laid down by
the International Organization of Securities Commissions (IOSCO) and is implemented in

21
Luxembourg by the Prospectus Act.10 A prospectus compliant with the Prospectus Regulation
is required when securities are offered to the public or listed on a regulated market within the
sense of MiFID II, or both.11 The Luxembourg competent authority to approve such
prospectuses is the Commission de Surveillance du Secteur Financier (the CSSF), which is
the regulator of the financial sector in Luxembourg. The CSSF accepts prospectuses in four
languages, notably English, German, French and Luxembourgish and is perceived to be a
sensible regulator with a vast experience in dealing with capital markets matters in Europe.

Luxembourg has taken advantage of the implementation flexibilities of the prospectus

exemptions under the Prospectus Regulation. A prospectus does not need to be drawn up for
offers to the public below €8 million over a 12-month period. Nonetheless, for public offers
above €5 million, an information notice needs to be published. Most recurrent structured
products issuers will not remain below the minimum thresholds and will not benefit from this
exemption.

Irrespective of the size of the offer, market participants commonly rely on further independent
exemptions to publishing a prospectus. In particular, offers of securities only to qualified
investors within the meaning of the Prospectus Regulation, to fewer than 150 investors or
with a denomination of at least €100,000 (or foreign currency equivalent), are not subject to
the obligation to publish a prospectus.

Structured product issuers who need to draw up a prospectus will, in most cases, establish a
programme with a base prospectus. A base prospectus containing overarching disclosures
and product descriptions is likely to be more cost-efficient for frequent issuers compared to
the use of a stand-alone prospectus for each issuance. However, a base prospectus is
unlikely to be able to foresee and disclose all contemplated permutations from the outset.
Therefore, certain complex structured products such as specific basket credit-linked
instruments will require additional disclosures and collateral descriptions to be made in a
drawdown prospectus, leveraging on the content of an existing base prospectus.

ii PRIIPs
Where the relevant structured products qualify as packaged retail and insurance-based
investment products (PRIIP) under the PRIIPs Regulation 12 and are offered to retail investors,
a key information document (KID) needs to be drawn up and published. A KID is a concise
document setting out the key risks and features of the product in a language comprehensible
for retail investors. The obligation to draw up a KID is incumbent upon the 'manufacturer' (as
the term is defined in the PRIIPs Regulation) of structured products. Any person who sells or
advises the product must make the KID available to retail investors in good time before such
investor is bound. Investment advisers and distributors must pay attention to their obligations
in this respect. Structurers and issuers, among others, must make sure their KID is prepared
in time to avoid delaying the issuance.

iii Securitisation Act

As mentioned above, a plethora of structured products are issued by SVs. The Securitisation
Act has been a pillar of the Luxembourg structured product market for nearly two decades. To
date, it has attracted arrangers and issuers with the balance between product flexibility and
legal robustness. Statutory segregation of assets and liabilities through compartments and
legal recognition of limited recourse and non-petition provisions have convinced many
structurers to make Luxembourg their jurisdiction of choice. 

The SVs can either take the form of a securitisation company or a securitisation fund without
legal personality, represented by a management company. 

SVs are generally set up in the form of a securitisation company which can take the form of a
public limited liability company, a private limited liability company, a partnership limited by

22
shares or a cooperative company organised as a public limited liability company. Historically,
public limited liability companies dominated the SV landscape because certain restrictions
applied to private limited liability companies with respect to issuing bonds to the public.
Following a reform of the Luxembourg legislation on commercial companies in 2016, there
are very few relevant distinctions left between the two forms and the use of private limited
liability companies has been on the rise.

SVs can be regulated or unregulated. The Securitisation Act requires an SV to be regulated

when it issues financial instruments to the public on a continuous basis. In that case, the SV
will need to apply for a licence to have its activities and framework supervised by the CSSF. At
the time of writing, there are 29 securitisation undertakings supervised by the CSSF, and the
vast majority of SV remains unregulated. In this context, out of these 29 securitisation
undertakings, a large number constitute platforms for the issuance of structured products (as
against more traditional securitisations).

The concept of 'issuing securities to the public on a continuous basis' under the Securitisation
Act is not to be confused with the 'issuance of securities to the public' under the Prospectus
Regulation. Under the Securitisation Act the criteria of continuity and offer to the public are
cumulative. The Securitisation Act provides that issuances are deemed to be made 'on a
continuous basis' when there are more than three issuances per year. Issuances are not
deemed to be made to the public when the denomination per unit of the financial instruments
is at least €100,000 or if the financial instruments are offered to professional investors only.
Therefore, a retail programme involving an SV is likely to trigger the above-mentioned
licensing requirement. Some structured product issuance platforms are designed in such a
way that the criteria for continuous issuance of financial instruments to the public are not met
so as to avoid separate licensing procedures.

SVs subject to the Securitisation Act must limit their activities to conducting securitisation as
determined in the Securitisation Act. Securitisation is defined under the Act as a transaction
whereby a securitisation undertaking acquires or assumes, directly or through another
undertaking, risks relating to claims, other assets or obligations assumed by third parties or
inherent in all or part of the activities of third parties, and issues financial instruments or
contracts, for all or part of it, any type of loan, whose value or yield depends on those
risks.13 The type of instruments that can be issued and the type of underlying assets that can
be used are very broad and are deliberately construed as such to grant flexibility as to the
operations SVs can undertake.

One of the main features of the Securitisation Act is that issuances of instruments by an SV
can be segregated into distinct compartments created by its board of directors or managers.
Each compartment forms a separate estate of the SV having its own assets and liabilities,
segregated from all other compartments of the SV. The Securitisation Act foresees statutory
limited recourse with respect to such compartments. Therefore, investors in structured
products issued by one compartment will not have any rights with regard to the structured
products issued by another compartment of the SV, which is a major driver for opting for an
SV under the Securitisation Act as issue vehicle for multi-compartment platforms. 

The Securitisation Act further allows for the constitutional document and offering
documentation to hardwire non-petition language into the issue documentation pursuant to
which all parties contracting with the SV accept not to commence any winding-up, liquidation
or bankruptcy proceedings against the SV, in particular when the assets in a compartment are
insufficient to satisfy their claims. A creditor initiating proceedings in breach of these
provisions will in principle find his or her claim declared inadmissible by a Luxembourg court
based on the provisions of the Securitisation Act.

23
To enhance the insolvency remoteness, most SVs on the Luxembourg market will be
structured as orphan vehicles. That means that the equity of the SV will be held by a trust or
charitable foundation (often a Dutch stichting) to minimise the risk of adverse shareholder
decisions and the insolvency of the holding company or financial group arranging the vehicle
(which in various cases will be credit institutions).

In some jurisdictions, there may be uncertainty as to whether structured products issuances

and structures fall within the remit of AIFMD. 14 The pragmatic position of the Luxembourg
financial regulator is very clear in this respect. In addition to the exemptions available under
AIFMD, the CSSF has, in its CSSF FAQ Securitisation, determined to what extent securitisation
undertakings can qualify as AIFs. Pursuant to this guidance, SVs exclusively issuing debt
instruments should not be considered to be AIFs. In the CSSF's view it was not the intent of
the European legislator to capture such instruments as they do not represent an ownership
interest in the securitisation undertaking. 15 Although this view was expressed in respect of
SVs, it can be extrapolated to other Luxembourg issuing vehicles as well. Where nonetheless
the constitutive elements of an AIF need to be further analysed, the CSSF states that in
respect of an investment policy, SV issuing structured products offering a synthetic exposure
to assets, such as, for example, shares, indices or commodities, based on a pre-established
formula, and that either or both of acquiring underlying assets and entering into swap
agreements with the sole purpose of hedging their payment obligations under the issued
structured products may be considered as not being managed according to an 'investment
policy'. Accordingly, these vehicles would not be considered as being managed according to
an 'investment policy' within the meaning of the AIFMD and hence not qualify as an AIF. 16

iv BRRD credit institutions

Credit institutions are not only active in the structured products market via their off-balance
sheet programmes through their SVs, but do issue a vast number of structured products from
their own on-balance sheet. These structured products are typically senior instruments issued
by the institution rather than any form of regulatory capital product. Of course, these
instruments may, in line with the European bank insolvency legislation adopted in the
aftermath of the financial crisis, potentially be subject to bail-in measures and write-down and
conversion mechanisms deriving from the Act dated 18 December 2015 on the failure of
credit institutions and certain investment firms (the BRR Act 2015), implementing the
BRRD.17In Luxembourg, the CSSF is the supervisory authority for credit institutions and the
competent authority under the BRR Act 2015.

v Fiduciary capacity and instruments

Credit institutions and SVs also make wide use of the Fiduciary Act to issue structured
products. The Fiduciary Act permits such entities to establish segregated fiduciary estates.
Fiduciary estates are booked off balance sheet and represent a separate pool of assets and
liabilities from the own assets of the fiduciary and any other fiduciary estates it has created.

Where structured products are issued by a credit institution or SV pursuant to the Fiduciary
Act, the entity acts as fiduciary and on a fiduciary basis (the Fiduciary). Each structured
product issued under the Fiduciary Act must be governed by Luxembourg law. Pursuant to the
Fiduciary Act, a structured note evidences the existence of a Fiduciary contract between the
holder of such product and the Fiduciary. The Fiduciary is considered the legal owner of the
fiduciary assets but it holds such assets for the sole and exclusive benefit of the structured
product holder(s). The fiduciary contract embeds the terms and conditions of the relevant
structured product ensuring that the product functions as intended.

The fiduciary construct may have a different tax treatment to where credit institutions or SVs
would not act on a fiduciary basis. Structurers do have a keen interest in this legal framework
as it allows combining the segregation of assets and liabilities with alternative tax treatments
which may be required by investors. Depending on the terms and conditions of the fiduciary

24
contract, assets that are legally owned by the Fiduciary may be allocated to the structure
product holders for tax purposes.

vi Benchmark Regulation
The Benchmark Regulation applies to issuers of structured products when using benchmarks
and indices for their structured products. Issuers will need to ensure that there are robust
fallback methods in place in case the relevant benchmark can no longer be utilised. In light of
the ongoing interbank offered rate (IBOR) reforms, the CSSF will take into account the
recommendations of the relevant IBOR working groups and regulatory bodies when reviewing
prospectuses. The CSSF recommends not to continue using benchmarks that are imminently
discontinued during the validity of the prospectus or are no longer recommended to be used
in their relevant market.

Issuers using proprietary indices outside the scope of the Benchmark Regulation for their
structured products are subject to particular disclosure requirements as and when they seek
approval of their prospectuses.

vii Court decisions

Luxembourg courts have rendered decisions with regard to structured products legislation
and product governance rules. However, there is no recent major publicly available case law
issued by the Luxembourg courts in this respect.

In review: securitisation law and regulation in Luxembourg

On 22 March 2004, the Luxembourg Act of 22 March 2004 on Securitisation (the

Securitisation Act) came into force, providing the general framework for securitisation
transactions. Ever since, the Grand Duchy of Luxembourg has been a major market
participant and a significant European hub for securitisation transactions, mainly because of
its flexible and innovative legal and regulatory framework and favourable tax regime.
According to the European Central Bank's statistics, approximately 30 per cent of the
European securitisation transactions are performed via Luxembourg (as of 31 December
2021). On 9 February 2022, the Luxembourg parliament adopted Law No. 7825 (the Law)
amending, among others, the Securitisation Act. It had been long awaited by market
participants and was prepared to take account of the requirements of a changing market, to
implement the EU Securitisation Regulation 2 and to provide for even more flexibility to
structure and collateralise securitisation transactions, among others.3

The number of active Luxembourg securitisation undertakings has been constantly growing
since the entry into force of the Securitisation Act, with approximately 1,370 active
securitisation undertakings as at May 2022, which between them have more than 6,000
compartments and represent more than €381 billion 4 in total assets under management.

Pursuant to the Securitisation Act, a securitisation undertaking may be set up either as a

securitisation company5 or as a securitisation fund that has no legal personality, consists of a
co-ownership of assets and is represented by a management company.

The private limited liability company is the most commonly used form of securitisation
undertakings. We estimate that less than 75 active securitisation funds exist at the time of
writing.

Only securitisation undertakings issuing financial instruments to the public on a continuous

basis are subject to the supervision of the Luxembourg financial regulatory authority (CSSF).

25
At the time of writing, only 29 securitisation undertakings were regulated. Both regulated and
unregulated securitisation undertakings benefit from the provisions of the Securitisation Act.

Deliberately broad in its scope of application, the Securitisation Act defines securitisation as
the transaction whereby a securitisation undertaking acquires or assumes, directly or through
another undertaking, risks relating to claims, other assets or obligations assumed by third
parties or inherent in all or part of the activities of third parties, and issues financial
instruments or enters into any type of loan agreements, whose value or yield depends on
those risks.6 Compared with other jurisdictions or legislation at an EU level, the definition of
securitisation is less restrictive in Luxembourg. The EU Securitisation Regulation, for instance,
only applies to securitisation transactions in which a credit risk associated with an exposure
or a pool of exposures is tranched.

The EU Securitisation Regulation was developed in the aftermath of the subprime crisis, as
part of the package of regulatory reforms for securitisation under the EU capital markets
union action plan, to foster investor protection in the European Union. It entered into force on
17 January 2018 and has applied in general since 1 January 2019 (subject to certain
grandfathering provisions). It lays down a general framework for securitisation and creates a
specific framework for simple, transparent and standardised (STS) securitisation.
Furthermore, the EU Securitisation Regulation provides for the following:

1. risk retention obligations for the sponsor, originator or original lender;

2. disclosure requirements to the investors and the competent authority regarding the
underlying assets; and investor-specific due diligence regimes and suitability tests.

At the time of writing, only 37 issuances by a Luxembourg securitisation undertaking

qualifying as STS securitisation are registered.

The asset classes that are securitised in the Luxembourg securitisation market are mainly
auto and mortgage loans, debt securities, equity (including fund units) and trade receivables.
The acquisition of the underlying assets is typically financed via the issuance of debt
securities. Most of the securities issued by regulated securitisation undertakings consist of
structured products, the performance of which is linked to indices or swaps.

On 21 December 2018, the law implementing the Anti-Tax Avoidance Directive 1 (the ATAD 1
Law)7 was published. The ATAD 1 Law applies for fiscal years starting on or after 1 January
2019 and has introduced interest deduction limitation rules (IDLRs) into the Luxembourg tax
framework, which may limit the deductibility of exceeding borrowing costs (see Section II.vii)
at the level of a securitisation company.8

Regulation

i Luxembourg securitisation regime

For the Securitisation Act to apply, the securitisation undertaking must, in respect of each
compartment under which it carries out a securitisation transaction, acquire or assume risks
relating to claims, other assets or obligations assumed by third parties or inherent in all or
part of the activities of third parties and must issue financial instruments or enter into any
type of loan agreement, for all or part of it, 9 whose value or yield depends on those risks.
Consequently, on the liability side, it will issue equity or debt securities or borrow funds, and
on the asset side, it will acquire or assume risks.

The regime of the Securitisation Act covers all types of assets. It is important, however, to
ensure that the securitisation undertaking does not, in principle, generate its own risk and act
as entrepreneur, but instead acquires or assumes risks generated by third parties or relating

26
to assets of third parties. Generating and securitising own risks could be considered a
transaction that is not a securitisation in the sense of the Securitisation Act.

ii Regulated securitisation undertakings

A securitisation undertaking that is subject to the Securitisation Act must be authorised by
the CSSF and obtain a licence if it issues, financial instruments to the public on a continuous
basis (these two criteria apply cumulatively). An issue of financial instruments is not deemed
to be made to the public if the denomination is at least €100,000 or if it is offered to
professional clients only.10 A securitisation undertaking is deemed to issue financial
instruments on a continuous basis if issuing more than three times per year. The question of
whether a vehicle issues financial instruments to the public on a continuous basis would have
to be assessed at the level of the vehicle with all compartments combined.

The status of a regulated securitisation undertaking implies prudential supervision by the

CSSF and the requirement to keep its liquid assets in custody with a Luxembourg credit
institution.

iii Securitising loans

A Luxembourg securitisation undertaking can carry out the securitisation of existing loans
with a fixed interest rate and fixed repayment date or with a floating or variable interest rate
(known as profit participation) under the Securitisation Act provided that the investor in the
instrument issued by the securitisation undertaking to finance the acquisition of the loans is
not linked to the borrowers under those loans (in accordance with the prohibition against
intra-group securitisation transactions). As explained in Section II.v, Luxembourg
securitisation undertakings benefit from a carve-out from the Luxembourg Act of 5 April 1993
on the Financial Sector, as amended (the Banking Act), and therefore do not require a licence
to carry out securitisation activity under Luxembourg law. If securitising loans, however, it
should be clarified whether there are any licensing requirements in the jurisdictions where the
borrowers are located or under the governing laws of the loans to be securitised.

iv Financial statements and auditing

A securitisation undertaking subject to the Securitisation Act must always appoint a statutory
auditor chartered in Luxembourg who is in charge of auditing the securitisation undertaking's
annual financial statements.

Annual financial statements are established at the end of the securitisation undertaking's
financial year. Those financial statements will provide for information on the assets of each
of the securitisation undertaking's compartments, as well as consolidated accounts of the
securitisation undertaking and will be made available to investors. 11

v Banking Act
The Banking Act, which regulates credit institutions and other professionals in the financial
sector, contains a specific carve-out for securitisation undertakings.

vi Alternative Investment Fund Managers Directive

Directive 2011/61/EU on alternative investment fund managers (AIFMD), which was designed
to regulate all entities that manage arrangements or entities covered by the term 'alternative
investment fund' (AIF), has been implemented in Luxembourg pursuant to the Luxembourg
Act of 12 July 2013 on Alternative Investment Fund Managers (the AIFM Act). There are a
number of arguments to the effect that a securitisation undertaking would not be caught by
the AIFMD (although the analysis would have to be effected in respect of each compartment
of the securitisation undertaking, and a transaction carried out under one compartment may
have an impact on the overall status of the securitisation undertaking).

In line with the AIFMD, the AIFM Act contains an exemption for securitisation special purpose
entities (SSPE), which are defined in the AIFM Act as entities that have the sole purpose of

27
carrying out securitisations within the meaning of Article 1(2) of the European Central Bank's
Regulation (EC) No. 24/2009, provided, however, that:

1. first lenders (i.e., lenders securitising loans that they themselves have granted and
that issue notes to finance their securitisation activities) are not considered ad hoc
securitisation vehicles, since no asset (and hence no credit risk) is transferred to or
purchased by that entity; and

2. securitisation vehicles issuing structured products that primarily offer a synthetic

exposure to assets other than loans (non-credit-related assets) do not benefit from
the foregoing exclusion.

Regardless of whether or not the vehicle qualifies as an SSPE, the CSSF has, in its revised set
of frequently asked questions on securitisation, specified that securitisation undertakings
issuing only debt instruments shall not be considered AIFs and thus shall fall outside the
scope of the AIFM Act.

In the event that a securitisation undertaking cannot rely on any of the above-mentioned
exclusions, it could potentially be considered an AIF. If a Luxembourg securitisation
undertaking is subject to the provisions of the AIFM Act, one consequence is the requirement
to designate an AIF manager for the purpose of managing the securitised assets. Depending
on the type and amount of assets under management, the board of directors of the
securitisation vehicle may itself act as internal AIF manager, or the securitisation vehicle has
to appoint a fully licensed external AIF manager. A fully licensed AIF manager is required to
appoint a depositary in relation to securitised assets. This will inevitably result in an increase
in the fees, costs and expenses of a Luxembourg securitisation undertaking, payable to
various parties.

vii Tax aspectsTax aspects applicable to a securitisation companyCorporation tax

A securitisation company is a fully taxable Luxembourg company. As such, it is subject to
corporate income tax at a rate of 17 per cent, municipal business tax at a rate of 6.75 per cent
(in Luxembourg City (the rate varies from one municipality to another)) and a contribution to
the unemployment fund of 7 per cent. The overall combined corporation tax burden thus
currently stands at 24.94 per cent (in Luxembourg City).

The securitisation company is assessed based on its global profits, after deduction of
allowable expenses and charges, determined in accordance with Luxembourg general
accounting standards (subject to certain fiscal adjustments) and subject to the provisions of
applicable tax treaties. Expenses that relate to an item of income that is not taxable in
Luxembourg are not deductible for tax purposes.

However, the Securitisation Act provides for specific rules applying to a securitisation
company in relation to tax deductibility. The Securitisation Act states that the obligations
assumed by a securitisation company towards the investors (including shareholders) and any
other creditors are to be considered tax deductible expenses. In other words, a securitisation
company should be able to deduct any payments due or made to any investors, or to any
other creditors, from its taxable profits, subject to the IDLRs, which have recently been
introduced into Luxembourg tax law under the ATAD 1 Law (see 'IDLRs' below).

Investors may generally hold either equity or debt securities issued by a securitisation
company. Therefore, any payments to the investors (whether they hold shares or notes issued
by a securitisation company), whether in the form of dividends or interest, as well as any
commitments to the investors, whether in the form of due and unpaid dividends or accrued
and unpaid interest (regardless of the actual date of payment), will be deductible for tax
purposes, subject to the IDLRs.

28
To the extent the IDLRs do not negatively impact the securitisation company, a securitisation
transaction entered into by a securitisation company should not give rise to any corporation
tax burden in Luxembourg, if properly structured (i.e., if it is ensured that, during each financial
year, any income realised by a securitisation company may be offset by corresponding
deductible expenses, including interest paid or accrued to the investors under the debt
securities it has issued). The Luxembourg tax authorities do not require a securitisation
company to realise any minimum profit margin that would be subject to tax.

IDLRs
The IDLRs have been introduced into Luxembourg tax law pursuant to the requirements under
the ATAD 1 Law, which themselves are largely based on the work realised by the Organisation
for Economic Co-operation and Development and the G20 in the context of the base erosion
and profit shifting project, specifically on the 'Limiting Base Erosion Involving Interest
Deductions and Other Financial Payments, Action 4 – 2016 Update'.

The IDLRs have been applicable since 1 January 2019 with respect to accounting years
starting on or after 1 January 2019 (subject to the grandfathering clause 12). The IDLRs provide
that taxpayers are only able to deduct 'exceeding borrowing costs'13 up to the higher of €3
million and 30 per cent of the taxpayer's earnings before interest, tax, depreciation and
amortisation (EBITDA).

For the purposes of the IDLRs, EBITDA is adjusted according to tax criteria and thus
corresponds to net income, as increased by the adjusted amounts for exceeding borrowing
costs, depreciation and amortisation. Tax-exempt revenues, as well as expenses related to
such revenues, are excluded from EBITDA.

The ATAD 1 Law also contains a carve-out for loans used to fund long-term infrastructure
projects and financial undertakings. Financial undertakings are defined broadly, in particular
to (currently still) include SSPEs as defined under Regulation (EU) 2017/2402. Following
scrutiny from the EU Commission, the carve-out for SSPEs will be deleted from Luxembourg
tax law with effect as of 1 January 2023. Luxembourg has also provided the option (at
request) to deduct the entire amount of a taxpayer's exceeding borrowing costs if the
taxpayer is a member of a consolidated group for accounting purposes and, among other
conditions, it can demonstrate that the ratio of its equity over total assets (with a tolerance of
2 per cent) is equal to or higher than the equivalent ratio of the group based on the
consolidated financial statements.

Finally, Luxembourg has opted for the full deductibility of borrowing costs for standalone
entities, as defined in the ATAD 1 Law.

Net wealth tax

The Securitisation Act fully exempts securitisation companies from net wealth tax. 14

Withholding tax
There is no withholding tax on interest payments or on dividends paid by a securitisation
company.

Tax analysis of a securitisation fundCorporation taxes, withholding tax and net wealth tax
The Securitisation Law provides that a securitisation fund is subject to the same tax regime
as a collective investment fund in the form of a mutual fund. Therefore, it should generally be
treated as transparent for Luxembourg tax purposes. Consequently, it should not be subject
to Luxembourg corporation taxes, withholding tax or net wealth tax.

IDLRs
The IDLRs should not adversely impact the securitisation fund itself, given its tax transparent
status under Luxembourg tax law. Indeed, a securitisation fund is not itself subject to

29
Luxembourg corporation taxes, and therefore does not rely on deductibility, for tax purposes,
of interest paid under the debt securities it issues to reduce its tax base in Luxembourg.

What is SEC Rule 434 structured products?

SEC Rule 434 (Prospectus Delivery Requirements in Firm Commitment Underwritten
Offerings of Securities for Cash) 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 ...

What is the CSSF Luxembourg transparency law?

Pursuant to the Law of 11 January 2008 on Transparency requirements for issuers (the
“Transparency Law”), the CSSF is monitoring that financial and non-financial information 

Enforcement of the 2022 annual reports published by issuers subject to the Transparency Law

Topics and issues that will be the subject of a specific monitoring in 2023

Pursuant to the Law of 11 January 2008 on Transparency requirements for issuers (the “Transparency
Law”), the CSSF is monitoring that financial and non-financial information published by issuers is
drawn up in compliance with the applicable reporting frameworks.

As issuers are now preparing their reporting for the 2022 financial year, the CSSF wishes to draw the
attention of those issuers preparing their financial statements in accordance with IFRS and/or their non-
financial report in accordance with the Law of 23 July 2016 1, as well as of their auditors, to a number
of topics and issues that will be the subject of a specific monitoring during the CSSF’s enforcement
campaign planned for 2023.

European Common Enforcement Priorities

As in previous years, the European Securities and Markets Authority (“ESMA”), together with the
European national accounting enforcers, including the CSSF, identified European common
enforcement priorities (the “ECEPs”) for the 2022 annual reports to which particular attention will be
paid when monitoring and assessing the application of the relevant reporting requirements. ESMA
issued on 28 October 2022 a public statement which presents these 2022 ECEPs. That document is
available on the CSSF website under Enforcement of financial information.

The 2022 ECEPs related to IFRS financial statements focus on the following topics:

1. Priorities related to IFRS Financial Statements

1.1. Priority 1: Climate-related matters

30
This ECEP is articulated around four areas of focus: i) consistency between IFRS financial statements
and non-financial information; ii) impairment of non-financial assets; iii) provisions, contingent
liabilities and contingent assets; and iv) power purchase agreements.

As climate-related matters were already identified as an ECEP for the 2022 campaign, the CSSF
carried out focused examinations of the 2021 financial and non-financial information of issuers for
which significant climate-related risks were identified.

The results of this review highlighted that this priority remains particularly relevant for 2022 annual
reports. Therefore, in order to address this first priority, the CSSF will tailor its review procedures in
view of addressing both the aspects covered by this ECEP and the follow-up of the observations made
during its 2022 campaign thereon.

The CSSF recalls that, in the given context, boilerplate disclosures on climate related topics are not
what is needed by users of the financial statements. They require specific and relevant information on
how climate risks have been factored in the financial statements.

It goes without saying that the CSSF supports the ESMA recommendation to group these disclosures
into one single note or, at least, to make this information easily accessible by providing a mapping of
where different notes address climate-related matters.

1.2. Priority 2: Direct financial impacts of Russia’s invasion of Ukraine

In its statement on implications of Russia’s invasion on half-yearly financial reports published in May
2022, ESMA reminds issuers of the following requirements and/or points of attention: i) presentation
of the impacts of Russia’s invasion in the financial statements; ii) loss of control, joint control or the
ability to exercise significant influence; iii) discontinued operations, non-current assets and disposal
groups held for sale; and iv) impairment of non-financial assets.

For issuers affected by this issue, it is absolutely necessary to present clear and detailed qualitative and
quantitative information on the financial impacts, both at the balance sheet and comprehensive income
levels, as well as the judgments and assumptions made.

1.3. Priority 3: Macroeconomic environment

ESMA and the national enforcers observe that the current macroeconomic environment pose
significant challenges to issuers and their operations. As indicated in the ECEP statement, the main
elements to be considered cover the increase in inflation, interest rates and energy costs, due to the fact
that all such issues have an effect on the current business climate and present risks to the activity and
financial situation of issuers.

Therefore, issuers are required to assess and reflect the impacts that the macroeconomic environment
and uncertainties will have on their financial statements, and provide clear and detailed disclosures to
ensure that investors obtain relevant, accurate and timely information.

In that context, four areas were identified on which national enforcers will focus for the enforcement of
2022 IFRS financial statements: i) impairment of non-financial assets; ii) employee benefits; iii)
revenue from contracts with customers; and iv) financial instruments.

When reviewing these areas, the CSSF will pay particular attention on how the following subjects have
been considered by issuers:

Discount rate 

Considering the environment of high inflation in Europe for the first time since 2011, the European
Central Bank’s Governing Council increased interest rates in July 2022. This rise has been followed by
three subsequent increases in September, November and December 2022. These decisions have a
significant impact for issuers notably regarding a potential impairment of non-financial assets. Indeed,
when the recoverable amount is based on discounted cash flows to determine either the value in use or
the fair value less costs of disposal, one of the major assumptions is the discount rate which determines
the present value of future cash flows.

31
The rise in interest rates will impact the long-term risk-free rates. All other things being equal, an
increase in the risk-free rate and, by implication, the discount rate, leads to a decrease in the
recoverable amount and, consequently, an increased risk that individual assets (or cash-generating
units) are impaired.

Inflation 

Harmonised Index of Consumer Prices (HICP) increased to 10.1% in November 2022 in the euro area
and inflation reached records. This high level of inflation affects issuers in different ways.

Indeed, depending on the price elasticity of demand for issuers’ products and services, some companies
can pass along the increased costs to customers while others must absorb the higher costs of energy and
raw materials. Moreover, even if issuers can increase their prices, the volume of sales and activity
could nonetheless be affected by the decrease in purchasing power of their customers.

In these circumstances, the CSSF asks issuers to disclose, in their management report or financial
statements, sufficient information explaining how inflation affects their business. This means that
issuers should present the impact of inflation on their profits, margins, liquidity as well as on their
overall level of activity and explain how the forecasts have been revised to take into consideration the
surge in prices.

Finally, we also ask issuers to assess the effect of this new environment, in combination with the rise in
interest rates, when applying notably the following standards (in addition to those mentioned in the
ESMA statement):

 IAS 1 Presentation of Financial Statements (notably when reviewing judgments and

estimates, going concern assessment…)
 IAS 2 Inventories (notably when assessing the net realisable value)
 IAS 10 Events after the Reporting Period (as high inflation could lead to major events after
the reporting period);
 IAS 12 Income Taxes (when assessing deferred tax assets for instance);
 IAS 37 Provisions, Contingent Liabilities and Contingent Assets (notably when assessing the
risk of contracts becoming onerous);
 IFRS 2 Share-based Payment (as risk-free rates and volatility are assumptions used in pricing
models);
 IFRS 13 Fair Value Measurement (impacts where models consider inflation and interests
rates);
 IFRS 16 Leases (notably for incremental borrowing rate, exercise of lease extension, variable
lease payment based on consumer price index…).

2. Priorities related to non-financial Statements

In its communication, ESMA also sets priorities in relation to the requirements of the Non-Financial
Reporting Directive (the “NFRD”) for the 2022 annual reports.

2.1. Priority 1: Climate-related matters

ESMA recalls that beyond the consistency of financial and non-financial information and further to the
IFRS requirements as described in priority 1.1, non-financial statements shall include information on
the impact of climate change in application of the NFRD and in anticipation of the requirements of the
future European Sustainability Reporting Standards that will apply with the forthcoming Corporate
Sustainability Reporting Directive (the “CSRD”).

In 2021, the CSSF carried out a thematic review to examine the status of climate-related information
reported by issuers. That review was based on the recommendations made by the guidance on non-
financial reporting as issued by the European Union for companies on how to report the impacts of
their business on the climate and the impacts of climate change on their business.

As the review largely covered the different disclosure requirements of the Law of 23 July 2016, it
confirms that the current areas of attention pointed out by the ECEP for the 2023 campaign are largely

32
justified. Therefore, the CSSF expects significant progress to be made on this topic in the 2022 non-
financial information.

2.2. Priority 2: Disclosures relating to Article 8 of the Taxonomy Regulation

2023 marks a major step for the reporting under Article 8 of the Taxonomy Regulation. Indeed, the
financial year 2022 is the first year for which non-financial undertakings are required to disclose not
only the taxonomy eligibility, but also the alignment of their economic activities with climate change
mitigation and adaptation objectives as provided by the Taxonomy Regulation.

As mentioned in its report released on 26 October 2022, the CSSF will continue to examine the
information published under Article 8 of the Taxonomy Regulation by issuers that are covered by that
regulation, and will also challenge issuers on the outstanding issues and recommendations made in the
above-mentioned report and resulting from the observations made by the CSSF in 2022.

Further to the guidance already released on this topic, the CSSF would like to inform issuers on new
FAQs published by the EU Commission in December 2022. These FAQs provide further guidance on
the application of Article 8.

2.3. Priority 3: Reporting scope and data quality 

Supply chains are often the main source of a company’s carbon emissions and are therefore central to
the fight against climate change. An entity’s environmental and social footprint extends well beyond its
own walls: it includes indirect emissions that occur throughout the company’s value chain, such as
emissions embedded in purchased goods and services, employee travels, and the use and end-of-life
treatment of products sold. It may therefore be appropriate for entities to effectively measure their
environmental and social scopes across their entire chain.

Indeed, benchmarking ESG performance across the entire cycle against competitors and players in
other sectors is useful and can not only reveal hidden ESG strengths within the value chain, but can
also show companies where they need to improve in order to match or exceed industry standards.

Furthermore, issuers are encouraged to provide transparency on the robustness of their data collection
processes in order to ensure that quality data are used when preparing non-financial reporting.

3. Other considerations
Finally, ESMA addresses other considerations in relation to alternative performance measures (APMs)
and European Single Electronic Format (ESEF).

3.1. Alternative Performance Measures (APMs)

As ESMA priorities highlight, APMs remain an important topic for the 2023 campaign, especially as
issuers use them a lot in their communications. Based on the examination of the 2021 annual reports,
the CSSF has decided to focus, in addition to those points mentioned in the ECEP statement, on the
following topics in the context of its future examinations of the application of ESMA Guidelines on
APMs:

First of all, APM labels should be meaningful and clear in order to avoid confusing or misleading the
users of these measures.

Then, issuers should identify every APM presented in management reports or press releases. Indeed,
we noted that issuers, once having correctly identified measures as APMs, respect most of the
principles of the Guidelines.

Moreover, disclosure of APMs should not be more prominent than other measures that stem directly
from the financial statements. Prominence is judged not only by the number of APMs given in
comparison to other IFRS measures, but also by the presentation and place given to them in issuers
communications.

The CSSF will pay particular attention to the respect of these requirements during its 2023 campaign.

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Finally, we recommend that issuers, if concerned, use caution when making adjustments to APMs used
and/or when including new APMs solely with the objective of depicting the impacts that macro-
economic environment, such as inflation or increase in discount rates, may have on their performance
and cash flows.

3.2. European Single Electronic Format (ESEF)

As from the financial year 2021, issuers’ Annual Financial Reports (AFRs) have to be prepared in
compliance with ESEF. A first requirement from the Regulatory Technical Standard (RTS) on ESEF
was to publish all AFRs in xHTML and to mark-up IFRS consolidated financial statements using
XBRL tags foreseen by Annex II of this RTS.

Issuers are now reminded that for their 2022 AFRs, further mandatory elements will have to be marked
up if they are present in the consolidated financial statements. Whereas the first mandatory mark-up
elements were defined as simple text elements, the consolidated Table in Annex II of the RTS now
comprises a number of elements defined as, amongst others, “text block” and which are expected to be
used for marking up larger pieces of information contained in the consolidated financial statements,
such as explanatory notes and accounting policies.

Different levels of granularity are expected and specific attention should be brought to the existence of
multiple block tags. While using multiple block tags and nested block tags, issuers will have to pay
attention that narrative blocks extracted from the XBRL instance will be properly formatted and human
readable. Common noticed issues are, amongst others, lost table structures, inconsistencies in applied
styles, or different line breaks.

Issuers are encouraged to refer to the dedicated page on the ESMA website to consult supplementary
and detailed guidance material on the block tagging approach.

Issuers may address their questions and remarks in this respect to enforcement@cssf.lu.

More information on inspections and findings by the CSSF within the framework of its mission under
Article 22 (2) h) of the Transparency Law are given under Enforcement of financial information.
1
 Law of 23 July 2016 concerning the publication of non-financial information and information relating
to diversity by certain large undertakings and certain groups, which transposes the Non-Financial
Reporting Directive in Luxembourg legislation

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