Financial markets developed in response to the need to involve a large number of investors in the market place. As the number of investors keeps on increasing, the average size of each investment keeps on diminishing, which is a simple rule of the marketplace, because growing size means involvement of a wider base of investor. The small investor is not a professional investor, and is not in the business of investments. Hence, an instrument is needed which is easy to understand, and is liquid. These two needs set the stage for the evolution of financial instruments which would convert financial claims into liquid, easy to understand and homogenous products, at times carrying certified quality labels (credit ratings or security), which would be available in small denominations to suit everyone’s purse.
Following are the reasons as to why the world of finance prefers a securitized financial, instrument to the underlying financial claim in its original form:
Helping Small Investor
Financial claims often involve sizeable sums of money, clearly outside the reach of the small investor. The initial response to this was the development of financial intermediation, whereby an intermediary, such as a bank, would pool together the resources of the small investors and use the same for a larger investment need of the user.
Small investors are typically not in the business, and hence, liquidity of investments is most critical for them. Underlying financial transactions need investments over affixed time, ranging from a few months to may be a number of years. This problem could not even be sorted out by financial intermediation, since if the intermediary provided a fixed investment option to the seeker, and itself sought funds with an option for liquidity, it would get caught in a serious problem of mismatch. Hence the answer is a marketable instrument.
Utility of instruments
Generally, instruments are easily understood than financial transactions. An instrument is homogenous, usually made in a standard form, and generally containing standard issuer obligations. Besides, an important part of investor information is the quality and price of the instrument, and both are far easier known in case of the instruments than in case of underlying financial transactions.
Special Purpose Vehicle (SPV)
The entity that intermediates between the originator of the receivables and the end investors is known as ‘Special Purpose Vehicle’. Since securitization involves a transfer of receivables from the originator, it would be inconvenient, to the extent of being impossible, to transfer such receivables to the i9nvestors directly, since the receivables are as diverse as the investors themselves. Besides, the base of investors could keep changing, since the resulting security is essentially a marketable security. Therefore, it is necessary to bring in an intermediary that would hold the receivables on behalf of the end investor. This entity, created solely for the purpose of the transaction, is called a Special Purpose Vehicle (SPV) or a Special Purpose Entity (SPE) or, if such entity is a company, Special Purpose Company (SPC). The function of the SPV in a securitization transaction could stretch from being a pure conduit or intermediary vehicle, to a more active role in reinventing or reshaping the cash flows arising from the assets transferred to it, which in turn would depend on the end objectives of the securitization exercise.
Therefore, the originator transfers the assets to the SPV, which holds the assets on behalf of the investors, and issues to the investors its own securities. For this purpose, the SPV is also called the issuer.
In case the securitization involves any asset or claim which needs to be integrated and differentiated, unless it is direct and unsecured claim on the issuer, the issuer will need an intermediary agency to act as a repository of the asset or claim which is being securitized. Let us take the easiest example of a secured debenture, a secured loan from several investors. Here, the security charge over the issuer’s several assets needs to be integrated, and thereafter broken into marketable lots. For this purpose the issuer will bring in an intermediary agency whose basic function will be to hold the security charge on behalf of the investors, and then to issue certificates to the investors of beneficial interest in the charge held by the intermediary. So, the charge continues to be held by the intermediary, beneficial interest therein becomes a marketable security. The same process is involved in securitization of receivables, where the special purpose intermediary holds the receivables with it, and issues beneficial interest certificates to the investors.