Credit Risk Retention refers to the requirement for originators or securitizers of financial assets, such as loans, to retain a portion of the credit risk associated with those assets rather than selling off all risk to investors. In the crypto lending and structured product space, its purpose is to align the incentives of asset creators with those of investors, mitigating moral hazard and enhancing underwriting quality.
Mechanism
This mechanism typically mandates that a specific percentage of the securitized asset pool’s credit exposure must be held by the originator, often in a first-loss position. This retained interest ensures the originator suffers losses alongside investors if the underlying assets default. In crypto, this might involve locking up a portion of a protocol’s native tokens or stablecoins as collateral against a DeFi lending pool or structured product.
Methodology
Regulatory frameworks or protocol designs enforce credit risk retention, promoting responsible origination practices. The methodology aims to prevent the securitization of excessively risky assets by making originators financially accountable for a portion of the default risk. In decentralized finance, this can be implemented through smart contract logic that automatically assigns a risk retention tranche to the originator, increasing transparency and reducing information asymmetry for participants.
Voluntary retention is a superior signal because its discretionary and variable nature allows informed originators to send a costly, credible message of quality.
Hedging retained securitization interests is restricted to prevent neutralizing the mandated credit risk, permitting only hedges of non-credit risks like interest rates.
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