In structured finance, particularly securitization, an ‘Eligible Horizontal Residual Interest’ refers to a specific tranche or equity position in a securitized asset pool that meets certain regulatory criteria for risk retention. Its purpose is to ensure that the originator or sponsor of the securitization retains a meaningful financial exposure to the underlying assets, aligning their incentives with those of investors and mitigating moral hazard. This concept, while primarily traditional, offers conceptual parallels for risk distribution within complex decentralized finance (DeFi) protocols and tokenized asset structures.
Mechanism
The mechanism of an eligible horizontal residual interest involves the sponsor holding a specified percentage of the fair value of all tranches issued in a securitization, typically the most junior or “first loss” position. This structural arrangement means the sponsor absorbs losses from the underlying asset pool before senior tranches are affected. In a crypto context, this could be analogous to a protocol developer or liquidity provider retaining a portion of the highest-risk tokenized debt or a specific share of a decentralized autonomous organization’s (DAO) governance token that carries direct exposure to protocol performance.
Methodology
The methodology for establishing an eligible horizontal residual interest is driven by regulatory requirements and risk alignment principles. It mandates that the sponsor calculates and holds a quantifiable economic interest that is subordinate to other investment tranches. This ensures that the sponsor shares in the downside risk, promoting diligent underwriting and ongoing asset management. In exploring crypto parallels, this would necessitate clear, auditable smart contract logic or governance mechanisms that transparently define and enforce the retention of junior liabilities or performance-linked token stakes by relevant protocol actors.
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