The CDO market Functioning and implications in terms of financial stability
OLIVIER COUSSERAN
Monetary Research and Statistics Directorate

IMÈNE RAHMOUNI
Financial Stability Coordination Directorate Market and Financial Stability Research Division

The result of relatively recent financial innovations, collateralised debt obligations (CDOs) are securities that represent a portfolio of bank loans and/or different financial instruments. Part securitisation instrument part credit derivative, these increasingly-popular structured finance products are used by financial institutions for various purposes, ranging from reducing their cost of financing to exploiting arbitrage opportunities or transferring credit risk. Irrespective of their form, CDOs are issued in different tranches that are tailored using securitisation techniques. The process of tranching allows credit risk and returns on their underlying portfolio to be redistributed to investors in an ad hoc fashion. CDOs are part of an ongoing trend of converting credit risk into a marketable commodity. This process started with securitisation, and was then sustained by the development of credit ratings and corporate bond markets and, more recently, by that of credit derivatives. While CDO issuance represents at most the equivalent of a sixth of that of corporate bonds, the influence of these products has a far greater significance because of the amount of credit risk they allow to be transferred. The sharp growth in synthetic structures backed by credit derivatives, especially in Europe, has heightened this trend. The rapid development of CDOs has improved non-bank investors’ access to credit markets and has enabled them to overcome the obstacles posed by the size and limited diversification of the corporate bond market, notably in Europe where bank intermediation remains predominant. Investors can now choose portfolios with specific risk-return profiles and take exposures to credit risk previously confined to