The newest and arguably best known financial derivatives were dreamed up over twenty years ago. Financial innovation has stalled since that time, in part due to the financial crisis.
Credit Default Swaps (CDS), the most recent major innovation, were created in the mid-1990s as a means to efficiently transfer risk and credit exposure for corporate bonds, municipal bonds, and commercial loans.
A CDS contract essentially functions as insurance for a bond. If the bond issuer defaults, restructures, or files for bankruptcy, the CDS seller of protection (insurance) will compensate the buyer. The buyer of protection pays premiums to the seller over a set period of time in exchange for this protection. The higher the perceived risk of the underlying issuer, the higher the premiums required to compensate for this risk.
By 2007, the CDS market was over $44 trillion.
The Definition and History of Derivatives
Since CDS contracts derive their value from an underlying asset (a corporate, municipal, or commercial bond), they are classified as financial derivatives. Simply put, derivatives are instruments that derive their value from a separate underlying security. Buyers and sellers make or lose money depending on the performance of the underlying bond from which the contract derives its value.
The concept of a derivative is not new. Hundreds of years ago, commodity futures helped farmers lock in prices for their crops to avoid price fluctuations affected by unpredictable weather patterns. This was beneficial for the continuity of their business, and helped to make the market more efficient.
Lack of Derivatives in Real Estate
Until the recent advent of the derivative note in real estate crowdfunding, there was never an opportunity for individuals to invest in financial instruments that derive their value from real estate.
Real Estate Investment Trusts (REITs) carry a different legal structure than most real estate investments available through crowdfunding. They also have a different investment strategy. The fundamental difference is that REITs pass cash flow to investors from a blind pool of stabilized cash-flowing properties, while crowdfunding platforms provide capital for individual ground-up construction and value-add projects.
Importantly, REITs do not give investors the ability to dig into the fundamentals of a specific project. (More on REIT fees can be found here)
Companies like Lending Club and Fundrise have taken financial derivatives and used them to expand the investment landscape for individual investors. Where it was once exceedingly difficult to invest small amounts of capital in assets like student loans or commercial buildings, derivatives make these investments widely accessible for average individual investors by facilitating passive fractional ownership.
Fundrise and other crowdfunding platforms invest directly in underlying assets, such as a loan or mortgage for a ground up or value-add development, and then issue a series of derivative notes whose performance is linked to the underlying projects. The notes are issued by Fundrise, for example, but they expose investors to the same upside as lending to the asset directly.
On the sponsor side, the efficiency stems from a variety of improvements. The note structure removes the need for sponsors to deal with individual investors, all of whom come with questions and demands.
From an investor’s standpoint, the derivative structure is equally advantageous. Documents are standardized, which alleviates the headache of sifting through lengthy agreements each time you invest. Furthermore, Fundrise manages distributions and reporting, which adds efficiencies and improves service quality.
The Bottom Line
The new wave of financial innovation is here after a twenty-plus year hiatus. The addition of the real estate derivative will transform an investor’s ability to build a diversified portfolio, a crucial foundation for building wealth.
Image Source: Dave Curlee, Flickr