For example, a mezzanine CDO tranche might have attachment and detachment points of say 7% and 10%, meaning that for losses on the underlying collateral of less than 7% they continue to pay out at par, but become worthless when losses reach 10%. The pay-offs to such instruments are therefore highly sensitive to quite minor changes in expected credit conditions. In a full-information world with known probability distributions, instruments with such highly sensitive pay-offs are no more difficult to price than any others. But when lack of complete information makes the future uncertain, in a Knightian sense, contracts with highly sensitive pay-offs to slight changes in credit conditions become increasingly risky. Moreover, innovative instruments inherently will not have a long run of performance data. Those seeking to summarise their likely performance using statistical metrics based on limited data and drawn from very benign circumstances have a very difficult task. Many investors in RMBS and ABS CDOs linked to US sub prime mortgages have been surprised by the extent to which the performance of these instruments has fallen short of even their worst expectations. Securities with complex pay-offs, therefore, are highly vulnerable to increased macroeconomic uncertainty. 20 Second, information loss is built into the securitisation process because of the separation between the originator of the loan and the end investor. Chart 2 illustrates how information is lost at every step in the chain of risk transfer. To some extent, holding a diversified pool of underlying loans acts as protection against a lack of information about idiosyncratic risk.

The more closely a specific financial instrument is matched to the risk preferences of an individual investor, the harder it is to find another investor willing to trade that exact instrument in the event of a shock to those risk preferences. 32 In other words, the improved matching of risk to an individual’s risk profile has given rise to an increase in basis risk within the system. As one illustrative example, any investor wishing to hedge any exposure to the US sub-prime mortgage market over the past year or so would have little alternative but to trade in the standardised ABX indices (which themselves have often been relatively illiquid) rather than in the specific instrument they held. The developments over the past year have illustrated that hedges have often provided less effective than envisaged, and that there was a significant under-pricing of the inherent basis risk of many innovative structured instruments at the point of origination, given the lack of secondary market liquidity for such specific risk. Looking forward, it is quite likely that there will be greater unbundling of complex instruments into standardised components that are likely to be liquid and readily traded with low transactions costs, and bespoke elements that will command a higher risk premium given their inherent illiquidity. 8  BIS Review 93/2008  Strengthening financial infrastructure 33 Because of the specificity of the risk, innovative financial products are rarely exchange traded. Non-standardised products require the services of a broker-dealer to trade.