In traditional, or 'cash', securitisation, a bank bundles up loans and sells them to a special purpose vehicle (SPV), physically moving the assets off its balance sheet. Investors then buy notes from the SPV, and their returns are tied to the performance of those specific loans.

Synthetic securitisation works differently. The bank keeps the loans on its balance sheet. Instead of selling the assets, it transfers the credit risk associated with them. The bank is essentially buying insurance on a portfolio of its own assets, paying a premium to investors who agree to cover potential losses.

This transfer of risk is achieved through credit derivatives. The most common instruments are bilateral financial guarantees or Credit-Linked Notes (CLNs). With a CLN, an investor pays the bank the full principal amount of the note upfront. This cash is held in a secure account as collateral. If the underlying loan portfolio performs well, the investor receives their principal back plus interest at maturity. If the portfolio suffers losses, those losses are deducted from the collateral, and the investor receives back a reduced amount, or nothing at all.

To transfer risk, the loan portfolio is conceptually sliced into different layers, or tranches, each with a different level of risk. This structure determines who bears losses and in what order.

The key terms defining this structure are:

• First-Loss Tranche: This is the bottom layer. The bank typically retains this portion, meaning it agrees to absorb the first wave of losses up to a certain point. This demonstrates to investors that the bank has 'skin in the game'.
• Mezzanine Tranche: This is the middle layer of risk, and it's the portion that is usually transferred to investors in an SRT transaction. Investors in this tranche are protected by the first-loss piece but are exposed to losses that exceed it.
• Senior Tranche: This is the safest, top layer, which the bank also retains. It only suffers losses if both the first-loss and mezzanine tranches are completely wiped out.

The boundaries are defined by attachment and detachment points:

• The attachment point is the threshold where investor losses begin. For the mezzanine tranche, this is the top of the first-loss tranche.
• The detachment point is the ceiling where investor losses stop. For the mezzanine tranche, this is the bottom of the senior tranche.

The 'thickness' of the mezzanine tranche, the difference between the detachment and attachment points, is critical. A thicker transferred tranche means more risk has been offloaded, which directly leads to greater capital relief for the bank under regulatory frameworks. This reduction in Risk-Weighted Assets (RWA) is the primary motivation for the transaction.

Unlike a static pool of 30-year mortgages, SRT transactions often back portfolios of more dynamic assets, like loans to small and medium-sized enterprises (SMEs) or auto loans. These loans have shorter maturities and are repaid throughout the life of the deal. To maintain the size of the portfolio backing the security, these transactions often include a 'replenishment' or 'revolving' period.

During this period, typically the first few years of the deal, any principal repaid by borrowers can be used by the bank to add new, similar loans to the portfolio. This keeps the total value of the asset pool stable, ensuring the investors' risk exposure remains consistent. All new assets must meet strict eligibility criteria defined at the start of the deal.

Once the replenishment period ends, the transaction enters the 'amortisation' phase. As loans are repaid, the cash is not reinvested. Instead, it is used to pay down the notes held by investors, gradually winding down the transaction until all underlying loans have either matured or been repaid.

SRT transactions are complex financial instruments, but their core function is straightforward: they allow banks to manage their capital more efficiently by transferring the risk of specific loan portfolios to investors, without having to sell the underlying assets. The architecture of these deals, particularly the thickness of the transferred mezzanine tranche, is carefully calibrated to achieve a significant reduction in regulatory capital requirements.