The Level 2 / Level 3 Boundary

The distinction between Level 2 and Level 3 assets, as defined under fair value accounting frameworks such as ASC 820 and IFRS 13, represents a classification system based on the observability of valuation inputs rather than the intrinsic nature of the asset itself. Level 2 assets are valued using observable inputs, including quoted prices for similar instruments, dealer quotations, interest rate curves, credit spreads, and other market-corroborated data. Level 3 assets, by contrast, rely on unobservable inputs derived from internal models, assumptions about projected cash flows, recovery values, discount rates, or estimates of how a hypothetical market participant would price the asset in the absence of direct market evidence. This framework applies across asset classes, including corporate credit, structured products, private loans, asset-backed securities, derivatives, and other forms of illiquid or esoteric financial instruments, and is fundamentally driven by the existence, quality, and repeatability of market activity rather than by contractual structure alone.

Corvid Partners is a global leader in the valuation, analysis, and advisory of complex and illiquid financial instruments, with particular expertise in assets that fall near or across the Level 2 / Level 3 boundary. Members of Corvid have traded, structured, valued, and restructured a wide range of instruments across multiple market cycles, including the structured credit expansion of the early 2000s, the dislocations of the global financial crisis, the European sovereign debt crisis, the COVID-19 market shock, and the more recent environment characterized by reduced dealer balance sheet capacity, increased regulatory constraints, and episodic liquidity fragmentation. Through active participation in secondary markets, direct engagement with counterparties, and the sourcing and execution of transactions in otherwise opaque sectors, Corvid plays a central role in price discovery. In doing so, the firm contributes directly to the formation of observable market inputs, helping to transform model-driven valuations into market-corroborated pricing and, in certain cases, facilitating the transition of assets from Level 3 classification toward Level 2.

The modern fair value hierarchy did not emerge in isolation, but rather as a response to decades of increasing financial complexity and periodic market dislocation. Prior to the formalization of ASC 820 and IFRS 13, valuation practices across institutions were often inconsistent, with significant reliance on internal models and limited transparency regarding assumptions. The growth of derivatives markets in the 1980s and 1990s, followed by the expansion of structured finance in the early 2000s, introduced a wide range of instruments whose value could not be readily observed in active markets. This created a need for a standardized framework that would distinguish between prices derived from observable transactions and those based on internal estimation.

https://asc.fasb.org
https://www.ifrs.org/issued-standards/list-of-standards/ifrs-13-fair-value-measurement/

The introduction of the fair value hierarchy formalized this distinction. Level 1 inputs, consisting of quoted prices in active markets for identical assets, represent the highest degree of observability. Level 2 inputs include observable data for similar assets, quoted prices in less active markets, or market-derived parameters such as yield curves and implied credit spreads. Level 3 inputs reflect unobservable assumptions, often derived from discounted cash flow models or other valuation techniques. Crucially, classification is determined by the lowest level input that is significant to the overall valuation, meaning that even a single unobservable assumption—such as a recovery rate or default probability—can result in a Level 3 designation.

Regulatory frameworks have reinforced the importance of this hierarchy, particularly in the aftermath of the global financial crisis. Under Basel III, valuation uncertainty associated with illiquid or model-driven assets is addressed through prudent valuation adjustments, capital requirements, and enhanced disclosure obligations. European regulatory bodies, including the European Banking Authority and the European Central Bank, have emphasized independent price verification, model validation, and the consistent application of valuation methodologies. In the United States, the Securities and Exchange Commission has similarly focused on transparency and the robustness of fair value disclosures, particularly for assets classified as Level 3.

https://www.bis.org/bcbs/basel3.htm
https://www.eba.europa.eu/regulation-and-policy/prudent-valuation
https://www.ecb.europa.eu
https://www.sec.gov

In practice, the boundary between Level 2 and Level 3 is not static. It reflects the continuous interaction between market activity and valuation methodology, and can shift rapidly in response to changes in liquidity, risk appetite, and macroeconomic conditions. Assets may move from Level 2 to Level 3 during periods of market stress, when trading activity declines and observable inputs become unreliable, and may subsequently return to Level 2 as liquidity improves and transactions resume.

A defining characteristic of Level 2 classification is not the existence of a deep or highly liquid market, but rather the presence of observable inputs that can be corroborated across multiple sources. These inputs may include recent transactions in the same or similar instruments, executable broker quotations, or pricing derived from comparable assets. In contrast, Level 3 classification reflects a situation in which such inputs are unavailable, inconsistent, or insufficient to support a market-based valuation. In many cases, this distinction is less about the absence of a market than about the absence of documented and verifiable evidence of that market.

Case Study: Structured Credit During the Global Financial Crisis

During the 2007–2009 financial crisis, large segments of the structured credit market—including residential mortgage-backed securities, collateralized debt obligations, and other securitized products—experienced a collapse in liquidity. Instruments that had previously traded with observable spreads and dealer support became effectively illiquid as market participants withdrew and dealer balance sheets contracted. As a result, many of these securities were reclassified from Level 2 to Level 3.

https://www.bis.org/publ/work394.pdf
https://www.federalreserve.gov

Importantly, this reclassification did not necessarily reflect a complete loss of economic value, but rather the disappearance of observable market inputs. In the absence of transactions, valuations relied on internal models incorporating assumptions about default rates, prepayment behavior, and recovery values. As distressed investors and specialized credit funds began to re-enter the market in subsequent years, selective transactions established new clearing levels, providing observable data that supported a gradual transition back toward Level 2 classification for certain instruments.

Micro-example: legacy subprime RMBS tranches that had been marked using internally modeled loss curves in 2009 began to trade in small sizes between distressed funds at levels implying specific loss assumptions, allowing those assumptions to be replaced with market-implied inputs.

Case Study: European Bank Capital and Sovereign Stress

During the European sovereign debt crisis, subordinated bank capital instruments and certain sovereign-linked securities experienced periods of severe volatility and reduced liquidity. While benchmark government bonds continued to trade actively, more complex or subordinated instruments often lacked consistent two-way markets, leading to increased reliance on model-based valuation.

https://www.ecb.europa.eu
https://www.eba.europa.eu

As policy interventions stabilized markets and investor confidence improved, trading activity returned, and observable spreads re-emerged. The reappearance of executable quotations and secondary transactions allowed for the incorporation of market-based inputs, supporting a transition toward Level 2 classification.

Micro-example: Additional Tier 1 bank capital instruments, which at times traded only by appointment, later exhibited consistent dealer runs and cross-market spread relationships relative to senior debt, enabling observable spread inputs.

Case Study: Private Credit and Direct Lending

The growth of private credit markets has introduced a large and expanding universe of assets that are often classified as Level 3 due to limited secondary trading. Direct lending transactions are typically bilateral, bespoke, and held to maturity, with valuations derived from discounted cash flow models, comparable public spreads, and periodic third-party marks.

https://www.imf.org
https://www.bis.org

However, secondary markets for private credit have begun to develop, including portfolio sales, fund-level liquidity solutions, and direct secondary transactions. Even limited trading activity can provide observable reference points, particularly when combined with comparable public market data, supporting the incorporation of Level 2 inputs.

Micro-example: sponsor-backed middle-market loans, initially valued using internal discount rates, later trading in secondary portfolio sales at defined yields, allowing those yields to serve as observable inputs for similar assets.

Case Study: COVID-19 Market Dislocation

In March 2020, the rapid onset of the COVID-19 pandemic led to a sharp deterioration in liquidity across fixed-income markets. Bid-ask spreads widened significantly, and in some sectors, trading activity became intermittent. Market participants faced challenges in determining whether observed prices reflected orderly transactions or distressed conditions.

https://www.federalreserve.gov
https://www.imf.org

During this period, certain assets experienced temporary shifts toward Level 3 classification as observable inputs became less reliable. Subsequent central bank interventions restored liquidity, leading to a re-establishment of observable market inputs and a return toward Level 2 classification.

Micro-example: investment-grade corporate bonds that briefly traded at highly dislocated levels with limited depth were initially treated as unreliable inputs, but later regained Level 2 status as trading normalized and multiple executable quotes became available.

Corvid Case Study: Creating Observability in Fragmented Structured Credit

In fragmented structured credit markets, assets are frequently classified as Level 3 not because no market exists, but because the available evidence is insufficiently developed or documented. In such cases, the transition to Level 2 requires not only valuation expertise but also direct market engagement.

Corvid has been active in situations where securities—often legacy asset-backed tranches, esoteric ABS, or off-the-run structured products—were valued using internally generated assumptions due to a lack of observable inputs. By identifying counterparties with aligned risk appetites, facilitating bilateral transactions, and establishing executable levels, Corvid has helped generate the primary data points necessary for market-based valuation.

Micro-example: a thinly traded structured security initially valued using a discounted cash flow model with assumed spreads is transacted in small size between informed counterparties. The execution establishes a clearing level, which, when corroborated with additional dealer indications and comparable assets, provides a basis for observable inputs. Subsequent transactions reinforce this level, allowing for a transition from model-driven valuation to market-corroborated pricing.

This process illustrates that the boundary between Level 3 and Level 2 is not purely analytical. It is transactional. The presence of even limited, but verifiable, market activity can fundamentally alter the classification and perception of an asset.

Industry literature has consistently highlighted the limitations of model-based valuation in the absence of market data. Pricing services, independent valuation firms, and dealer runs attempt to bridge this gap, but often rely on inferred relationships rather than direct transactions. The most robust valuations remain those supported by observable, repeatable market activity.

https://www.pwc.com/gx/en/services/audit-assurance/assets/pwc-fair-value-measurement.pdf
https://www2.deloitte.com

The evolution of market structure has further increased the importance of specialized participants in this process. Regulatory changes have reduced dealer balance sheet capacity, while the growth of private and structured markets has increased the number of assets reliant on limited liquidity. In this environment, the ability to source, execute, and validate transactions becomes central to valuation.

The Level 2 / Level 3 boundary is therefore best understood as a process of market formation. It reflects the aggregation of data, the validation of pricing through independent sources, and the demonstration that an asset can be transacted at levels consistent with observed inputs. While some assets will remain inherently Level 3 due to their bespoke nature, many exist in markets that are not absent, but fragmented and underdeveloped.

For investors, this boundary represents both a challenge and an opportunity. Assets classified as Level 3 may offer higher yields or structural advantages, but require specialized expertise to evaluate. As markets develop and observability increases, these assets may transition toward Level 2, with implications for valuation, liquidity, and regulatory treatment. Participants capable of operating within this space—combining valuation, trading, and structuring expertise—are positioned to identify and capitalize on these dynamics.

Bibliography

Financial Accounting Standards Board — ASC 820 Fair Value Measurement
https://asc.fasb.org

International Accounting Standards Board — IFRS 13 Fair Value Measurement
https://www.ifrs.org/issued-standards/list-of-standards/ifrs-13-fair-value-measurement/

Bank for International Settlements — Basel III Framework
https://www.bis.org/bcbs/basel3.htm

European Banking Authority — Prudent Valuation Guidelines
https://www.eba.europa.eu/regulation-and-policy/prudent-valuation

European Central Bank — Market Liquidity and Supervisory Guidance
https://www.ecb.europa.eu

U.S. Securities and Exchange Commission — Fair Value and Disclosure Guidance
https://www.sec.gov

BIS Working Paper — Structured Finance and Risk Transfer
https://www.bis.org/publ/work394.pdf

Federal Reserve — Market Liquidity and Valuation Studies
https://www.federalreserve.gov

PwC — Fair Value Measurement Guidance
https://www.pwc.com/gx/en/services/audit-assurance/assets/pwc-fair-value-measurement.pdf

Deloitte — Fair Value Hierarchy and Valuation Practices
https://www2.deloitte.com

International Monetary Fund — Liquidity, Valuation, and Financial Stability
https://www.imf.org