Secured Credit Insight: new EU securitisation regulations made simple
Over conversations with various clients it has become clear that while many have heard of the newly implemented EU regulations relating to the issuance of European securitised transactions and investment in securitisations globally, a high level summary of the key provisions and implications may be useful. We need to start with the usual disclaimer that this note is meant to be a high level overview of the rules and does not constitute legal advice. Some aspects of the rules are uncertain and ambiguous. This note sets out our interpretation of the regulations and there may be other possible interpretations. We would of course welcome further discussion.
What and when?
EU Regulation 2017/2402 (the “regulation”) became effective on 1 January 2019. It sets out various requirements with which issuers, originators, original lenders and sponsors of European securitisations, and European institutional investors in securitisations from anywhere in the world, must comply. It replaces all other regulations with regards to securities issued after the effective date. Previous regulations still apply for securities issued prior to the effective date. Who and what do they cover?
The regulation covers broadly all European issuers, originators and sponsors of securitisations issued in Europe, certain aspects of the securitisations themselves and European institutional investors in securitisations regardless of where they have been originated. The rules apply to public as well as private transactions and it should be noted that the definition of what is a securitisation is quite technical and different from the definition that might apply in other jurisdictions, such as the US. It should also be noted that the definition of being an investor may cover both direct investment by an institution or when investment is made on its behalf by a third party, for example through a managed account or an investment fund.
Institutional investors are defined to cover a broad range of ‘regulated’ financial institutions in the EU including banks, insurance companies, occupational pension schemes, UCITs management companies and alternative investment fund managers. The regulation also appears to apply to managers of alternative investment funds domiciled outside the EU who market the fund in the EU. This certainly makes sense to us as it is difficult to see why, having introduced the regulations to cover European institutions they could be effectively circumvented by investment in a fund managed outside the EU.
What are the main provisions?
The regulation broadly covers what actions the various parties must take, the information that must be provided on the transaction structure and the underlying securitised exposures and certain characteristics that all securitisations must have. It further sets out the requirements for a securitisation to be deemed as “simple, transparent and standardised” (STS); however, those requirements will not be addressed here. If a securitisation qualifies for STS treatment then certain institutional investors may achieve preferential capital and/or liquidity treatment in regulatory tests.
The main provisions relating to issuers and/or the originator of the underlying loans, mortgages, etc, cover the origination practices used, the type and frequency of information that must be disclosed to investors or potential investors (including disclosure of the relevant transaction documents), and the risk retention requirements. The latter relates to the form and amount of risk that originators or sponsors are required to hold in the securitisation or underlying assets, often referred to more colloquially as ‘skin in the game’.
For institutional investors within scope of the regulation, the main provisions are the requirement to conduct specified due diligence prior to purchase in order to ensure that all requirements are being met. There is also a requirement to conduct ongoing surveillance on ‘owned’ positions. This includes cash flow stress tests on a periodic basis and ensuring that senior management is appropriately aware of the risks associated with owning the securitisations.
Investors are able to delegate due diligence and ongoing surveillance requirements to third party managers of their funds, however, regulatory responsibility for compliance with the regulations does not shift to such a manager unless it is itself subject to the rules as an ‘institutional investor’.
What are the implications if not met?
For European issuers, originators and sponsors the implications of non-compliance can be very penal, including fines of up to 10% of annual turnover for egregious breaches. Investors may need to sell non-compliant securitisations and in some instances may face censure, fines, penal capital charges, etc, depending on the terms of the regulations applicable to the relevant investor. Broader implications
The requirement for institutional investors (including potentially those within the scope of the regulation through their exposure to securitisation positions through managed accounts and investment funds) to assure themselves that the securitisations they are investing in comply with the regulations, brings all securitisations into scope, regardless of where they are originated.
While certain items, such as the provision of information on underlying exposures, are likely to be met by non-European securitisations, other provisions may not. Potentially most problematic is the risk retention requirement as set out in the regulation, which details how it can be met, what size it must be (5% of the securitisation) and how long it needs to be retained (for the life of the transaction). These rules apply to all securitisations under the regulations, although securitisations guaranteed by central governments such as US Agency mortgaged-backed securities are not considered to be securitisations for the purposes of the regulation.
The European requirements are more stringent than those seen in the other two major securitisation markets, namely Australia, where there are no risk retention requirements and the US, where certain asset classes are exempted, with those on other asset classes being time limited. While transactions in the US and Australia may be structured to comply with the European regulations, in practice, these differences will limit the amount of non-European securitisations in which European institutional investors within the scope of the regulation can invest. This has certainly been the case to date.
Please read the following important information regarding funds related to this article.
- An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall. High yielding (non-investment grade) bonds are more speculative and more sensitive to adverse changes in market conditions.
- When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise (or are expected to rise). This risk is typically greater the longer the maturity of a bond investment.
- Callable debt securities, such as some asset-backed or mortgage-backed securities (ABS/MBS), give issuers the right to repay capital before the maturity date or to extend the maturity. Issuers may exercise these rights when favourable to them and as a result the value of the fund may be impacted.
- Emerging markets expose the Fund to higher volatility and greater risk of loss than developed markets; they are susceptible to adverse political and economic events, and may be less well regulated with less robust custody and settlement procedures.
- The Fund may invest in onshore bonds via Bond Connect. This may introduce additional risks including operational, regulatory, liquidity and settlement risks.
- The Fund may use derivatives to help achieve its investment objective. This can result in leverage (higher levels of debt), which can magnify an investment outcome. Gains or losses to the Fund may therefore be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- If the Fund holds assets in currencies other than the base currency of the Fund, or you invest in a share/unit class of a different currency to the Fund (unless hedged, i.e. mitigated by taking an offsetting position in a related security), the value of your investment may be impacted by changes in exchange rates.
- When the Fund, or a share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency (hedge), the hedging strategy itself may positively or negatively impact the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- The Fund may invest in contingent convertible bonds (CoCos), which can fall sharply in value if the financial strength of an issuer weakens and a predetermined trigger event causes the bonds to be converted into shares of the issuer or to be partly or wholly written off.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
- The Fund invests in Asset-Backed Securities (ABS) and other forms of securitised investments, which may be subject to greater credit/default, liquidity, interest rate and prepayment and extension risks, compared to other investments such as government or corporate issued bonds and this may negatively impact the realised return on investment in the securities.