In the third of six chapters surveying the synthetic securitisation market, SCI explores recent structural developments in SRT

IACPM’s latest risk-sharing survey notes that 2022 highlighted not only a substantial growth in SRT product utilisation by banks, with €200bn in new issuance, but also some structural changes in the risk-sharing activity of banks. Nevertheless, a number of regulatory challenges remain outstanding.

SCI’s Global Risk Transfer Report examines how the risk transfer community is addressing these issues – through regulation or structural enhancements – and the fallout from the turmoil in the US bank sector in March. It also explores the new frontiers that are emerging across jurisdictions and asset classes.

Chapter 3: Structural developments
The CRT market is dominated by direct CLN structures, which some market participants believe are the simplest and most cost-effective transactions to execute. But the recent pause in US issuance is attributed in some quarters to the Federal Reserve’s dislike for these structures. Now SPV structures appear to be gaining traction as an alternative among some issuers.

“I have not heard anything beyond the Fed’s cryptic FAQs that would indicate that US banking regulators are publicly softening their stance on CLN structures. The conflicts proposal from the SEC shows that some US regulators have no direct objection to CRT, including the CLN variations. But also it shows how some US regulators have not considered CRT as closely as the industry has and, therefore, there is a continuing need to educate regulators on its important, risk-mitigating function,” says Matthew Bisanz, a partner in Mayer Brown’s bank regulatory practice.

Jon Imundo, md and co-head of credit risk sharing at Man GPM, confirms that on the question of CLN structures, market participants are focused on understanding whether US regulators are softening their stance. “It’s something that comes up in almost every meeting,” he says. “What is clear, however, is that regulators globally appear to recognise the benefits of this market to the banking system. We hope that at some point there will be a framework that allows banks to issue in a more programmatic way.”

In the US, three main CRT structures are utilised: credit default swap structures, bank-issued CLN structures, and bank-sponsored SPV-issued CLN structures. Sagi Tamir, partner at Mayer Brown in New York, notes: “From an economics perspective, the market finds the CLN structures to be the most capital relief favourable because they typically involve a cash collateral element for optimising capital relief.”

He continues: “With credit default swap structures, you don’t always optimise capital relief and you also start to get into more complicated questions, such as US insurance law, US derivatives law, margin calculations and so on. It certainly can be done. But they require a higher level of sophistication on both sides.”

Imundo points out that the decision to undertake bilateral, club or syndicated transactions is often driven by the issuer, rather than the investor. “A lot is down to how the issuer wants to run its programme. There are pros and cons to bilateral, and pros and cons to syndicated transactions. There are different motivations. For our part, we are agnostic across bilateral, club or syndicated transactions.”

He adds: “What’s important is that a transaction meets the thresholds that we deem appropriate; in particular, around concentration limits. There's a whole list of metrics that we have in terms of how we think about a transaction, both on a standalone basis and as an aggregate, with respect to a given portfolio.”

Different CRT structures offer different levels of comfort for different banking tiers, according to Tamir. “Some participants have been willing to give up some level of capital relief in exchange for certainty. You might see a bilateral deal where credit protection is provided by way of a credit default swap, or a deal where you would have an intermediary in the middle. The idea of those structures is providing a greater level of comfort around recognition of the capital relief.”

Regulatory certainty
Ultimately, banks want certainty from their regulator. If one bank learns that a similarly situated bank has been given the nod from their regulators for a slightly different structure, they might change their structure in turn.

“I've seen flexibility both at the bank level, to meet a given regulator’s preference, and at the investor level, to accommodate the applicable bank,” Tamir says. “In the US, my experience is that investors focus more on economics and are flexible in the structure that a bank chooses, because they fully understand that the main driver of the deal is capital relief.”

In Europe, the IACPM reports that usage of SPVs in the CRT market has been decreasing year after year. The main risk transfer instruments are collateralised guarantees, CLNs with embedded guarantees and unfunded credit insurance.

A bilateral guarantee is an option if the guarantor is of a sufficient credit quality required by the regulations. “With these structures, you're trying to substitute the quality of the credit protection provider for the quality of the debtors in the reference portfolio. So, you need both the counterparty and the guarantee to be of sufficient quality,” observes Edmund Parker, partner and global practice head of derivatives and structured products at Mayer Brown.

The advantages are that the legal documentation is relatively simpler because there is just a guarantee and an administration agreement, thereby avoiding the broader infrastructure arising from a note issuance. “For bilaterals, it can be easier from an issuer's perspective to deal with one counterparty negotiating documents. Of course, sourcing the size of the transaction is a key issue. Bilaterals naturally bring in larger investors, as well as allowing negotiations with a single counterparty,” Imundo notes.

He continues: “The flipside is that doing a more open option or syndicated, or flip transaction, allows the issuer to drive a bit more discovery and there are times where that can be more beneficial. As the market has grown, price discovery is less of an issue generally speaking, but there are still cases where that approach may be preferred.”

While individual deal format remains largely issuer-dependant, the trend has been for more club deals and bilateral deals than were seen in the market a decade ago.

Parker says that direct CLN structures come with other downsides. “The trouble for an investor with direct CLN structures, where the originating institution issues a note credit-linked to the reference portfolio, is that you are getting credit exposure to the institution issuing the notes in addition to the reference portfolio. So, if you're looking at one of the major financial institutions in Europe, as an investor, you might be quite comfortable with that. But if you're looking at lower credit quality institutions, then this will have a greater impact on pricing - which may give you more of a push towards an SPV issuance, to isolate against the credit risk inherent in the originator.”

Some market participants believe that direct financial guarantees are the most straightforward to execute. Their utilisation is seen as less complex, with less set-up needed and a reduced cost. The downside is that there are fewer protection providers who can execute them.

“Many investors want a CLN because they need to be able to demonstrate liquidity and theoretical tradability of their instrument, even if they don't intend to sell it. For them, the downside of the direct financial guarantee is that you don't get a CLN. For some investors, that's fine; for many, it’s not. Those investors able to execute direct guarantees, however, can use this to their advantage when banks for some reason prefer not to issue a CLN,” says Robert Bradbury, md and head of structured credit execution at Alvarez & Marsal.

Ultimately, by utilising a direct CLN, an issuer can avoid the need for certain regulatory permissions that would otherwise be required in a more conventional SPV structure. “An SPV-issued CLN structure has proved a useful way for issuers to navigate tax, regulatory, licensing and other issues in the context of European SRTs. It is not, however, of universal applicability. For example, we’ve worked with new entrants and would-be issuers who have the balance sheet to make capital relief trades desirable, but lack the requisite regulatory permissions to execute such trades via an SPV,” concludes Jack Thornber, a broker in Texel’s structured and bespoke solutions group.

SCI’s Global Risk Transfer Report is sponsored by Arch MI, Man GBM, Mayer Brown and Texel. The report can be downloaded, for free, here.