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Update on EU STS and Risk Retention: Simple, Transparent and Standardised Securitisations

On 19 May 2016, the Committee on Economic and Monetary Affairs of the European Parliament (“ECON”) published a working document on the European Commission’s proposal for a regulation (the “Proposed Regulation”) intended to harmonise risk retention, transparency and due diligence requirements applying to securitisations and to create a legal framework to encourage “simple, transparent and standardised” securitisations (“STS securitisations”). 

Legislative Background

The Commission’s Proposed Regulation was announced on 30 September 2015, together with a proposal for amendments to the Capital Requirements Regulation (the “CRR Proposal”) designed to reduce the regulatory capital requirements for exposures to STS securitisations.

The European Council then moved rapidly in its considerations of the Proposed Regulation and on 30 November 2015, the Presidency of the Council published its “third compromise proposal”, which is the Council’s agreed negotiating position.

Progress through the European Parliament

The Proposed Regulation is now being considered by the European Parliament, which in contrast to the Council, is taking much more time in its deliberations.

ECON, under Rapporteur Paul Tang MEP, is currently reviewing the proposals in detail.  The working document dated 19 May 2016 (the “Draft Report”) indicates the approach that Paul Tang intends to take on the Proposed Regulation. Paul Tang is coordinating his work with that of a separate working group in ECON which is considering the CRR Proposal. There was a first exchange of views on the Draft Report within ECON on 24 May 2016.

Proposed European Parliament Timetable

ECON’s intended timetable is that:

  • there will be a public hearing on 13 June 2016 and consideration of the Draft Report on 21 June 2016;

  • the deadline for amendments is late July 2016;

  • ECON will then consider the amendments in October with voting taking place in ECON in November 2016; and

  • the European Parliament’s full vote is not due until mid-December 2016. 

Some MEPs have criticised the length of this process and have compared it unfavourably with the speed at which the Council produced their amendments to the Proposed Regulation. The timetable may therefore be shortened, but probably by no more than about a month.

Once the European Parliament has developed its proposals, the three EU legislative institutions will negotiate a common position in a process known as trialogue. Once the final text is agreed and approved, the Regulation will be published in the Official Journal of the European Union. It is due to enter into force 20 days after publication and shall apply to securitisations the securities of which are issued on or after that date, subject to transitional provisions. It will apply directly across the EU without the need for separate legislation in each EU Member State.

The Key Issues in the Draft Report: Asymmetric Information and Moral Hazard

The Draft Report starts with a summary of the advantages and disadvantages of securitisation, and then provides an analysis of what is viewed to have gone wrong in the securitisation market in the past. “Asymmetric information” and “moral hazard” are identified as being the two fundamental issues that need to be addressed.

The Draft Report notes that asymmetric information exists between the issuer and the investors, with the issuer knowing much more about the security, the credit quality of the underlying loans, the profile of the credit receivers and the relative quality of the different tranches.

It then describes how asymmetric information can give rise to problems of moral hazard, because of a misalignment of interests between the parties in a securitisation. To address the potential problems of moral hazard, the different interests of the market participants need to be aligned. Asymmetric information can be dealt with by strengthening transparency requirements.

Transparency and Proposed Public Register for STS Securitisations

The Draft Report stresses the importance of transparency within the securitisation market so that investors, regulators and the market as a whole can better understand the sources of the key risks in a securitisation.

In this context, the Draft Report considers that a public register for STS securitisations would improve transparency, both as regards securitisations and their underlying assets. This would assist market participants as well as regulators. It proposes that key data could be sent to a trade repository, with loan-level data being anonymised in order to protect confidentiality. It considers that the availability of this data would also facilitate market participants being able to assess better the risks of the underlying loans, and would assist investors generally in this loan-level data being publicly available.

Risk Retention and Moral Hazard

The importance of the risk retention requirements in overcoming moral hazard is recognised in the Draft Report. It notes that alternative mechanisms to align interests have been looked at by the European Banking Authority (“EBA”) and the Commission, but that these alternatives were thought to have been too complex to establish and too difficult to enforce. It notes, however, that Paul Tang “is open to strengthening the risk retention rules if necessary” and refers to the recent EBA report which proposes that regulators’ supervision practices could be improved and harmonised in relation to risk retention.

The Importance of Setting the STS Criteria at the Right Level

The Draft Report highlights the challenges in clarifying the distinction between STS and non-STS securitisations and the consequences of this delineation in creating a two-tier market for securitisations. Paul Tang believes that a balance needs to be achieved between making the criteria so restrictive as to undermine market take-up and making the criteria insufficiently stringent so as to avoid riskier forms of securitisation being classed as STS.

In this context, the Draft Report stresses the necessity for “clear, quickly-applicable and uniformly-enforced criteria for the STS concepts” and the importance of the STS being sufficiently certain so as to avoid the possibility of “loopholes.”  It indicates support for greater clarification in the definition of certain aspects of the STS criteria.

It believes that there should not be an intention to eliminate non-STS securitisations, but that the aim should be to ensure that those who carry the risk in non-STS securitisations are aware of the nature of those risks and have sufficient assets to cover any potential losses.

It also supports moving towards a single European interpretation of STS criteria, by limiting the number of authorities involved in such an interpretation.

Asset-Backed Commercial Paper (“ABCP”)

The Draft Report discusses some of the difficulties in applying the STS regime to ABCP securitisations. It highlights the importance of car lease and loans in the ABCP market and views that that they should be included within the STS regime.

Self-Attestation and Penalties for Non-Compliance

The Draft Report supports the Commission’s proposals for self-attestation of STS compliant securitisations, with the responsibility for adhering to the STS criteria lying with issuers and investors.

It notes that the strictness of the applicable penalties for non-compliance is a reflection of the self-attestation nature of the STS regime. It points out that having a strict penalty regime should not however be a substitute for a failure to have clear STS criteria, and warns that severe penalties could act as deterrent for investors.

The Draft Report is of the view that to reduce divergent interpretations as regards the application of the Proposed Regulation, the authorities involved in interpreting the STS rules should be restricted to the national securities markets regulators, with the European Securities and Markets Authority taking on a central role. 

Balance Sheet Synthetics and SME Securitisations

The Draft Report recognises that synthetic transactions that are used by institutions to transfer credit risk, i.e. balance sheet synthetic transactions, have a default rate no worse than that of traditional securitisations, and so should not, in principle, be deemed to be too complex to fall within the STS regime.

It notes that SME loans have only formed a small part of the overall securitisation market in Europe and believes that SME securitisations should be encouraged through the STS proposals. It considers that a regulatory framework for synthetic securitisations within the STS regime could help develop the SME securitisations market in Europe.

Interaction with Other Markets and Investment Products

The Draft Report points out that an assessment of the attractiveness of the STS regime for investors and issuers should not be looked at in isolation, but in conjunction with the indirect effect of the proposals on other investment products such as covered bonds and whole loan portfolios. Any developments in the securitisation market that affect (positively or negatively) the markets for these other instruments should also be considered in looking at the overall consequences of the Proposed Regulation.

Third Country STS Securitisations and Equivalence of Non-EU Regimes

The Draft Report looks at whether or not it would be sensible to include a mechanism for determining whether a third-country STS regime is equivalent to that in the EU, having regard to the access to the EU market by non-EU entities. It concludes that, since the EU has been a first mover in creating an STS regime, it would be difficult to create an equivalence regime for non-EU jurisdictions at this stage, but that a review of this issue at a future date would be a more appropriate approach.

Conclusion

The conclusion of the Draft Report highlights the potential economic benefits of securitisation. However, in order to realise such economic advantages, the Draft Report stresses the importance of dealing with the issues of the asymmetry of information and moral hazard through the STS framework.

As regards moral hazard, it approves of the proposed self-certification process that seeks to prevent market participants from relying solely on third parties such as credit rating agencies, and which puts the onus for compliance with the STS regime on issuers and investors.

In respect of asymmetry of information, it stresses the relevance of transparency, citing the importance of disclosure rules for issuers and the due diligence requirements for investors. One of its key recommendations is a public register to contain information on STS  securitisations, which it considers would allow regulators to keep track of the securitisation market and would be of assistance generally to market participants.

The Draft Report acknowledges the real gains to the EU economy that would arise from a revival of the EU securitisation markets, and so is broadly supportive of the legislative proposals designed to encourage STS securitisations and to improve the functioning of the securitisation markets.

We would note that this is in contrast to the position of those MEPs who remain suspicious of securitisation in general. A number of MEPs are sceptical that the benefits of securitisation outweigh its potential risks. Even amongst those who are broadly supportive of the proposals to revive the European securitisation market, many view the Proposed Regulation with caution and intend to scrutinise it closely. Given the concerns of many MEPs, it appears that the legislative progress of the Proposed Regulation through the European Parliament will not be as quick as the European Commission had originally anticipated.

© Copyright 2020 Cadwalader, Wickersham & Taft LLPNational Law Review, Volume VI, Number 146

TRENDING LEGAL ANALYSIS


About this Author

Stephen Day, Capital Markets attorney, Cadwalader law firm
Partner

Stephen Day is a partner in the Capital Markets Group, resident in the London office. He advises leading financial institutions and corporations in Europe and the United States in connection with a wide range of structured finance and securitisation transactions, with a focus on complex cross border deals. His work in this area includes structuring commercial paper conduits, structured investment vehicles, multi-country receivables (trade, auto loan/lease, credit card) securitisations, securitisation bridge and private equity take-out deals, whole business transactions and...

T.+44 (0) 20 7170 8535 M.+44 (0) 7944 370 395
Neil Macleod, special counsel, financial services attorney, Cadwalader, london law firm
Special Counsel

Neil Macleod is a special counsel in the Capital Markets Group in Cadwalader’s London office.  Neil focuses on financial services, counseling clients on FCA authorization; regulated activities and exclusions thereto; financial promotion; FCA change of control approvals; the Markets in Financial Instruments Directive and the FCA’s Disclosure and Transparency rules.

Neil also has broad experience advising clients on the UK civil and criminal insider dealing and market manipulation regimes; the European Market Infrastructure Regulation; the Alternative Investment Fund Managers Directive; UK regulatory issues concerning collective investment schemes; client money, custody and collateral provisions in prime brokerage and futures agreements; the regulatory consequences of rehypothecation and title transfer collateral arrangements; regulatory issues relating to the insolvency of financial institutions; the use of appointed representatives in fund advisory structures; the FCA's approved persons regime; anti-money laundering regulations and procedures and anti-bribery policies; benchmark regulation; and international securities laws.

+44 (0) 20 7170 8641
David Quirolo, Capital Markets Attorney, Cadwalader, London Law firm
Partner

David Quirolo is a partner in Cadwalader’s Capital Markets Group, resident in the London office. Focusing his practice primarily on CLOs, securitisation and repackaging transactions involving various asset types in the United States and Europe, David represents banks, arrangers and asset managers in a variety of structured finance transactions. 

+44 (0) 20 7170 8635
Nick Shiren, finance capital markets attorney Cadwalader law firm
Partner

Nick Shiren is a partner in the Capital Markets Group, resident in the London office. His practice focuses on complex financing transactions involving a wide variety of asset classes. In particular, Nick has extensive experience in derivative products (including credit default swaps, credit-linked notes, total return swaps, currency and interest rate swaps, repos and other derivative instruments), structured credit transactions (including collateralised loan obligations) and securitisation transactions (including securitisations of residential and commercial...

+44 (0) 20 7170 8778
Jeremiah M. Wagner, Cadwalader, London, derivative transactions attorney, asset classes lawyer
Partner

Jeremiah Wagner is a partner in the Capital Markets Group of Cadwalader’s London office. He has extensive experience across a range of structured finance, securitisation and derivative transactions and asset classes, including credit card receivables, residential and commercial mortgages, auto loans and leases, dealer Floorplan loans, insurance products, trade receivables and synthetic exposures.

Jeremiah represents clients (issuers, underwriters and arrangers) in international capital markets transactions, and focuses on advising on...

44 (0) 20 7170 8542