EBA finalises STS framework for synthetic securitisations

The STS framework for true sale or traditional securitisations (see White Paper 81) is already being well received by participants on the securitisation market. Between 1 January 2019 and mid-May 2020, 245 STS securitisations have already been registered on the ESMA website. The EBA (in conjunction with ESMA and EIOPA) is now responding to the requirement under art. 45 of the Securitisation Regulation by presenting a draft report on the creation of a framework for synthetic STS securitisations (limited to synthetic balance sheet securitisations). The report submitted to the EU Commission now serves to discuss and develop further legislative initiatives to complement the European securitisation framework.

The synthetic securitisations, some of which had unfairly fallen into disrepute in the because of the financial crisis, were initially excluded from the STS framework due to their very different structures. This was because of so-called synthetic arbitrage transactions, which were often complex, not transparent and had high default rates. On the other hand, synthetic balance sheet securitisations have existed and continue to exist which are simple in structure and c.p. not subordinate to traditional securitisations in terms of risk. In recent years, this form of synthetic securitisation (EUR 15.5 billion in 2010 compared with EUR 104.5 billion in 2018) has again become more common in the European market and seen an increasing degree of standardisation. A comparison of performance between traditional and synthetic transactions shows that synthetic transactions perform better both in terms of default rates over their term and regarding changes in ratings/credit quality [1].

It is worth noting that the framework planned by the EBA for synthetic securitisations does not correlate with the Basel STC Framework. The Basel STC Framework does not stipulate any special treatment of synthetic securitisations in the near future. This would result in differences between European and non-European regulatory requirements in the way synthetic securitisations are treated. 

The existing STS framework for traditional synthetic securitisations has been used as a basis for establishing the criteria of the synthetic securitisation framework. In order to reflect the structural characteristics of STS securitisations, some existing criteria have been amended and some new ones were added as well. First of all, the creation of the simplicity criteria will include questioning why no arbitrage securitisations exist, as this form of securitisation is to be excluded from the framework for synthetic securitisations. The standardisation criteria must include details on the use of interest rate and currency swaps. Some criteria take into account cases where a special purpose entity is not always involved in synthetic securitisations, such as the requirements for early termination or amortisation or termination of the revolving period. The criteria on transparency requirements are similar to those for traditional securitisations.

New criteria concern the requirements for the definition of credit events, credit protection agreements and credit protection payments, as well as the rules on early termination. Accordingly, a time call option may not be determined earlier than the WAL at the beginning of the transaction. Specific requirements are also defined for cash collateral. Therefore, only high-quality bonds held by an independent trustee or the protection buyer or cash collateral deposited with a third-party institution of high creditworthiness qualify. Legal opinion in all the relevant jurisdictions should be sought on whether the hedge can be enforced. Furthermore, a verification agent is to be involved as an independent party who will, e.g., perform audits on credit events or loss allocations. In addition, before closing the transaction, the pool of receivables to be securitised must be verified based on a sample using a minimum confidence level of 95%.

Contrary to the discussion paper, the excess spread, which is very common in synthetic structures, is now permitted as per the current report under certain conditions, e.g. the size of the excess spread must be set as a fixed percentage, an unused excess spread must be returned to the originator (use-it-or-lose-it mechanism) and the total excess spread must not exceed the expected loss (viewed over one year) of the underlying portfolio.

Eagerly awaited is also the response to the question, which still has not been answered, but is justified given the complexity of an STS classification, as to whether and to what extent a more favorable risk weighting for synthetic STS securitisations will be granted by the regulators. Although this important issue has been touched upon in the present report, the concrete form and decision is left to the EU institutions.

New STS framework for synthetic securitisations

On 25 September 2019, the EBA published its discussion paper on the creation of a framework for synthetic securitisations that are to be considered as STS-compliant (simple, transparent and standardised). 

The STS framework for true sale or traditional securitisations (see White Paper 81) is already being well received by participants on the securitisation market. Between 1 January 2019 and mid-October 2019, more than 70 STS securitisations have already been registered on the ESMA website. The EBA (in conjunction with ESMA and EIOPA) is now responding to the requirement under art. 45 of the Securitisation Regulation by presenting a draft report on the creation of a framework for synthetic STS securitisations (limited to synthetic balance sheet securitisations). The purpose of the discussion paper now published is to prepare and flesh out this report and was debated on with various participants in the market at a public hearing on 9 October 2019.

The synthetic securitisations, some of which had unfairly fallen into disrepute as a result of the financial crisis, were initially excluded from the STS framework due to their very different structures. This was because of so called synthetic arbitrage transactions, which were often complex, not transparent and had high default rates. On the other hand, synthetic balance sheet securitisations have existed and continue to exist which are simple in structure and c.p. not subordinate to traditional securitisations in terms of risk. In recent years, this form of synthetic securitisation (EUR 15.5 billion in 2010 compared with EUR 104.5 billion in 2018) has again become more common in the European market and seen an increasing degree of standardisation. A comparison of performance between traditional and synthetic transactions shows that synthetic transactions perform better both in terms of default rates over their term and regarding changes in ratings/credit quality ^[1].

If we compare synthetic transactions with traditional ones, it is the different risk transfer that is important above all. In the case of traditional securitisations, the focus is more on the legally secure transfer of (high-quality) underlyings (risk and ownership); the connection between the originator and investor is considered to be less relevant. The regulatory focus lies much more on protecting the investor. In the case of synthetic securitisation, extra attention must now be paid to the risk transfer instruments and the parties involved. Guarantors, counterparts for derivative risk transfer instruments, also have to be taken into account. In other words, regarding synthetic transactions, the supervisory authority’s focus should not just be on the investor but on the originator too.

On the other hand, it is worth noting that the framework planned by the EBA for synthetic securitisations does not correlate with the Basel STC Framework. The Basel STC Framework does not stipulate any special treatment of synthetic securitisations and no such treatment is currently planned by the Basel Committee, at least not in the near future anyway. This would result in differences between European and non-European regulatory requirements in the way synthetic securitisations are treated. However, changes in the Basel STC framework with regard to high-quality synthetic securitisations might be discussed in the future.

The existing STS framework for traditional synthetic securitisations has been used as a basis for establishing the criteria of the synthetic securitisation framework. In order to reflect the structural characteristics of STS securitisations, some existing criteria have been amended and brand new ones added as well. First of all, the creation of the simplicity criteria will include questioning why no arbitrage securitisations exist, as this form of securitisation is to be excluded from the framework for synthetic securitisations. The standardisation criteria must include details on the use of interest rate and currency swaps. Some criteria take into account cases where a special purpose entity is not always involved in synthetic securitisations, such as the requirements for early maturity, early repayment or termination of the revolving period. The criteria on transparency requirements have been incorporated into the regulatory framework for synthetic securitisations and have not changed.

New criteria concern the requirements relating to credit events, credit protection agreements and credit protection payments, as well as the rules on early termination. The EBA believes using an excess spread is too complex and it has been excluded from the framework. Specific requirements are also defined for cash collateral. Accordingly, only EU government securities that are creditworthy and have a risk weighting of 0% qualify as collateral. Legal opinion in all the relevant jurisdictions should be sought on whether the hedge can be enforced. Furthermore, a verification agent is to be involved as an independent party who will, for example, perform audits on credit events or loss allocations.

The adoption of the homogeneity criteria from the framework for traditional securitisations or the strict way the excess spread, which is very common in synthetic structures, is treated, has been criticised in some quarters. Eagerly awaited is also the response to the question, which still hasn’t been settled but is justified given the complexity of an STS classification, as to whether and to what extent a more favourable risk weighting for synthetic STS securitisations will be applied.

The deadline for comments on this consultation is 25 November 2019. According to the work programme published in October by the EBA for 2020 the final report on the qualification of synthetic STS securitisations is expected in the second quarter of 2020.

^[1] _{EBA/DP/2019/01; p. 14 cf}

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Andrea Flunker
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