Navigating the Tangled Forest - Clifford Chance€¦ · Navigating the Tangled Forest...

Navigating the Tangled ForestSecuritisation regulation in Europeand the United States

This time last year we talked about a picture that was brightening, if still mixed with darker spots, andthat largely remains the case. This is not to say that things have failed to move on. The EuropeanCommission’s Capital Markets Union project has made significant progress. The improved mood musicfrom policy makers and regulators has taken shape as concrete proposals covering “simple,transparent and standardised” securitisation, regulatory due diligence, disclosure and transparency, andrisk retention – as well as proposals introducing the new Basel Securitisation Framework for bankcapital and integrating the STS concept within it. These proposals have been greeted with enthusiasmby the Council and (as at the time of writing) seem to be receiving a warmer welcome in the EUParliament than many had expected. The CRA3 public website disclosure obligations that were sohotly debated before being finalised no longer seem likely to be actually be applied. The Volcker ruleand Regulation AB II have now mostly settled and US risk retention has caused less market dislocationthan many had feared, although it is yet to apply outside the residential mortgage market.

Other than ongoing uncertainty around the practical operation of risk retention and third party duediligence rules – the notable outstanding items on the US securitisation markets’ regulatory agenda –things appear to be settling nicely on the American side of the Atlantic. That market has broadlyrecovered and is an example for Europe of how securitisation markets should operate: deep, liquid andresilient. This is broadly what the Capital Markets Union project seeks to achieve.

Capital Markets Union promises a great deal to securitisation: streamlined and harmonisedtransparency and disclosure, regulatory due diligence and risk retention requirements; lower capitalcharges for STS securitisations in the hands of banks and insurers; harmonised criteria for those lowercapital requirements, LCR eligibility and better treatment under EMIR. Moreover although they areprovided for separately, it looks like these may even overlap significantly with central bank repoeligibility criteria.

The new legislation still has a few hurdles to cross before it is tested in the real world, however. Itsjourney in the EU Parliament is uncertain and far from complete – it may change significantly there or inthe trilogues that follow. This is not to say all change would be bad – indeed some may well bebeneficial. Despite promising much, the legislation still fails to provide adequately for existing deals andfor private deals, for example. In particular, many challenges remain for ABCP, notwithstanding recentsignificant moves in the right direction by regulators and policy makers to address them.

Finally, if we are to reach our goal of vibrant, well-functioning securitisation markets around the worldwe’ve little choice but to continue travelling through the tangled forest of regulation. Unfortunately thepath is not clear and is often difficult to follow. We hope the reflections in this volume help provide youwith a few signposts to guide you and show, at least, the direction of travel.

Introduction

Kevin IngramPartner, On behalf of the International Structured Debt Group

Andrew E. BryanSenior PSL – Structured Debt

Contents1. The Securitisation Regulation: where to next? ................................................................. 4

2. PD3: what does the CMU mean for the Prospectus Directive? ....................................... 16

3. Bank Recovery and Resolution: what impact on securitisation? ...................................... 22

4. Synthetic Securitisation: returning from the wilderness? .................................................. 26

5. Third Party Due Diligence: reports under 15Ga-2 and 17g-10 ......................................... 32

6. US Risk Retention: what we know… and what is yet to come ........................................ 36

7. EU and US Comparative Risk Retention: can they work together? .................................. 42

8. The EU Covered Bond Framework: towards a 29th regime? ........................................... 50

9. The Next Step in ‘Step-In’ Risk: the BCBS considers the position .................................. 54

Clifford Chance contacts (London) ......................................................................................... 60

Clifford Chance contacts (Global) ........................................................................................... 61

Other contributors.................................................................................................................. 63

Acknowledgements................................................................................................................ 63

1. The Securitisation Regulation:where to next?

STS PracticalitiesMuch has been written on the STScriteria, which are numerous and detailed.This level of focus is appropriate giventhat compliance with the criteria willprovide access to a far more benignregulatory regime than would otherwisebe available for securitisations. This isexpected to include lower capital chargesfor both banks1 and insurers, exemptionsfrom some of the clearing and marginingrules for under EMIR for the associatedsecuritisation swaps, and eligibility for theLCR – plus the possibility of other benefitsbeing introduced later.

That said – and other than the debateabout third party certification – relativelylittle focus has been placed on thepracticalities of achieving STS status.Although it was proposed by a number ofmarket participants at early stages, it nowseems fairly clear that the final position isunlikely to be one where a regulator (orregulated third party) certifies transactionsas STS and all other market participantsmay then rely on that certification. Instead,the proposed regulation sets out a regimewhereby the issuer, originator andsponsor jointly file an STS notificationwhich may (in the EU Council’s version ofthe legislation) include a statement that ithas been verified by an authorised third

party. Investors are then required as partof their regulatory due diligence to verifywhether the criteria have been compliedwith prior to investing.

All of this creates a kind of market-based,distributed responsibility for STSdesignation. Although they did notcontemplate detailed complianceprocedures in the same way as theproposed Securitisation Regulation, theLevel 2B securitisation criteria in thecontext of the liquidity coveragerequirement and the Type 1 securitisationcriteria in the context of Solvency IIprovide some guidance as to the waySTS categorisation might work. Theexperience with those two regimesprovides some comfort that, even in theabsence of a definitive arbiter of STSdesignation, the market will nonethelessbe able to come to sensible conclusionsabout the meaning of the criteria and,ultimately, which transactions are STS andwhich are not.

Lessons from the LCR andSolvency II criteriaThe broad lesson from the LCR andSolvency II criteria is that it is possible tocheck most, if not all, criteria based onthe offering document in the case of apublic securitisation offered by way of a

Prospectus Directive-compliantprospectus. The market in these securitiesgenerally requires enough information tobe disclosed that the securitisation will beable to be sensibly assessed against mostof the criteria in the LCR and Solvency II,even if it is found that the securitisationitself doesn’t meet those criteria. In fact,when looking at examples ofsecuritisations of the type regulators andpolicy makers were probably thinking ofwhen coming up with those initial criteria,it is not surprising to find that most criteriaare met.

This is not to say, however, that thereare not some issues around the edges.The pool homogeneity requirement and theexclusion of credit-impaired obligors aretwo useful examples that illustrate theissues encountered thus far.

Pool homogeneityIn the case of the pool homogeneityrequirement, the issues have arisen largelyout of an ill-defined criterion. Taking theSolvency II wording for residentialmortgages as an example, the requirementis that the securitisation be “backed by apool of homogeneous underlyingexposures which all belong to only one[category]”. One of those categories is“residential loans secured with a first-

The proposed Securitisation Regulation will affect most of the important aspects of theregulation of securitisation in the EU. Bank capital, insurance capital, disclosure andtransparency, regulatory due diligence, risk retention and liquidity treatment are allcontemplated in the EU Commission’s proposal, and it seems likely that the effects willspread once the regulation is in place. In this article, we take a look at the main aspectsof the regulation: the new simple transparent and standardised (“STS”) securitisationregime, disclosure and transparency, regulatory due diligence, and risk retention.

© Clifford Chance, June 2016

Navigating the Tangled Forest 5

1 It is worth noting that the capital relief to be provided to banks is capital relief as compared to the new Basel Securitisation Framework published by the Basel Committeein December 2014, which will dramatically increase the capital banks must hold against securitisation investments as compared to the current system. That newframework is supposed to be implemented in January 2018, but the current CRR amending proposals would bring it in early, along with the STS framework set out in theproposed Securitisation Regulation.

6 Navigating the Tangled Forest


ranking mortgage granted to individuals forthe acquisition of their main residence…”.

Although this may seem relativelystraightforward on its face, a number ofquestions arise as soon as it is comparedto a real world deal. What if there aremultiple mortgages on the home? What ifthe mortgage loan was not for theacquisition of the borrower’s mainresidence, but refinances a loan thatwas? What if the mortgage loan is partlyfor the acquisition (or refinancing theacquisition) of the borrower’s mainresidence and partly for other purposes,such as renovations to that residence? Orperhaps just refinancing other forms ofconsumer debt, such as credit carddebts? These are all common situationsand most or all would typically bepermitted by the eligibility criteria of astandard UK RMBS transaction,sometimes subject to conditions (e.g.multiple mortgage loans on the sameproperty are usually allowed provided allhigher ranking mortgages are alsoincluded in the securitisation, and theoverall LTV limit is not exceeded).

Although the Solvency II criteria have onlybeen applicable for a relatively short periodof time, the market is beginning to getbroadly comfortable with all of thesesituations. As with the introduction of mostother new laws, there has been an initialperiod of uncertainty, but marketparticipants on all sides have workedthrough these new criteria with theiradvisers. Because it is in everybody’sinterests to comply, this not has generallybeen unduly difficult. Where the deals theyare marketing comply, sell side institutionsare eager to take full advantage.Accordingly, they will go to some effort toensure that the buy side has thenecessary information to conclude thedeal complies. Buy side institutions, inturn, have been making clear to sell side

institutions when they need furtherinformation or more explicit disclosure inorder to come to that conclusion.

Credit-impaired obligorsThe situation with credit-impairedobligors has been problematic in aslightly different way. The requirementhere is that at the time of issuance (orinclusion in the pool, if later) none of theobligors on the underlying loans shouldhave “declared bankruptcy, agreed withhis creditors to a debt dismissal orreschedule or had a court grant hiscreditors a right of enforcement ormaterial damages as a result of a missedpayment within three years prior to thedate of origination” (emphasis added),nor should any obligor be “on an officialregistry of persons with adverse credithistory”, nor should any obligor have“a credit assessment…or…a credit scoreindicating a significant risk thatcontractually agreed payments will notbe made compared to the averageobligor for this type of loans in therelevant jurisdiction”.

Obviously this raises some of the sameproblems of simple uncertainty of thetype present with the homogeneitycriterion. What is meant by “this type ofloans” for the purpose of benchmarkingcredit scores in the final part of thecriterion? Would that make it acceptableto have very poor credit history if it was aspecialist payday loan securitisation,for example?

That said, there is the additional problemthat this criterion does not reflect anexisting best practice in the market –most credit processes simply do notinclude the three year history required tobe disclosed by the criterion. Fortunately,transactions issued before the Solvency IIregulation came into force are exemptfrom this requirement, but that still leaves

a sizable stock of receivables that wereoriginated prior to the criteria beingpublished but were not ready to besecuritised until after they came intoforce. Since it would be impractical (if notimpossible) to go back and perform thesechecks, originators will not be in aposition to disclose against this criterionand consequently may have difficultysecuritising these exposures onreasonable terms, or at all. Goingforward, many credit institutions may beable to change their credit processes tocheck these things, but some may not.There has, for example, been significantconcern expressed by some Frenchlawyers about the legality of performingthree years worth of checks under Frenchprivacy laws.

Given that some of these problems areless susceptible of being resolved bygeneral market consensus, it is perhaps agood thing that the Commission intendsto replace these criteria with the STScriteria in due course.

STS criteria and the way forwardMany of the lessons from the LCR andSolvency II can be applied to the newSTS criteria. In particular, many of thecriteria have been crafted in a way thatcan be relatively simply andstraightforwardly checked in theprospectus. Fortunately some of thelacunae appear to have been correctedas well. For example, the credit-impairedobligor criterion in the proposedSecuritisation Regulation is qualified by“to the best knowledge of the originatoror original lender”, meaning there willpresumably be no problems caused byrequiring information that hasn’t beencollected (because it wasn’t required atthe time of origination) nor will institutionsbe put in the awkward position of havingto choose between STS qualification orcomplying with local privacy laws.



Further, while a number of the criteriamay not be completely straightforwardand clear, the experience of the SolvencyII and LCR criteria suggests that themarket may be in a position to managethis uncertainty, provided there is apractical mechanism for ensuring quickresolutions where differences of opinionon interpretation do arise. A goodexample of this is the prohibition on“severe clawback provisions”. This is notclear on its face, but the market has beenliving with some form of this language formany years and is now unambiguouslycomfortable with it, largely on the basisthat the European Central Bank includedit in its asset eligibility criteria and hasbeen implicitly making decisions on thisfor some time now.

Unfortunately, the story doesn’t endthere. Some of what was got right in theSolvency II legislation, such asgrandfathering of existing transactions, isthus far absent from the SecuritisationRegulation. What’s more, there are agreater number of criteria requiringongoing monitoring, which will raise thecompliance burden for investors. Finally,the criteria are very much designed withpublic transactions in mind, which ignoresthe fact that a large proportion of allsecuritisation activity at the moment isnot undertaken with a ProspectusDirective-compliant prospectus.

GrandfatheringWhile the grandfathering in the Solvency IIRegulation may have been imperfect, theSecuritisation Regulation does not seemto provide for it at all in respect of theSTS criteria. Neither the Commission northe Council version of the SecuritisationRegulation contains this, and (as of thetime of writing) there doesn’t seem to beany suggestion this is an issue that will bechampioned by the EU Parliament.

The argument thus far from theCommission is that it would dilute theSTS criteria to allow the label to be usedby legacy deals that don’t comply fully.This is unfortunate, and misses the pointfor at least two reasons.

The first is that that fails to take accountthe reason a number of the criteria arepresent. For example, the requirementthat at least one payment has been madeon each underlying exposure before it isincluded in the securitised pool is a fraudprevention measure. That requirementbecomes irrelevant in the context of aseasoned securitisation with a credithistory and pool performance data of itsown. Similar arguments can be madeabout the requirement that, at the time ofinclusion in the securitised pool, theremay not be any defaulted assets orexposures where the obligor is creditimpaired. To require compliance withthese criteria before allowing e.g. athree-year old residential mortgagesecuritisation to qualify as STS clearlyserves no purpose.

The second is that the market needs tohave critical mass in order to functionproperly. STS will only work if a largeproportion of existing deals are more orless immediately able to qualify. Withoutthat, there is a serious risk of fire sales ofexisting securitisation positions, effectivelypunishing existing investors for continuingto invest in securitisations andencouraging them to leave the market –the opposite of the result intended by theSTS regime and the SecuritisationRegulation more generally. For thisreason, it makes eminent good sense toprovide grandfathering for technicalcriteria that attempt to introduce newmarket standards, such as therequirement to include certain specificperfection events, the requirement thatthe seller should give certain

representations and warranties and therequirement to include certain specificearly amortisation triggers. Existing dealsare highly unlikely to contain all of theserequirements and any attempt to amendtransaction documentation to includethem would, at the very least, be lengthyand cumbersome – and may well proveimpossible in a number of cases.

We understand that the Commission maybe prepared to reconsider its stance ongrandfathering, and it is to be hoped thatthis serious flaw in the legislation will beaddressed before the end of thelegislative process.

Ongoing monitoringA further difficulty with the STS criteria isthe introduction of criteria that requireadditional ongoing monitoring. Both theLCR and Solvency II criteria require somedegree of ongoing monitoring, but theseare generally obvious, easy to check andthe type of thing any responsible investorwould pay close attention to anyway (e.g.the requirements for listing, maintaining aparticular credit rating and providingongoing disclosure). The STS criteria addto this, with a number of criteria that aremeasured not only at origination orissuance, but thereafter as well. Therequirement to “fully disclose” all “materialchanges in underwriting standards” is agood example. This obligation will fallprimarily on originators, but someinvestors may get nervous that they haveto start reading the originator’sdisclosures unrelated to the securitisationto ensure their ongoing due diligenceobligations in respect of this criterion arefulfilled. While we are of the view that thisis probably not necessary, it highlightssome of the difficulties with certainongoing obligations and the importanceof circumscribing the informationinvestors are required to review in orderto fulfil their regulatory due diligence



obligations more generally. Similarquestions could arise with respect to therequirement to mitigate interest rate andcurrency risks (e.g. where events occurpost-issuance that reduce theeffectiveness of the mitigation).

The fact that failure to disclose a materialchange in underwriting standards couldeasily result from a good faith differenceof opinion as to materiality also highlightsthe importance of proportionate sanctionsfor failures to comply and the need tomitigate the cliff effects that occur whenthere is technical (and sometimestemporary) non-compliance with the STScriteria after issuance – although a fullerexploration of these issues is beyond thescope of this article.

Difficulties for private securitisationsThe final area of practical difficulty arisingout of the STS criteria is that they – likethe LCR and Solvency II criteria beforethem – are largely designed with publicsecuritisations in mind. So while it may betechnically possible for privatesecuritisations – which are a large part ofthe market at the moment – to comply

with the STS criteria, it would in manycases be unnecessarily burdensome todo so. Where, for example, a portfolioacquisition is financed by way of a privatebank loan that is technically asecuritisation, the transparencyrequirements (which, to be fair, wouldapply to any securitisation whether or notit is STS) would be excessivelyburdensome. To then add therequirements relating to disclosure ofhistorical default and loss performancedata on similar exposures, and anongoing liability cash flow model (to namebut two) rapidly makes it highly unlikelyprivate securitisation could or wouldcomply. And that is before one begins toconsider the difficulties engendered bythe STS regime’s assumption that therewill be an SPV issuer in everysecuritisation – often not the case inprivate securitisations, including portfoliofinancings. Contrary to the intended effectof the Securitisation Regulation, it seemsto us that is likely to discouragesecuritisation rather than encouraging it.

While many of these difficulties are due tothe suboptimal definition of securitisationused in the EU with its roots in Basel III, it

is nonetheless the case that – unless anduntil that definition is changed –legislation has to take account of it andprovide accordingly.

ConclusionSo a fair bit of good news. Thecriteria are numerous but broadlymanageable. They are not always asprecise as one might hope, butthere are ways of dealing with thisas the market has demonstratedwith the Solvency II and LCRcriteria. Nonetheless, somesignificant challenges remain – forlegacy securitisations and privatesecuritisations in particular. Withsome very clear benefits of the STSlabel laid out – and more likely tocome in the foreseeable future – thecrucial point for the success of thenew regime fundamentally remainshow practical compliance will be. Itis to be hoped that the difficultieslaid out above will be addressedbefore the Securitisation Regulationis finalised.



TransparencySecuritisation has always been adata-rich asset class, with theperformance of the securitisationinvestment dependent, ultimately, on theperformance of a number – sometimeshundreds of thousands – of underlyingassets. For that reason, understandingthe creditworthiness of a securitisation ismore complex than understanding thecreditworthiness of e.g. an individualcorporate loan. Not only do investorsneed an understanding of the behaviourof the individual underlying exposures,they also need an understanding of howthose exposures act as a portfolio. Afterall, if the 2008 financial crisis reminded usof one thing, it was that the performanceof the individual exposures in a portfoliomay become highly correlated incertain circumstances.

Because of the complexity of the creditanalysis, disclosure and transparency havebeen an integral part of Europeansecuritisation markets for a very long time.Even before the financial crisissecuritisation transactions providedsignificantly more data than your typicalbond. Nonetheless – and quiteunderstandably – ensuring that the rightdata is provided at the right time has beena particular focus of regulators, policymakers and central banks since thefinancial crisis. This was manifested first asthe general disclosure requirements underArticle 122a(7) of the Capital RequirementsDirective (now Article 409 of the CapitalRequirements Regulation) and then asloan-level data requirements imposed bothby the Bank of England and the EuropeanCentral Bank as conditions of asseteligibility in their respective repooperations. Most recently, it has taken theform of Article 8b of the Credit RatingAgencies Regulation and its correspondingregulatory technical standards (“RTS”). By

and large originators have been happy toprovide additional information to the extentit is useful to investors. Of these regulatoryinitiatives, only Article 8b and its RTS haveattracted significant industry criticism, andthis was because of their:

n unprecedented broad scope:effectively all securitisation instrumentswere intended to be subject,

n unprecedented broad audience: allinformation was to be made freelyand publicly available, regardless ofwhether the deal was private; and

n unnecessary duplication of efforts: allinformation was to be hosted on awebsite established by the EuropeanSecurities and Markets Authority(“ESMA”) (which seemed largelyduplicative of the EuropeanDatawarehouse) in precisely theprescribed form, regardless ofwhether substantially similarinformation was already publiclyavailable elsewhere (e.g. pursuant toexisting ECB or BoE requirements).

Fortunately, the requirements of Article 8bseem destined unlikely ever to bepractically implemented, with a rumouredrepeal via the proposed SecuritisationRegulation in the pipeline, and a recentadministrative announcement by ESMAappearing to plug what had threatened tobe a very awkward gap between the 1January 2017 application date of Article8b and the time the new SecuritisationRegulation comes into force.Unfortunately, it would appear that thescrapping of Article 8b may come withthe loss of a very helpful transitionalprovision in the Article 8b RTS thatexempts securitisations outstanding on orbefore 26 January 2015. As currentlyproposed, the transitional provisions inthe Securitisation Regulation do not carryover this or any similar exemption,

meaning all securitisations would berequired to comply with the newdisclosure obligations once theSecuritisation Regulation begins to apply.This would clearly be problematic and it isto be hoped that this lacuna in thetransitional provisions will be addressedbefore the legislative process concludes.

The Securitisation Regulation willreplace rather than simply repealingArticle 8b, however. The proposedSecuritisation Regulation picks up manyof the same themes, but makes a freshattempt at regulating disclosure forsecuritisations in a manner that seeks todeal with some of industry’s concernswith the Article 8b regime.

The draft Securitisation Regulationand term securitisationsAs with Article 8b, the transparencyprovisions of the draft SecuritisationRegulation apply to all securitisations.Although this broadly follows the approachadopted by the Article 8b RTS, theSecuritisation Regulation as proposedrequires the disclosure to be madeaccessible only to investors, competentauthorities and, upon request, potentialinvestors (although the latter requirement isonly in the Council general approach andnot the Commission proposal). That said,the draft report prepared by the EUParliament’s rapporteur (the most recentdevelopment at the time of writing)suggests the creation of a repository ofSTS securitisation disclosure data thatwould be publicly accessible, so there is apossibility that some element of fully publicdisclosure will be re-introduced, at least forSTS securitisations, before the legislationreceives final approval.

What needs disclosing and by whom?The types of information required to bedisclosed under the draft SecuritisationRegulation are broadly similar to those



intended to be required under theArticle 8b regime. These include:

n the prospectus or other offeringdocument; where no prospectusexists, a summary covering the keyfeatures of the securitisation must beprovided, but this may included in thenon-prospectus offering document;

n the STS notification, where relevant;

n the transaction documents (excludinglegal opinions);

n quarterly investor reports covering thecredit quality and performance of theunderlying exposures, asset andliability cash flows, the breach of anytriggers resulting in changes to thepriority of payments or replacement ofcounterparties, and risk retention;

n quarterly loan-by-loan data inprescribed format.

As with the Article 8b RTS, the draftSecuritisation Regulation would requiredisclosure without delay of certainsignificant events in respect of thesecuritisation. Where the securitisation issubject to reporting anyway under EUmarket abuse rules, no furtherrequirements are imposed. Where it is notsubject to EU market abuse rules, thedraft Securitisation Regulation imposessimilar requirements that mimic theireffect. The originator, sponsor and thespecial purpose entity are required todesignate amongst themselves one entityto comply with the disclosure rules.

Information must be available free ofcharge and in a timely and clear manner.

How should information be disclosed?As with the Article 8b RTS, the draftSecuritisation Regulation contemplates the

use of disclosure templates for the loanlevel data. It requires ESMA, in closecooperation with the European BankingAuthority and the European Insurance andOccupational Pensions Authority to developstandardised templates for reporting, takinginto account the usefulness of informationto the investors, whether the securitisationis of a short term nature and, in the case ofABCP transactions, whether it is fullysupported by the sponsor. ESMA is likely tohave a year to develop these templates. Itmay be, however, that a year will not benecessary as the templates introduced bythe Article 8b RTS represented the productof extensive market consultation and wereanyway very similar to the templatesdeveloped in the context of the EuropeanDatawarehouse for ECB eligibility purposes.The market therefore widely expects thatthese will be largely recycled and carriedover into the new regime – although this willclearly not be possible for ABCP andcertain other categories of “private andbilateral” transactions for which furthertemplates were contemplated but neverdeveloped under the Article 8b regime.

It is hoped that the regime for private andbilateral transactions, which are by theirvery nature much more varied andbespoke, will take into account theextensive work done by ESMA and theindustry on these transactions beforework was suspended on this workstreamunder Article 8b.

Where should information be disclosed?This is perhaps one of the mostsignificant areas of difference with theArticle 8b regime, which contemplated fullpublic disclosure on a websiteestablished by ESMA. As noted above,the draft Securitisation Regulationintroduces a more flexible approach. Theconcept of an ESMA-established website

is replaced with a requirement to makeinformation available on a website “free ofcharge to the holder of a securitisationposition and competent authorities, in atimely and clear manner”

2.

In order to comply, the relevant websiteneed not be established by any particularentity or in any particular way, so long asthe entity responsible for disclosure:

n develops a well-functioning dataquality control system;

n puts in place and maintainsadequate organisational structure,respects appropriate governancestandards and ensures continuity andorderly functioning;

n sets up appropriate systems, controlsand procedures to ensure that thewebsite can function in a reliable andsecure manner and identifies sourcesof operational risk;

n develops systems to ensure theprotection and integrity of theinformation received and the promptrecording of information; and

n ensures that the information is keptand is available for five years after thematurity date of the securitisation.

Additionally, the Council explicitlyauthorises the use of passwordprotection. That seems superfluous in thecontext of the Commission proposallimiting the audience to which informationmust be disclosed. It seems irrelevantwhether the limitation of the audience isachieved through password protection, IPaddress restriction or some other method.

Thus, while the new regime introduces anadditional flexibility for originators,sponsors and issuers in terms of how thewebsites may be set up and run, it also

2 This is the wording of the Commission proposal. As noted above, the Council’s general approach document expands the audience to include potential investors upon request.



potentially shifts the onus of ensuringconsistency, integrity and adequacy ofthe reporting infrastructure onto them.There is no reason, however, that thesefunctions could not be delegated and itseems on its face as though someexisting facilities (such as the EuropeanDatawarehouse) might fulfil theserequirements already.

This clearly represents a step in the rightdirection from the regime under theArticle 8b, especially as concerns thebreadth of audience for disclosures inrespect of private and bilateraltransactions. But is this step big enoughto cater for the specific needs andsensitivities of non-public structures? It isnot clear what additional benefits themandatory reporting of particularinformation at particular frequencies andin prescribed format would confer oninvestors in a private transaction who,often very small in number, wouldtypically be in a position to negotiate theright to receive the information they findmost useful at a frequency of theirchoosing and in the format they findmost convenient.

Special concerns of the ABCP marketUnlike the Article 8b RTS (that explicitlyleft for later the question of ABCPdisclosure), the draft SecuritisationRegulation expressly applies to ABCPtransactions. Some practical concernsarising from that are discussed below.

Asset level disclosure The draft Securitisation Regulationextends the requirement to disclose assetlevel data to ABCP transactions. In itsunqualified form, this requirement maycreate serious practical issues forsponsors of ABCP transactions and thefunctioning of the ABCP market. First,unlike with other asset classes, there istypically a lot more commercial sensitivity

around the underlying transactions and itis not uncommon for originators (who aretypically non-financial corporates) toprohibit onward disclosure of informationby the sponsor. Secondly, given the shortterm nature of the underlying assets(e.g. trade receivables), the sheer volumeof the asset level data would makecompliance extremely difficult, and mightnot be technically feasible at all.

The Council general approach helpfullyrelaxes this general requirement andprovides that investors and potentialinvestors will only receive access to assetlevel data in aggregated form. Loan leveldata will have to be made available onlyto the sponsor and, upon request, tocompetent authorities.

There is no indication in the draft ofwhat specific level of aggregation mightbe appropriate in this context. Thecurrent practices of reporting for ABCPtransactions involve a high degree ofaggregation. Investor reports wouldtypically include concise, often one-page, summaries on a transaction bytransaction basis looking at the keyeconomic metrics of each (such as thedifference in the balance of receivablesduring each reporting period, levels ofdefaults and delinquencies, ineligiblereceivables, concentration). A similarapproach to the level of aggregationwould most certainly be helpfulalthough it is unclear whether it will beeventually adopted.

Frequency of reporting and volumeof dataThe draft Securitisation Regulationrequires the asset level data and investorreports for ABCP transactions to bemade available on a monthly basis. Whilemonthly investor reporting is already verycommon, if a sensible balance onaggregation of the asset level data is not

achieved, it may present a significantpractical challenge.

At this stage, it is unclear whether themore nuanced approach to ABCPtransactions included in the Councilgeneral approach will prevail, and alsowhat degree of aggregation will bepermissible. It is, however, clear that aregime which requires asset leveldisclosure to the investors and potentialinvestors would certainly makecompliance very problematic from both apractical perspective (given the volume ofdata and monthly reporting) and acommercial one (given the highly sensitivenature of information). It would also giveABCP investors something they are notrequesting and do not need.

ConclusionMuch is still left to play for in thefield of transparency – particularlysurrounding ABCP transactions.That said, it is already apparent thatthe approach to transparency anddisclosure under the draftSecuritisation Regulation, whilelargely similar to the Article 8bregime, should deliver a morenuanced balance between the needfor quality information and thepractical considerations andcommercial sensitivities involved inits disclosure.



Regulatory DueDiligenceOf all the areas affected by the proposedSecuritisation Regulation, regulatory duediligence is probably the one leastdramatically affected. Other than theharmonising of due diligence obligationsacross categories of institutional investor(which is mainly helpful for the sell side,who are not the main targets of theseprovisions) the changes are by and largeminor, technical and helpful.Requirements to check long lists offactors relating to the originator of thesecuritisation (but not necessarily relatingto the securitisation or the underlyingassets) are mostly eliminated. Pointsrequired to be verified in due diligence arebetter aligned with those required to bedisclosed under the transparencyobligations. The list of underlying assetdata points to monitor is slightlylengthened, but not in a way that is likelyto cause serious problems for the market,and this article will not dwell on them.

The main story when it comes toregulatory due diligence is one of missedopportunities, and important technicalpoints that need fixing in order to makethe regime set out in the SecuritisationRegulation function properly.

GrandfatheringClearly the most important of the areasthat needs to be addressed in theregulatory due diligence rules is thosethat affect the grandfathering provisionsin respect of risk retention andtransparency. Under the transitionalprovisions in the proposed SecuritisationRegulation, transactions can broadlycontinue to comply with the risk retentionrules as they were when the deal wasdone. It is hoped that the grandfatheringrules in respect of transparency

obligations will be amended to a similareffect, as discussed in our section ontransparency above.

Even so, the due diligence provisionsthreaten to undermine any good thetransitional provisions might do. In boththe Commission and Council versions ofthe text, institutional investors are notsimply required to check that thetransparency and risk retention rulesapplicable to the relevant securitisationare complied with. Instead, they arerequired to check that the transparencyand risk retention rules set out in theSecuritisation Regulation are compliedwith. If these rules were to be enacted asproposed even where a securitisation islegitimately permitted to comply with therisk retention rules under the CRR, itwould have to comply with the newSecuritisation Regulation rules orbecome hopelessly unattractive as aninvestment for EU institutional investors –thereby reducing liquidity, increasingvolatility and presumably reducing theprice of the security due to drasticallyreduced demand.

It is hard to believe that this is theintended result, however, and industryhas pointed out the problem to therelevant policy makers. It is to be hoped,then, that this issue will be addressed ingood time to avoid what would be a verynegative – and almost certainlyunintended – result.

Delegation of dutiesUnder the various pieces of sectorallegislation applicable to institutionalinvestors, there has been a level ofuncertainty about how to address duediligence obligations where investmentdiscretion is delegated to an assetmanager, as is often the case. Where, forexample, an insurance company gives anasset manager (itself often an AIFM

subject to its own regulatory regime)money to invest, either as part of a fundor on an individual mandate, theinsurance company will often not know(much less control) what specificinvestments are being made on its behalfon a day-to-day basis. To require theinsurance company to conduct its owndiligence separate from the mandate ithas given the asset manager would beinefficient and would defeat substantiallythe whole of the purpose of granting themandate in the first place.

The Commission version of the legislationstayed silent on this issue, leaving someinstitutional investors concerned thatthey might simply have to stop investingin securitisations, as having to conductthe relevant due diligence themselveswould have rendered securitisationinvestments uneconomic compared toother investments that have no suchrequirements and that will generallyhave much lower regulatory capitalcharges as well.

The Council general approach, however,contains a provision explicitly authorisingthe delegation of investmentmanagement authority to anotherinstitutional investor, the effect of which isto transfer the responsibility forconducting due diligence to themanaging entity, and relieving the entitywith the investment exposure. TheCommission has not, to our knowledgeexpressed any objection to thisadjustment, so it seems plausible thatthis improvement might well make its wayinto the final legislation.

Limits of investigationA further source of concern in theproposed rules relating to due diligence isthe scope of investigation an institutionalinvestor must conduct in order to satisfyits regulatory obligations. They are



presumably required to familiarisethemselves with the prospectus (or otheroffering document) and the relevant otherinformation required to be disclosed underthe transparency provisions. They are alsoexpressly entitled to place “appropriatereliance” on the STS notification wherethey are investing in a securitisation that ispurporting to be STS. Most marketparticipants further assume that thesealso represent the limits of theinvestigations institutional investors arerequired to carry out.

No one is seriously suggesting thatinstitutional investors should audit thebooks of the originator to double-checkthe information disclosed in the offeringdocument or the loan-by-loan datadisclosures. But the picture becomes lessclear when it comes to, say, theoriginator’s annual report and financialstatements or its regulatory informationannouncements unrelated to thesecuritisation. While these are alsoprobably outside the scope of whatneeds to be checked in the context of asecuritisation investment, a number ofinstitutional investors would certainlyappreciate clarity in this respect. Givenone of the purposes of the SecuritisationRegulation is to encourage investors tojoin or return to the securitisationmarkets, drawing a bright line of this typeis something that policy makers should atleast consider seriously.

ConclusionOverall the regulatory due diligenceprovisions in the SecuritisationRegulation are a step in the rightdirection as compared to theexisting rules. The changesproposed would largely make themarket more efficient and the ruleseasier to comply with. There isnonetheless room for improvement,including the areas we have set outabove. Given that at least one ofthese areas seems to be a draftingerror that would produce anunintended result (grandfathering)and another fix has already beenagreed by the Council (delegateddue diligence), there is reason foroptimism that these provisions mayyet come out of the legislativeprocess in a form likely toencourage investors back to themarket after all.



Risk RetentionRisk retention has been one of the keyaspects of securitisation regulation sincethe 2008 financial crisis, and in practicehad been a structural feature of manysecuritisations since well before that.Starting with Article 122a of the CapitalRequirements Directive the imposition of aregulatory risk retention requirement soughtto align interests and thereby reduce therisks associated with the originate-to-distribute model of securitisation which hadbeen identified as one of the causes of thecrisis. In this section, we discuss thepotential impact of the proposedSecuritisation Regulation on risk retention.

OverviewThus far, risk retention requirements inEurope have been aimed mainly atregulated investors, with separate sectorallegislation affecting each of alternativeinvestment fund managers (“AIFMs”),banks (including investment banks) andinsurance companies (including reinsurancecompanies). While the various regimes areintended to achieve the same results, thelegislation is slightly different in each case,and a different sectoral regulator isresponsible for the enforcement of each,thereby increasing the possibility of differentinterpretations being applied to differentparticipants in the same market.The Securitisation Regulation would doaway with this sectoral approach andharmonise risk retention requirements for allinstitutional investors investing insecuritisations (all the while extending therisk retention requirements to UCITS funds,which had been expected eventuallyanyway). In addition to reducing the risk ofvarying approaches across differentsectors, this would also curtail discussionon transactions in respect of the specificlegislation to be referenced in the retainer’srepresentations, warranties andundertakings – a subject that has occupiedmuch transaction team time since the

introduction of risk retention requirementsfor AIFMs and insurers.

A further, more substantive change to thecurrent regime is that the SecuritisationRegulation would impose the risk retentionrequirement on the originator, sponsor ororiginal lender directly – over and above therequirement on institutional investors tocheck that risk is appropriately retained.This change was foreshadowed by theEBA’s December 2014 report on thefunctioning of the risk retentionrequirements under the CRR, whichconcluded that, while the “indirect”approach of the CRR was working andshould be retained, a “direct” approachshould be introduced to “improve legalcertainty for investors, thereby encouragingnew securitisation investors to invest”(presumably because as well as relying onongoing reporting requirements in relationto the risk retention, they would also havethe fear of direct regulatory sanctions onthe retainer as assurance). The EBA alsopointed out that the indirect approach waslimited inasmuch as it could only apply toEU regulated institutions and thereforeEuropean originators could sellsecuritisation positions to non-EU regulatedinstitutions or unregulated Europeanentities without having to comply with therequirements. This does beg the question,though, of whether the regulators shouldbe seeking to prevent systemicallyimportant European institutions frominvesting in transactions where there is no-one with skin in the game or trying tostamp out such transactions completely.

The Securitisation Regulationcontemplates, in the first instance, theoriginator, sponsor and original lender (tothe extent these are different) agreeingwhich of them should act as risk retentionparty. So long as one does, therequirement will be complied with. In theabsence of agreement, the SecuritisationRegulation puts the obligation on theoriginator. This is the obvious choice since

in many cases the original lender will not beinvolved and there will be no party fallingwithin the definition of “sponsor” (which theSecuritisation Regulation does not proposeto amend). This could, however, provedifficult because, as has become apparentunder the current regime, there will betransactions in which multiple entities couldbe the originator, one or more of whommay not even be aware the transaction istaking place. There could also be,especially in the light of the limits on theoriginator entities who can validly retain riskintroduced by the Securitisation Regulation,no originator capable of retaining that isinvolved in the transaction – this isdiscussed further below.

SanctionsIf the originator fails to comply with riskretention requirements (and neither thesponsor nor the original lender has agreedto do so instead), what sanctions will applyto it? The Securitisation Regulation putsthis decision in the hands of the MemberStates and their respective regulators butprovides that the arsenal of sanctionsshould include, as a minimum, publiccensure, fines, bans on the relevant entity’smanagement from exercising managementfunctions and orders for compliance. TheSecuritisation Regulation also makesreference to the potential for MemberStates to impose criminal sanctions for thebreach of the Securitisation Regulation –though it seems unlikely these would beimposed for breaches of the risk retentionrequirement alone.

Ban on “special purpose” originatorsThe draft Securitisation Regulation, havingset out the risk retention requirement, goeson to state that, “For the purposes of thisArticle 4, an entity shall not be considered tobe an originator where the entity has beenestablished or operates for the sole purposeof securitising exposures.” This is clearlyaddressing the EBA’s concern voiced in itsDecember 2014 report that transaction


parties could use a special purpose vehicleto comply with the second limb of thedefinition of “originator” (“an entity whichpurchases a third party’s exposures for itsown account and then securitises them”)without properly aligning the interests of anyof the transaction’s real architects with itsinvestors. That said, the proposedSecuritisation Regulation’s articulation of therule seems to move away from the twotests proposed by the EBA as to whetheran entity is an originator within the spirit ofthe CRR: that it is an entity of real economicsubstance and that it has held theexposures to be securitised for a minimumperiod of time before securitising them.

Hopefully the proposed ban on specialpurpose originators retaining will giveincreased certainty to market participantscompared to the EBA’s description, whichclearly suffers from an unhelpful lack ofclarity and definition. The problems ofidentifying “real economic substance” andan appropriate “minimum period of time”have been especially acute on morecomplex transactions where e.g. aconsortium of purchasers have wanted touse an SPV to acquire a portfolio of loansfor completely legitimate reasons and thenfinance that acquisition via a securitisationof those loans. That said, the new test isnot without its own issues.

First, while this test is objectively morecertain than that in earlier drafts rumouredin the market (which had referred tobanning retention by originators whose“primary purpose” was acquiringexposures to securitise them) and it iscertainly clearer than the EBA’s report, itleaves itself open to similar abuses to thosepossible under the current regime ifinterpreted literally. For example, if a fundacquires £1bn of mortgages using a thinly-capitalised SPV and then immediatelysecuritises £999,900,000 of them, equityfunding the rest, the SPV is clearly notestablished “solely” to securitise exposures.However, it is clearly not in the spirit of the

legislation as its other activities are,relatively, de minimis. This case is clearlyextreme, and almost certainly untenable inthe context that that EU legislation must beinterpreted purposively, and not just literally.But that begs the question of where theline is. What value of mortgages wouldneed to be held in the SPV and equityfunded before it was not there “solely” toacquire exposures and securitise them?How long would the SPV have to hold themortgages before securitising them inorder to establish the case that it had not“solely” acquired exposures for thepurpose of securitising them?

Secondly, it could lead to instances wherecertain transactions have no originatorwilling and able to retain. This isproblematic when the draft SecuritisationRegulation seeks to impose the riskretention obligation on the originator in theabsence of agreement. Take the case of awhole portfolio of mortgages acquired viaan orphan SPV, with the acquisitionconcurrently financed by a securitisation ofthe underlying mortgage loans. As written,the current draft would impose thisobligation on the “limb (a) originator”, i.e.the original lender or a related party, sincethe “limb (b) originator” (the SPV) is notcapable of retaining under the ban. This isclearly unjust if the limb (a) originator hasnothing to do with the securitisation, andpartially defeats the purpose of thetransaction for the seller, who presumablywants rid of the portfolio entirely.

For these reasons, it seems unlikely wehave seen the end of the “real economicsubstance” and “minimum hold period”tests. Although they are not enshrined inlaw, they appear to be favoured by theEBA, they are beginning to be understoodby the markets and they continue to serveas a useful guide to what is within thespirit of the limb (b) originator definition. Infact, it is more likely that the “solepurpose” test will be added to these twoEBA-approved tests.

Other minor changesThere are several further changesintroduced to the risk retention regime bythe draft Securitisation Regulation. First,risk retention option (b) – originatorinterest – has been amended to refer to“revolving securitisations”, rather than just“securitisations of revolving exposures”.This is clearly helpful since revolving truststructure is used in relation to a variety ofasset classes rather than just revolvingones such as credit cards.

Secondly, the rules relating to retention ona consolidated basis have been changedsuch that they no longer require theexposures to have been originated byseveral different entities within the group –another minor but helpful adjustment.

ConclusionWhile the principal changes to theEuropean risk retention rules proposedin the draft Securitisation Regulation areset out above, there are some changeswhich had been hoped for by marketparticipants that have not beenincluded. For example, managed CLOsstill do not fit particularly well within theexisting regime. Additionally, while thechange to facilitate retention on aconsolidated basis is useful, the draftSecuritisation Regulation still does notcontemplate extending this beyond EUregulated institutions.

Finally, as with the CRR, the draftSecuritisation Regulation provides for thepublication of an RTS in relation to therisk retention provisions within 6 monthsof the Regulation coming into force.However, in a quirk of the transitionalprovisions, it also provides that thecurrent RTS will apply until the new oneis published. There will therefore be 6months where an RTS applies which isbased on a disapplied regulation thewording of which, in some respects (e.g.the originator interest retention option),has been superseded.


2. PD3: what does the CMU meanfor the Prospectus Directive?

1. PD1: The ProspectusDirective from creationto 2010Lamfalussy, the Wise Men andthe FSAPBaron Alexandre Lamfalussy, a respectedEuropean policy maker, played an integralrole in the FSAP over a decade ago.He chaired the “Committee of Wise Men”which developed the four tier legislativeapproach for regulation of financialmarkets in Europe, now known as the“Lamfalussy Process”. In fact, much ofthe fabric of our current Europeanfinancial markets was woven fromlegislative measures created by the “WiseMen” as part of the EU FSAP – amongthem, the EU directives and regulationssuch as the PD.

FSAP and its goalsA priority of the EU FSAP (1999 – 2005)was to create a single, more liquid EUcapital market. This was to be achievedthrough goals such as:

n removing barriers to raising capital onan EU-wide basis;

n providing legal certainty to underpincross-border trading in securities;

n ensuring that collateral could beaccepted cross-border;

n removing barriers in the form oftaxation; and

n improving informationand transparency.

FSAP and the PD regimeThe Prospectus Directive was the‘centrepiece’ of the EU FSAP drive tocreate a ‘large, liquid and integrated’European securities market. Its aim wasto make it easier and cheaper for issuersto raise capital throughout the EU and tocreate a market to rival the size of theUnited States capital markets. The way inwhich it sought to achieve this was bycreating a uniform offering and disclosureregime across all EU Member States.Uniform disclosure would enable issuersto offer their securities to the public in anyEU Member State – or to seek admissionto trading on any regulated market of anEU Member State – using a singleprospectus, approved by a singleregulator. This prospectus could be“passported” into another jurisdiction,without any changes – other than, incertain circumstances, a translation of thesummary. The PD regime replaced thefragmented mutual recognition approachwhich previously existed.

Under the previous securities regime, rulesfor debt securities had drawn a distinctionbased on the type of investor to whom the

securities were offered. In contrast, underthe new PD regime, a distinction was nowalso made based on the type of security –such as, by reference to its denomination.So, for example, alongside an exemptionfor offers made to “qualified investors”,there was also a public offer exemption inthe PD for securities offered which had aminimum denomination of EUR 50,000.Securities offerings with suchdenominations would not need aPD-compliant prospectus, irrespective ofthe type of investor to whom they mightbe targeted.

Where a PD prospectus was required,however, the regime was built on the basisof investor protection through fulldisclosure. One of the Recitals in the PDstates that: “The provision of fullinformation concerning securities andissuers of those securities promotes…. theprotection of investors”. Having said that,a small distinction was made between thelevel of disclosure required for debtsecurities with a denomination of EUR50,000 and greater (“wholesale securities”)and securities with a denomination lowerthan EUR 50,000 (“retail securities”) .

2. PD2: Revisions in 2010,post-financial crisisThis article will not dwell in detail onrevisions made as part of PD2,

The Prospectus Directive (“PD”) regime and its evolution can be viewed as a ‘bellwether’for European financial markets and political aspirations. Created in 2003, it was one of thecentral measures in the EU Financial Services Action Plan (“FSAP”) and came into forcein July 2005. Five years later, its scheduled review (“PD2”) coincided with widespreaddisillusionment with financial markets in the aftermath of the 2008 financial crisis. Thisresulted in some stringent fine-tuning by regulators. Now, as part of its 10 year review(“PD3”), the PD regime is once again a flagship for growth. It is a priority measure, alongwith securitisation, in the EU’s new Capital Markets Union (“CMU”) initiative.





post-financial crisis, amidst a swathe ofother post-crisis legislation. Changeswere made through an amendingDirective in 2010, implemented insummer 2012, and various Regulations. Itis, though, worth highlighting a few factsand trends about the PD2 changes asthey help to illustrate why some of theCMU measures are being proposed.

n PD2 changes in 2010/2012: Somemeasures “lightened” the PDdisclosure regime in 2012, notably inrelation to rights issues andprospectuses for small andmedium-sized companies (“SMEs”).There was also a step to limit anissuer’s concern about so-called

“retail cascades” by restricting theability for someone to use an issuer’sprospectus for an offer without thewritten consent of an issuer. However,the overriding changes which weremade under PD2 were seen by manyas “consumer protection” measures.These included:

• increasing the denomination for“wholesale securities” from EUR50,000 to EUR 100,000;

• prescribing a very detailed form ofprospectus summary, with veryprecise rules about content;

• requiring both a summary for a“retail” base prospectus and forany individual tranches of

securities issued under them.In practice, this change pushedsome programme issuers awayfrom “retail” to the “wholesale”regime; and

• curtailing the additionalinformation which might bedisclosed in the final terms for atransaction under a baseprospectus. Instead, it mandatedthat most information should becontained in the base prospectusand thus reviewed and approvedby a regulator (including anyformulas, any selling restriction, orany disclosure about an indexused for interest calculation).

Taking stock – prospectuses in 2014, pre-CMUProspectus approvals: Perhaps unsurprisingly, the number of prospectus approvals peaked pre-financial crisis in 2006 and 2007.Roughly twice as many prospectuses overall were approved across the EU in 2006 or 2007 as compared to 2012, 2013 or 2014.The statistics are, broadly, over 8,000 in 2006 and over 10,000 in 2007, compared with around 4,000 in each the years 2012, 2013and 2014. More significantly, fewer than a quarter of prospectuses were passported “out”, following approval, in any of those years3.

n Breakdown, by security, of prospectuses approved in 2014: ESMA figures show that, in 2014 (the latest figures available onthe ESMA website) over 60% of the prospectuses approved were for debt securities. Of these, 11.5% were for asset-backedsecurities (“ABS”) and 50% for corporate or other debt. (For corporate or other debt, there was an equal split betweenprospectuses for securities with a denomination of EUR 100,000 (“wholesale” securities) and those for securities with adenomination of less than EUR 100,000 (“retail” securities).)

Number of PD prospectuses approved per year in EEA4

2006 2007 2008 2009 2010 2011 2012 2013 2014

8,005 10,932 6,901 4,909 4,789 4,429 4,100 3,991 3,931

Proportion of prospectuses by different security types approved in EEA in 20145

ABS Debt >100Kdenomination

Debt < 100Kdenomination

Shares Derivatives Closed-ended investment fundsor depositary receipts

11.5% 25.6% 25.0% 21.5% 14.9% 1.5%

3 October 2014 Report (ESMA/2014/1276) ; July 2015 report (ESMA/2015/1136); June 2008 report (CESR 08/452).4 Source: CESR/ESMA5 Source: ESMA



3. PD3 and CMUCMU: Déjà-vu ?The goals of CMU outlined in the CMUinitiative paper dated 30 September 2015carry an air of familiarity:

n Identifying barriers and knocking themdown one by one;

n Increasing transparency;

n Increasing access to thecapital markets;

n Making it less costly for businesses toraise funds;

n Integrating markets;

n Increasing investment choices forretail and institutional investors, alike.

Seasoned practitioners might be forgivenfor sensing a repeat of the aims of EUFSAP and struggle to guess whether thefollowing statement was made in 1994,2004 or 2014:

“To improve the financing of oureconomy, we should further develop andintegrate capital markets. This would cutthe cost of raising capital, notably forSMEs, and help reduce our very highdependence on bank funding.”

Care to hazard a guess?

The author was Jean-Claude Juncker.It was 2014.

In fact, it is not “Groundhog Day”Many of the goals of CMU seem strikinglyfamiliar (as illustrated by the first sentencein the quote by Jean-Claude Juncker).But there are a number of key differencesbetween FSAP and CMU (as illustratedby the second sentence in the quote).

Chief amongst the differences is thecurrent financial climate. Today’seconomic, political and financial situationis very different from the era in which the

EU FSAP was undertaken: a “brave newworld”, shortly after the introduction ofthe euro and monetary union in 1998. So,although the familiar issues surroundinglack of integrated capital markets (with allthe problems which ensue) still remain,there is now an additional incentive toencourage greater use of capital markets.This was encapsulated succinctly byLord Hill in April 2015:

“…over half a century on from the Treatyof Rome, we still don’t have a fullyfunctioning single market for capitalacross the twenty eight Member States.Why should this time be different?Because with low growth and highunemployment the need is greater. And Ibelieve that politicians’ will to actis greater….”

There is therefore a strong political andeconomic imperative to act. As well as thelow growth and high unemploymentmentioned by Lord Hill, there is also animpression of a reluctance by banks tolend – particularly to small businesses orSMEs – and a lack of growth capital.Given their on-going reliance on bankfunding, corporates are facing a crisis offunding. The CMU initiative paper of30 September 2015 mentions that SMEscurrently receive 75% of external fundingfrom loans. Additionally, compared withthe United States, European SMEsreceive 5 times less funding from thecapital markets. Even for larger corporatesthere is a problem with liquidity – asindicated by the ECB’s new CorporateSector Purchase Programme (“CSPP”)launched in June 2016. ICMA’s29 April 2016 commentary paper on theforthcoming CSPP reported that themarket consensus was that purchases ofcorporate bonds by the ECB would be inthe region of EUR 3-5 billion per monthand likely to be skewed towardspurchases of newly issued bonds.

The CMU initiative therefore reflectsadditional goals. These include: wideningthe investor base for SMEs; developingEuropean private placement markets;building sustainable securitisation;coordinating the approach to EuropeanLong Term Investment Funds; improvingaffordable and independent financialadvice for retail investors, and increasingways to save for pensions and retirement(for example, the CMU September 2015paper states that the direct shareownership of European households hasfallen from 28% in 1975 to 10 or 11%since 2007; furthermore, the proportionof retail investors amongst allshareholders is now less than half what itwas in the 1970s).

PD3How does the PD3 review fit withinthis context of the CMU initiative?Given the overall aims of CMU, there is asimilar focus in PD3 on improving accessfor SMEs to the capital markets and,more generally, broadening the retailinvestor base for shares and bonds.The proposal includes a broader definitionof what counts as an SME, with the aimthat a reduced “SME disclosure regime”will be available to more potential issuers.There is also an attempt to increaseissuance of securities with smallerdenominations which might appeal toretail investors.

It is still early days and the legislativeprocess is still underway. Interim andcompromise drafts have been released,but feedback to date is that the omissionof some contentious areas in the interimdrafts does not represent the finalposition; some have been “parked” forfurther debate. We have thereforeoutlined just a few selected issuescurrently under debate in the shortsummary table below.



Finally, for both CMU and PD3, legislatorshave sought input from a range of interestgroups during the legislative process. Thishas been well received by marketparticipants, as has the willingness of theCommission and Rapporteurs to discusssuggestions with market participants inperson. It is also interesting that the CMUconsultation last year acknowledged thatlegislation is not the only way and in

some cases market-led developmentsmay provide the way forward. Indeed,Lord Hill acknowledged in April 2015 that:“I do not think that we always have toreach for legislation as a first, or indeedthe only, option.” There are already somegood examples in existence, such asICMA’s Green Bond Principles and therecent ICMA/LMA private placementdocumentation initiatives. For those

measures which are not left to market-leddevelopment and for which formallegislation is yet to be agreed, it is to behoped that the constructive dialogue, todate, achieves a workable PD3 solutionfor all concerned – issuers, investors,politicians and practitioners, alike.

PD3 – Five selected issues under debate

EUR 100,000 threshold –“Public offer” exemption

The EUR 100,000 minimum denomination (“wholesale”) exemption from the public offer regimeprospectus requirement was removed in the Commission first draft in November 2015. TheCommission’s rationale behind such a proposed change was stated to be to remove any incentiveto issue larger denominations. This was intended to encourage issuance of bonds with smallerdenominations for retail investors to purchase. This item is still very much under debate.

EUR 100,000 threshold –Differentiated disclosure

In the Commission first draft in November 2015, uniform disclosure across all debt issues wassuggested, with the inclusion of a summary for all prospectuses. Should there be identical disclosurefor “wholesale” prospectuses (or those targeted at qualified investors) and for “retail” prospectuses(or those targeted at retail investors)? Do professional investors require a prospectus summary, forexample – or would it merely be a cost for the issuer? This has been a point of debate.

Risk factors Categorisation of risks into three groups ranked both by probability of occurrence and likely adverseimpact has proved to be a contentious suggestion by the Commission. Its aim was to make riskfactors easier for investors to digest and to rely on, but there is a concern that such “crystal ballgazing” would be an impossible task for an issuer. In particular, there are fears that it might lead tomore litigation and also make it impossible for issuers to include uniform risk factors acrossEuropean and other markets, such as the United States.

Summaries Very short prospectus summaries – and with a limited number of risk factors highlighted in thesummary. See “Risk factors” above. Similar concerns would arise.

New concepts Among the various measures suggested by the Commission as part of its aim to reduce costs andto facilitate access to the capital markets two are generating debate given the lack of claritysurrounding the proposals: a lighter disclosure regime for certain “secondary issuance” by issuerswith existing securities; and the concept of “universal registration document” (somewhat akin to aUS “shelf prospectus”) for frequent issuers, to enable faster access to markets. Market participantscurrently seem slightly wary of both.

3. Bank Recovery and Resolution:what impact on securitisation?



Background on the BRRD The European Bank Recovery andResolution Directive 2014/59/EU(“BRRD”) aims to harmonise MemberStates’ resolution frameworks for banksand investment firms when the relevantauthorities have determined that a bank isfailing or likely to fail. It was adopted atthe European level in June 2014 and wasrequired to be implemented in nationallaw no later than January 2015 (althougha number of Member States failed to dothis). The exception to this deadline wasthe incorporation of the bail-in provisionsfor which Member States could deferimplementation until January 2016.Nevertheless, some Member States,including the UK, implemented theseprovisions alongside the rest of the BRRDin January 2015.

The key aims of the BRRD are broadlyfocused on:

(i) crisis prevention: individual institutionsare required to prepare recovery andresolution plans dealing with financialdistress or failure, which the resolutionauthorities are then required tomonitor and assess;

(ii) early intervention: granting powers toregulators enabling them to interveneif an institution faces financial distressbut prior to the situation becomingcritical, such powers include theability to dismiss management andappoint a temporary administrator;

(iii) crisis management resolution:including the use of key resolutiontools such as selling the business,setting up a temporary bridgeinstitution, asset separation and theuse of bail-in; and

(iv) cooperation and coordination: aframework is provided to improvecoordination between nationalauthorities in cases where a cross-border banking group fails.

The purpose of the BRRD is essentially toprotect financial stability, preserve criticalfunctions, and to avoid the taxpayerhaving to pay for any losses in the eventof failure.

Use of the BRRDSeen in that light, it makes goodeconomic sense that securitisationsshould not get caught up in bankresolutions. Securitisations are normallydone to provide additional funding (andsometimes capital relief) to banks, sounwinding them as part of a bankresolution would generally harm, ratherthan help, the situation of the bank beingresolved. That is one of the fundamentalpolicy ideas behind the protection of“structured finance arrangements” fromthe exercise of various resolution powersavailable under the BRRD. For the samereason, we have known similar protectionfor “capital market arrangements” in theUK for many years – first as part of theinsolvency regime, preserving the right for

creditors to appoint an administrativereceiver, and later as part of the BankingAct, where “capital market arrangements”were protected from the exercise of thepartial property transfer power. This hasprovided a measure of certainty andcomfort to the market that, under thoseregimes, securitisations were largelyprotected. The equivalent protections inplace under the BRRD, however, havehad some measure of uncertainty aboutthem, often because of imprecise orunfortunate drafting either at theEuropean or national levels.

It is therefore reassuring that – so far aspublic information indicates – thingsappear to be playing out as expected.While the fact of resolution powers beingused and the broad brushstrokes areoften public, the details of bankresolutions are almost always hard tocome by for those not directly involved.Nonetheless, we do know that, since theadoption of the BRRD, resolution actionshave been taken in Austria, Croatia,Finland, Greece, Hungary, Italy andPortugal. We are aware that several ofthe banks subject to resolution had atleast one securitisation outstanding andwe are not aware of any situations wheresecuritisations were adversely affected orunwound as part of that resolution.

If anything securitisation seems to beviewed by at least some authorities aspart of the solution, rather than asarrangements to be taken apart as part

Ever since the introduction of the Banking Act 2009 in the UK, the structured debtmarkets have been preoccupied with ensuring deals were not just “insolvency remote”but also “resolution remote” – a concern that became even more acute with theintroduction of the Bank Recovery and Resolution Directive at the European level. Acouple of years – and several bank resolutions – on, we take a look at how bankresolution has affected securitisation and what is next in the pipeline.



of a bank resolution. The resolution toolswere used at the beginning of this year inan Italian bank resolution involving Bancadelle Marche, Banca Popolare dell’Etruriae del Lazio, Cassa di Risparmio di Ferraraand Cassa di Risparmio della Provincia diChieti. In that resolution, an Italian stateguarantee was given on a securitisationof non-performing loans (“NPL”) to getthem off the banks’ balance sheets. On26 January 2016, Italy and theCommission agreed on a structure whichuses the bridge bank resolution toolunder Articles 40 and 41 of the BRRDand the asset separation tool in Article 42BRRD. Under the structure, there was tobe a transfer of all the assets andliabilities of the banks (apart fromremaining equity and subordinated debt)from the banks to the bridge bank. Anasset management vehicle was to be setup and the NPLs transferred from thebridge bank to that vehicle. The NPLswere then to be subject to a securitisationand the Italian government would providea guarantee on the most senior trancheof notes issued. The junior tranches ofnotes to be sold to private investors(although a rescue fund financed by thelarger Italian banks will act as a buyer oflast resort) will absorb losses first and arenot to be repaid until the guaranteedsenior tranches have been repaid in full.

Perhaps the most controversial use ofresolution occurred in Portugal in 2014.This concerned the exercise of resolutionpowers by Banco de Portugal, acting asPortugese resolution authority, overBanco Espirito Santo SA (“BES”) andinvolved the creation of a bridge bank.Certain assets were transferred to thebridge bank in order to enable BES tocontinue on a ‘business as usual basis’;BES was then to be wound up in anorderly manner. Following a court ruling inPortugal in 2015, there was a subsequent

re-transfer of some liabilities back to BESas the judge found that some of the initialtransfers had in fact never been properlymade. This case and the subsequentlitigation that has ensued (in Portugal andEngland) illustrates that in effecting thetransfers, in particular when effectingpartial transfers, there is not always clarityon what has in fact been transferred.

Partial Property TransferRegulation As alluded to above, the BRRD providesprotection for “structured financearrangements”, among others, fromvarious resolution powers. Article 76 ofthe BRRD protects structured financearrangements in the context of the use ofthe partial property transfer power,though this is subject to additional detailthat was to be published at a later date.On 18 March 2016 the EuropeanCommission published a DelegatedRegulation which provides that detail.The Delegated Regulation is the result ofa consultation with the European BankingAuthority (“EBA”) in July 2014 and closelyfollows the advice provided by the EBA. Itwill come into force 20 days after it ispublished in the Official Journal of theEuropean Union, but at the time of writingit has not yet been published.

As mentioned above, the resolution toolsallow for the partial transfer of assets,rights and liabilities of an institution.Article 76 provides safeguards for certaincontracts in the event of a partial transferor in the event of forced contractualmodifications. Whilst the BRRDdetermines the form of protection and thelimits to the protection, the purpose ofthe Delegated Regulation is to identify theprecise types of arrangements which areto benefit from the protection. The list ofprotected arrangements is not

exhaustive, however, as coming up withan exhaustive list would be highlyburdensome, not least because it wouldrequire near-continuous updating.

While the Delegated Regulation arguablynarrows the safeguards in terms of set offand netting arrangements, one of the keyintended beneficiaries of the broaderprotections which are still available arestructured finance arrangements.For these purposes, structured financearrangements include securitisations,which are defined by incorporating thefamiliar and most widely used regulatorydefinition of that term from the CapitalRequirements Regulation (the “CRR”). TheDelegated Regulation makes clear that thescope of protection includes both true saleand synthetic securitisations but – forreasons that are not entirely clear – it doesnot incorporate the existing definitions of“traditional securitisation” and “syntheticsecuritisation” from the CRR.

There is some concern over the draftingof the Delegated Regulation since itappears to confer protection to true salesecuritisations where the issuer (orinvestor) is subject to the resolution tools,rather than the originator. This is likely anoversight, however, and representationshave been made by industry to theCommission in hopes of having thiscorrected. In any case, the DelegatedRegulation helpfully clarifies that in a truesale securitisation, any role of theoriginator in the structure, such asservicing the loans, providing any form ofrisk protection or liquidity, shall beconsidered as a liability which forms partof the structured finance arrangement,and is therefore protected.

As for a synthetic securitisations, the“security interest” (by which theDelegated Regulation is presumably



referring to the collateral for the paymentof the issuer’s obligations – normally inthe form of cash or highly liquidsecurities) is considered to be a rightwhich forms part of the structured financearrangement only if it is attached tospecific and sufficiently identified assetsor identifiable assets in accordance withthe terms of the arrangement and theapplicable national law. We would expectthis to be the case anyway, as havingeffective security over the collateral willrequire that it be sufficiently identifiable.

In all securitisations, the protection isextended to the relationship the issuer haswith third party service providers such asservicers, cash managers, swapcounterparties or trustees, provided thatthe relationships are “mutual” and “directlylinked to the underlying assets and the

payments to be made from the proceedsgenerated by these assets to the holdersof the structured instruments” – a test thatwill be easy to meet in most cases.

It is worth remembering that theprotections outlined above are notexhaustive and the resolution authority hasthe discretion, on a case-by-case basis, toinclude other arrangements within thescope of this provision such that they aresubject to the benefits of the safeguard.

From the perspective of the securitisationmarket the clarification and descriptionsof the types of arrangement that benefitfrom the safeguards in relation to partialproperty transfers are to be cautiouslywelcomed. It is helpful, in particular, thatthe issuer’s many relationships with theoriginator and with third party service

providers – without which mostsecuritisations would cease to function –are explicitly protected. It cannot beignored, however, that – in relation to truesale securitisations – the DelegatedRegulation seems mainly to contemplatethe situation in which the issuer is inresolution. As the issuer will be a specialpurpose vehicle, it is difficult to imaginethe circumstances where it might be thesubject of a bank resolution in its ownright. The far more important protection –and one industry has asked theCommission to extend by an amendmentto the Delegated Regulation – would beprotection for the securitisation in thecontext of an originator resolution,particularly in situations where there mightbe some doubt about whether the issueris a member of the originator’s group forBRRD purposes.

4. Synthetic Securitisation: returningfrom the wilderness?



The ugly duckling?Of the financial products which receivedmuch of the blame for the global financialcrisis in 2008, few attracted as muchnegative attention as syntheticsecuritisation. This was largely due to theway in which synthetic securitisationtechniques had been used to amplify theexcesses of the US sub-prime housingmarket, by allowing market participants totake large bets on the risky tranches ofsub-prime asset-backed securities,despite having no pre-existing exposureto such securities. The effect of theseso-called “arbitrage syntheticsecuritisations” was that losses in theunderlying asset-backed securities couldresult in many multiples of such lossesbeing suffered by investors in syntheticsecuritisations referencing thosesecurities. In light of this, when politiciansand regulators started to focus on theprime causes of the trouble, it is perhapsunsurprising that synthetic securitisationwas identified as one of the main culprits.

However, this critical view of syntheticsecuritisation ignored the fact that therehad been, for many years prior to theonset of the financial crisis, an entirelyseparate category of syntheticsecuritisation transactions, usuallyreferred to as “balance sheet”transactions, which had been used bybanks to manage their client creditexposures and regulatory capitalrequirements in connection with their

normal lending activity. Unlike thearbitrage transactions, the portfolio ofexposures referenced in a balance sheetsynthetic securitisation would compriseloans or other exposures on the originatorbank’s balance sheet, with a one-for-onecorrelation between the losses theoriginator would otherwise suffer uponthe default of such exposures and thelosses to be suffered by investors in therelevant tranche of the securitisation.

In essence, a balance sheet syntheticsecuritisation is exactly what the namesuggests – a securitisation of exposureson the originator’s balance sheet, whichdiffers from a true sale securitisation inthat the mechanism by which investors inthe securitisation derive their exposure tothe underlying assets involves a syntheticrisk transfer rather than a true sale of theexposures. Broadly-speaking, an investorin a particular tranche of such a syntheticsecuritisation is exposed to exactly thesame risks and losses as an investor inthe corresponding tranche of a true salesecuritisation of the same portfolio.

There are, however, two ways in whichsynthetic securitisations in practice tendto differ from true sale securitisation.First, synthetic securitisation tends to beparticularly well-suited to those assettypes which are, for various reasons,difficult to securitise by a true salesecuritisation in some jurisdictions, suchas large corporate, SME and tradefinance exposures. In addition, synthetic

securitisation can also be used tosecuritise more esoteric securitisationasset classes, such as finance leases,derivative exposures, project financeloans and shipping loans. In contrast, it isunusual to see synthetic securitisationused to securitised residential mortgages,credit cards or auto loans, all of whichhave well-established true salesecuritisation markets.

The second difference relates to thepurpose for which an originator bankenters into a synthetic securitisation. Truesale securitisation is primarily a fundingtool, with the originator looking to sell thesenior, highly-rated tranches to investors,while it retains the junior or equitytranches. The effect of this is that, underthe securitisation framework in the EUCapital Requirements Regulation (“CRR”),the originator will often not have createdsignificant risk transfer in respect of thesecuritised exposures, or even if it has, itsexposure to the junior tranches will resultin the securitisation issuer beingconsolidated onto the originator’s balancesheet, such that for regulatory purposes,the originator has the same capitalrequirements as it would have had had itnot entered into the securitisation.In contrast, in a synthetic securitisation,the originator will usually be looking to sellenough of the risky tranches to achievesignificant risk transfer for the purposesof the securitisation framework, whileretaining exposure to the less risky seniortranches. As the risky tranches generally

Synthetic securitisation, rightly or wrongly, has taken a large share of the blame for the2008 financial crisis. Perhaps not surprisingly then, it has thus far been left out of plans tointroduce a category of securitisations with more benign regulatory treatment, such as theEU’s proposed “simple, transparent and standardised” securitisation. In this article, welook more closely at synthetic securitisation, how it might support the goals of the CMU,and the initial signs of a possible thaw in official attitudes to these transactions.



comprise less than 10% of the notionalvalue of the securitised portfolio, thismeans that balance sheet syntheticsecuritisations are of limited use as afunding technique, but are a very effectiveway of mitigating the credit risk on thesecuritised portfolio, and consequentlyreducing the amount of regulatory capitalwhich the originator is required to holdagainst that portfolio.

In the early years following the financialcrisis, relatively few syntheticsecuritisations were originated. However,in the last few years, there has been asignificant increase in the level of activity,and in the last year in particular, this hasalso been reflected in renewed interestfrom regulators and policy makers inwhether or not synthetic securitisationshould be included in the scope of thesimple, transparent and standardised(“STS”) securitisation reforms discussedearlier in this publication. This increasedinterest also reflects the impact ofincreased capital requirements for banks,as well as the greater focus on managingcredit and lending limits across thebanking sector. Thus, what was untilrecently a fairly small and niche corner ofthe securitisation market has expanded,with a number of new originators enteringthe market, and an increase in thenumber of investors looking to invest insynthetic securitisation transactions.

Pending regulatory changesAs outlined above, synthetic securitisationhas been undergoing something of arenaissance in the last few years. This isdespite the fact that regulators haveretained a cautious approach to suchtransactions where the originator hasbeen seeking to demonstrate significantrisk transfer for the purposes of applyingthe securitisation risk weightings to theretained senior tranches. This is one area

where there has been significant variationamong the approaches taken by differentregulators across the EU. Although themove to the ECB as the single supervisorfor systemically important Eurozonebanks is starting to lead to a greatercommonality of approach, it is by nomeans the case that the relevant rules inthe CRR are applied in the same way inall jurisdictions.

There are, however, a number of pendingregulatory changes which will have asignificant impact on the evolution of thesynthetic securitisation market in the nextfew years.

First, synthetic securitisation is currentlyexcluded from the proposed STSframework. One of the key criteria for asecuritisation to be classified as STS isthat there must be an effective true saleof the securitised exposures to the issuer,which by definition will never be the casein a synthetic securitisation. Thus, eventhough it is possible for a balance sheetsynthetic securitisation to comply withmany of the other STS criteria, it seemsthat synthetic securitisation will, for thepresent at least, not be capable of beingclassified as STS.

This is significant because of the impactof the other key regulatory reformscurrently being proposed to the CRR,which will increase significantly the riskweightings which apply under thesecuritisation framework to the seniortranches of all securitisations. Theseincreases will more than double theamount of capital which banks will needto hold in respect of those tranches.However, where a securitisation isclassified as STS, the capital requirementis effectively halved. Thus, the exclusionof synthetic securitisation from the STSframework leads to a significant disparityof treatment between a true sale

securitisation which complies with theSTS criteria and a synthetic securitisationof exactly the same portfolio whicheconomically creates the same exposurefor investors. The only current exemptionto this disparity is contained in proposedArticle 270 of the CRR, which wouldallow originator institutions to apply theSTS risk weightings to the retained seniorpositions in a synthetic securitisation ofSME exposures which otherwisecomplies with the STS criteria (other thanthe true sale requirement) and where thecredit risk in the tranches not retained bythe originator has been transferred to acentral government or central bank of anEU Member State, or a multilateraldevelopment bank or internationalorganisation which qualifies for a zero percent risk weight under CRR.

A third pending reform which will alsoaffect synthetic securitisation is a changeto the methodologies used to determinethe risk weight which applies to a tranchein a synthetic securitisation. Under thecurrent rules, banks which use theAdvanced Internal Ratings Based(“Advanced IRB”) approach are able tocalculate the risk weighting for a trancheusing what is referred to as the“Supervisory Formula Method”. Thisallows the risk weighted amount to becalculated by reference to the expectedlosses in respect of the underlyingsecuritised exposures. However, theSupervisory Formula Method can only beused where there is no external rating forthe tranches, and no external rating maybe inferred from an external rating whichapplies to other tranches of the syntheticsecuritisation. Where such ratings areavailable, the prescribed risk weightingswhich correspond to those ratings apply.Further, because only Advanced IRBbanks can apply the Supervisory FormulaMethod, banks under the StandardisedApproach under CRR can effectively only



calculate a securitisation risk weightingfor a tranche which is rated.

The proposed new arrangements willchange both the order in which themethodologies for calculating the riskweightings apply, and the way in whichthose calculations are actually made.To begin with, for Advanced IRB Banks,subject to certain conditions, they willalways be required to calculate the riskweighting pursuant to a revisedmethodology based on the expectedlosses for the securitised exposures(referred to as the “SEC-IRBA” approach).Where those requirements are notsatisfied (including for banks on theStandardised Approach), a revisedversion of the ratings based approach willapply if the tranche is rated, with the riskweighting being determined by referenceto the rating of the tranche (referred to asthe “SEC-ERBA” approach). However,if the tranche is unrated, a newmethodology has been introduced,referred to as the “SEC-SA” approach,which calculates a specific risk weightingbased on various attributes of thesecuritised exposures. Nevertheless,while these changes will reduce the needfor ratings for banks which are presentlyunable to apply the Supervisory FormulaMethod, they are expected in all cases tolead to a significant increase in the overallrisk weightings compared with thepresent situation, particularly forAdvanced IRB banks.

STS for syntheticsecuritisation?While the door appears shut on syntheticsecuritisation being included within thescope of the STS framework for thepresent, there are encouraging signs thatthis may not always be the case. First,under its proposal for a SecuritisationRegulation, the Commission sets out its

intention to assess “in the future” whetherthe STS framework should be extendedto include some types of syntheticsecuritisation, thus opening up theprospect that synthetic securitisationscould be brought within the scope of thisframework at some point.

Secondly, and rather more pertinently fororiginators, in 2015 the EBA undertook aconsultation and prepared a report onsynthetic securitisation. While that reportdid not recommend the inclusion ofsynthetic securitisation within the STSframework at this time, it did neverthelessrecommend that specific specialtreatment for the retained seniortranche(s) currently set out in proposedArticle 270 of the CRR for syntheticsecuritisations of SME exposures wherethe risk on the non-retained tranches hasbeen transferred to a central government,central bank, multilateral developmentbank or international organisation shouldbe expended to a broader range ofsynthetic securitisations. Given that, asnoted above, originators tend to retainthe senior tranches in a syntheticsecuritisation anyway, if implemented, thisextension would provide originators withmost of the benefits of STS even if thesecuritisation would not be classified asSTS for other investors.

In order to qualify for this preferentialtreatment, the synthetic securitisationwould need to comply with a number ofrequirements, of which the mostsignificant are:

n The synthetic securitisation must relateto SME exposures, as defined inArticle 501 of CRR. This is perhaps themost significant limitation in the EBArecommendations. In recent years,SME synthetic securitisations haverepresented approximately one third ofoverall market volumes, and this is anasset class which is often difficult to

securitise using traditional true salesecuritisation. However, by far thelargest asset class, representing over50% of all synthetic securitisationissuance, is large corporate loans, andthese securitisations would beexcluded under the EBA’srecommendations. This limitationappears to reflect the political desire toassist lending to SMEs across the EU.Given that in some jurisdictions it isdifficult to securitise SME loansthrough true sale securitisation, thismakes SME loans an obvious firstasset class to receive a morefavourable regulatory treatment.

n The securitised exposures must bedenominated in a single currency,which must also be the protectioncurrency. This is also a significantlimitation, and is likely to be particularlyproblematic for banks outside theEurozone (other than the UK), whichmay find it difficult to attract investmentin their local currency. Even for bankswithin the Eurozone, the inability tocombine assets denominated inmultiple currencies into a singlesecuritisation is a significant limitation.It is possible that this is a hangoverfrom the earlier EBA report onqualifying securitisation from July 2015,in which the EBA suggested thatexposures should all be denominatedin a single currency. However, this wasnot included in the Commissionproposal for STS Securitisation.

n The securitised exposures must begoverned by the laws of a single legalsystem. This limitation appears to bea hangover from the EBA version ofthe STS requirements for traditionalsecuritisation, where requiring thesecuritised exposures to be governedby a single legal system was thoughtto simplify enforcement against theunderlying assets should that ever



become necessary. However, it isdifficult to see why this should be arequirement in a syntheticsecuritisation where any enforcementwould be against the collateral for theissuer’s obligations and not thereference assets. As with theprevious bullet point, this was also arequirement in the EBA report onqualifying securitisation which did notmake it into the Commissionproposal for STS Securitisation. Inaddition, there are indications that thereference to a single legal system isintended as a reference to EU lawgenerally rather than the law ofindividual member state jurisdictions(or sub-jurisdictions).

n Unless the protection seller is a publicsector entity which qualifies for a zeroper cent risk weighting under CRR,the protection seller must collateraliseits obligations to the originator withcash placed on deposit with theprotection buyer. While most privatesector investors are alreadyaccustomed to providing collateral,the desire to limit their credit risk tothe originator has seen an increasingtrend for cash to be held either with athird party bank or in the form of highquality securities. While the EBArecommendations do not appear toprevent the originator from itselfproviding collateral for its obligation torepay the deposit, this addscomplexity to a transaction.

n As securitised exposures mature oramortise, tranches in thesecuritisation must amortisesequentially in order of seniority.Pro-rata amortisation is not permitted.This requirement goes against adeveloping trend in syntheticsecuritisations in recent years whichhas seen an originator preference forall tranches to amortise pro-rata, aftertaking accrued losses into account.

The securitisation must also comply withvarious other STS requirements which arebased closely on the requirements fortraditional true sale securitisation, as wellas a number of other criteria which aresimilar to the structural features alreadycommon in synthetic securitisationsdiscussed above.

Whether or not the EBArecommendations are adopted by theCommission in some form remains to beseen. At this stage, the indications arethat they will not be adopted in thecurrent round of amendments. However,if they are subsequently adopted by theCommission, they must then beconsidered by the EU Parliament and theCouncil of the European Union, and anagreed text be approved by all threebefore the proposals would become law.None of these matters is certain, and it is,of course, possible that at any step alongthe way, further amendments could bemade to the EBA proposals.

ConclusionAs is clear throughout this publication, the regulation of securitisation in the EU hascome a long way since the financial crisis. Much of the animosity directed atsecuritisation generally in the years following the crisis has dissipated, as regulatorsand policy makers have again come to recognise the importance of securitisationin providing liquidity to capital markets and making credit available to the realeconomy. Perhaps because of the additional perceived complexity of syntheticsecuritisation, and almost certainly because of some of the more extremeexcesses seen in the arbitrage synthetic securitisation market in the years leadingup to the crisis, regulators and policy makers have been slower to accept thatsynthetic securitisation also has a role to play, particularly in enabling banks tomanage their exposures in those asset classes which are difficult to securitisethrough true sale structures. However, notwithstanding the formidable challengeswhich still face the synthetic securitisation industry, there are encouraging signsthat things are starting to move in the right direction.

5. Third Party Due Diligence: reportsunder 15Ga-2 and 17g-10

Since 15 June 2015, all issuers that offer asset-backed securities (“ABS”) to USinvestors (including non-US issuers that privately place ABS into the US pursuant toRule 144A) and their underwriters have been required to comply with rules regardingthird-party due diligence reports imposed by the US Securities and ExchangeCommission (the “SEC”). In particular, under Rule 15Ga-2, the SEC requires issuersand underwriters of ABS to publicly disclose the findings and conclusions of thirdparty diligence reports. In addition, Rule 17g-10 requires third party due diligenceservice providers, such as accounting firms, to make certain representations toNationally Recognized Statistical Rating Organizations (“NRSRO”) regarding their duediligence reports. For these purposes, ABS includes any type of fixed income or othersecurity collateralised by any type of self-liquidating financial asset (such as a loan,lease, mortgage or receivable) that allows the holder of the security to receivepayments that depend primarily on the cash flow from the asset.



Third-party due diligencereportsAny report that contains the findings andconclusions of any due diligence servicesperformed by a third party is a “third-party due diligence report” for purposesof Rule 15Ga-2. In this context, thephrase “findings and conclusions” hasnot been defined by the SEC andremains open to some interpretation.

For purposes of the definition of third-party due diligence report, “due diligenceservices” includes evaluations of any ofthe following:

1. the accuracy of the information ordata about the assets provided,directly or indirectly, by the securitiseror originator of the assets;

2. whether the origination of the assetsconformed to, or deviated from,stated underwriting or creditextension guidelines, standards,criteria, or other requirements;

3. the value of collateral securingthe assets;

4. whether the originator of the assetscomplied with federal, state, or locallaws or regulations; or

5. any other factor or characteristic ofthe assets that would be material tothe likelihood that the issuer of theasset-backed security will pay interestand principal in accordance withapplicable terms and conditions.

The first four categories address thetypes of due diligence that the SECbelieves is typically conducted forofferings of RMBS, the primary area inwhich due diligence is conducted. Thefifth category is a catch-all for other assetclasses where such services may beperformed in the future.

Application to agreed-uponprocedures performed byaccounting firmsSome, but not all, services performedby accounting firms as agreed-upon

procedures (“AUP”) will be considered“due diligence” services. Those servicesthat are not considered “due diligence”will not be subject to these rules. If theprimary purpose of the service is toassist issuers and underwriters inverifying the accuracy of disclosures,the service will not be subject to thenew rules. Examples of this type ofservice include performing proceduresthat tie information included in theoffering documents to the loan tape orthe financial statements, orrecalculations of projections of futurecash flows.

AUP services consisting of comparisonby accountants of data on a loan tapeto a sample of loan files are an exampleof a service that must be disclosed.This type of review is typically reflectedin AUP letters that are delivered tounderwriters or initial purchasers forABS offerings. This type of review isalso reflected in Rule 193 letters, whichare used by issuers to satisfySEC-mandated asset review obligations.



When only some of the servicesperformed by an accountant constitutedue diligence services, an AUP lettermay have two annexes – only one ofwhich reports on “due diligence”services and only that annex would bepublicly disclosed.

Application to due diligence reviewsperformed by law firmsWhile it is widely understood that Rule15Ga-2 and Rule 17g-10 do not applyto general legal services traditionallyprovided in connection withsecuritisation transactions, these rulesdo not categorically exclude law firms asdue diligence service providers. Whethera legal review performed by a law firmconstitutes a third-party due diligenceservice to which Rule 15Ga-2 and Rule17g-10 apply depends on a facts andcircumstances analysis of the report inlight of the relevant regulatory definitionsand guidance provided by the SEC. Thefocus of the analysis is on the purposeof the report, and how closely itresembles a traditional third-party duediligence review conducted in the RMBSspace. If the primary purpose of a legalservice is to assist issuers andunderwriters in verifying the accuracy ofdisclosures, the service will not beconsidered to be a third party duediligence service. The interpretation andapplication of this rule in the context oftraditional legal reviews performed incertain non-US markets is still evolving.

Public disclosure ofthird-party due diligencereportsUnder Rule 15Ga-2, the SEC requiresany issuer or underwriter of registeredor unregistered ABS (including Rule144A securities) rated by a NRSRO to

publicly file a Form ABS-15G onEDGAR, the SEC’s electronic documentretrieval system, in connection with anythird party due diligence reports anissuer or underwriter obtains, whichdiscloses the findings and conclusionsof any such third-party due diligencereport. Form ABS-15G must be filed onEDGAR at least five business days priorto the first sale in the offering, but itneed only be provided with respect tothe initial rating of ABS. No filing isnecessary in connection with anysubsequent rating activities. While thisrule contemplates that a Form ABS-15Gwould be filed by either an issuer or anunderwriter, it has become marketpractice for issuers to bear theresponsibility for filing these forms. Thisallocation of responsibility to the issueris generally reflected in the underwritingor purchase agreement for asecuritisation transaction by theinclusion of a representation andwarranty by the issuer that it hasprepared and timely filed any requiredForm ABS-15G.

The Form ABS-15G disclosure may notmerely summarise the third-party duediligence report; it must contain theactual findings and conclusions. If thedisclosure requirements have been metin the prospectus filed with the SEC(including attribution to the appropriatethird-party), and the prospectus ispublicly available at the time the FormABS-15G is furnished by the issuer orunderwriter, the Form may refer to thatsection of the prospectus rather thanproviding the findings and conclusionsonce again in full.

A Form ABS-15G filing is not required ifan NRSRO engaged to provide an ABScredit rating provides the issuer or

underwriter with a representation that itwill publicly disclose the findings andconclusions of the relevant third-partydue diligence report. If the issuer orunderwriter reasonably relies on theNRSRO to make this disclosure and theNRSRO fails to do so in a timelymanner, the issuer or underwriter willhave until two business days prior tothe first sale of such ABS to file a FormABS-15G. A Form ABS-15G must befiled regardless of whether an NRSRO infact uses the third-party due diligencereport in its credit rating decision.

Whether a Form ABS-15G should coverpre-securitisation due diligence activities(e.g., acquiring underlying assets from theoriginator or a third-party seller) remainsunclear. The regulation requires the filingof a Form ABS-15G in respect of “allthird-party due diligence reports obtainedby the issuer or underwriter, includinginterim reports, related to an offering ofasset-backed securities.”

Redaction of personally identifiableinformation has been generally viewed aspermissible even without submitting aformal confidential treatment request tothe SEC so long as the findings andconclusions of the due diligence servicescan be reported without reference tosuch information. It has become marketpractice for the issuer to be responsiblefor the identification and redaction ofsuch sensitive information so that it is notpublished as part of a Form ABS-15G,and for the lead manager to have theright to review and approve any suchredactions prior to the filing of a FormABS-15G. An underwriting or purchaseagreement for a securitisation transactionmay include a representation andwarranty by the issuer that no portion ofthe Form ABS-15G contains personally



identifiable information (such as namesor addresses).

Exemption for non-US transactions Rule 15Ga-2 does not apply to a non-USoffering of ABS where the followingconditions are satisfied:

n the offering is not registered (and isnot required to be registered) underthe Securities Act;

n the issuer is not a “US person”; and

n the security issued by the issuer willbe offered and sold upon issuance,and any underwriter or arranger linkedto the security will effect transactionsof the security after issuance, only intransactions that occur outside theUnited States.

These conditions specifically exclude anyUS issuers from relying on the exemption.

Certification requirements for duediligence service providersWhen third party due diligence servicesare employed by an NRSRO, an issuer oran underwriter for ABS, the personproviding the due diligence services mustprovide to any NRSRO that produces arating for such ABS a written certificationmandated by Rule 17g-10 on Form ABSDue Diligence-15E (“Form 15E”)disclosing who paid for such services, a

detailed description of the manner andscope of the due diligence servicesprovided and a summary of the findingsand conclusions of the due diligence.The SEC has acknowledged thataccounting firms may be reluctant toprovide Rule 17g-10 certifications. As aresult, the SEC does not object to theinclusion of a description of thestandards that govern the performanceof AUP on Form ABS Due Diligence-15E.While Rule 17g-10 does not include anexemption for non-US transactionsparallel to the exemption provided forRule 15Ga-2, market participantstake the view that it does not apply toRegulation S transactions.

A Form 15E should be delivered promptlyafter the completion of due diligenceservices. This timing requirement isgenerally considered to be satisfied if theForm 15E is delivered within five businessdays of the final report. It is required notonly in connection with any third-partydiligence report produced in connectionwith the initial rating but also inconnection with additional due diligenceservices with respect to ABS offered toUS investors throughout the life of thesecuritisation transaction. Form 15E isnot required to be filed on EDGAR.Instead, it is typically posted by the issuerto the Rule 17g-5 website for the

transaction. An engagement letters withan NRSRO may include a statement orrepresentation by the issuer that anyrequired Form 15E will be posted to theRule 17g-5 website.

Transaction considerationsDeal teams should be aware of thethird-party due diligence report filingrequirements, as the ABS-15G forms aredue five business days prior to the firstsale. A failure to timely file a report maycause an inadvertent delay in the pricing ofan offering. Filing on EDGAR, while simpleand straightforward, requires at least twoto three business days of lead time forissuers that have not previously obtainedthe requisite passcodes and identifiers.

In addition, issuers and underwriters willneed to consider what, if any, provisionsshould be added to third-party duediligence service provider engagementletters to ensure that such parties complywith the new requirements, as well as thecontent and form of the disclosure to beincluded in the Form ABS-15G. Inparticular, issuers and underwritersshould make sure that the confidentialityprovisions in such engagement letterscontain appropriate carve-outs to permittransaction parties to comply with theseregulatory requirements.

Navigating the Tangled Forest

6. US Risk Retention: what weknow… and what is yet to come

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-FrankAct”) included an amendment to the US Securities Exchange Act of 1934 that requiressecuritisers to retain at least five per cent. of the credit risk of any asset pool theysecuritise and prohibits hedging or otherwise transferring such retained risk. Implementingrules were adopted in October 2014 and became effective with respect to residentialmortgage backed securities (“RMBS”) as of 24 December 2015. Compliance with USrisk retention requirements will be required as of 24 December 2016 for all other types ofABS, unless an exemption is available. The rules will apply to any issuer of asset backedsecurities (“ABS”) to US investors in a private placement under Rule 144A.



The implementing regulations reflect thatUS credit risk retention requirements aremandatory requirements of the securitieslaws. If applicable, compliance would becovered by standard no-contravention oflaw opinions. In the RMBS market,however, it has become commonpractice for legal opinions to carve outrisk retention compliance, as the risk ofcompliance is allocated to the issuer.These risk retention obligations aredesigned to apply to private placementsin the United States of ABS as well as inregistered public offerings. For thesepurposes, ABS includes any type of fixedincome or other security collateralised byany type of self-liquidating financial asset(such as a loan, lease, mortgage orreceivable) that allows the holder of thesecurity to receive payments that dependprimarily on the cash flow from the asset.The implementing regulations apply theretention requirement directly to thesponsor of a securitisation transaction.A sponsor, in this context, means aperson who organises and initiates asecuritisation transaction by selling ortransferring assets, either directly orindirectly, including through an affiliate, tothe issuing entity. In addition to severalasset-specific exemptions, a narrowexception for specified non-US offerings

is available and is discussed below inmore detail.

A sponsor may elect to retain therequired amount of credit risk indirectlythrough one or more majority-ownedaffiliates. A majority-owned affiliate of asponsor is any entity (other than theissuing entity) that directly or indirectlymajority controls, is majority controlledby or is under majority control with, thesponsor. Majority control meansownership of more than 50% of theequity of the relevant entity or ownershipof a controlling financial interest (asdetermined under US GAAP). A limitedexception permitting horizontal third-partyrisk retention by eligible third-partypurchasers is available for commercialmortgage backed securities (“CMBS”)transactions. Even when credit risk isretained by a third party, however, thesponsor will remain responsible forongoing compliance with the riskretention requirements.

Restrictions on hedging andrisk transfersRetained credit risk may not be hedgedor otherwise transferred until theexpiration of the relevant transfer andhedging restrictions. During this restricted

period, the following actions wouldnevertheless be permitted:

n A retained interest may be transferredby a sponsor to one or moremajority-owned affiliates, or by amajority-owned affiliate to anothermajority-owned affiliate of the sponsor.

n A retained interest may be pledged toa lender as collateral for a fullrecourse loan to the sponsor or amajority-owned affiliate, so long asthe payment obligations on such loanare not be materially related to thecredit risk of the retained interest.

n The sponsor or majority-ownedaffiliate may hedge the interest rate orforeign exchange rate risk associatedwith the retained interest.

n Subject to specified limitations, thesponsor or majority-owned affiliatemay enter into hedging transactionsbased on an index of instruments thatincludes the ABS giving rise to therisk retention obligation.

For all types of ABS other than RMBS,transfer and hedging restrictions willexpire on the latest of:

n two years after the closing date ofthe securitisation;



n the date on which the total unpaidprincipal balance of the securitisedassets that collateralise thesecuritisation is reduced to 33% of theoriginal unpaid principal balance; and

n the date on which the total unpaidprincipal obligations under the ABSinterests issued in the securitisation isreduced to 33% of the original unpaidprincipal obligations.

For RMBS, the transfer and hedgingrestrictions will expire on the later of:(1) five years after the closing date forthe securitisation; and (2) the date onwhich the total unpaid principal balanceof the securitised assets is reduced to25% of the original unpaid principalbalance, but not later than seven yearsafter the closing date. A limitedexception to these transfer restrictions isavailable for CMBS risk retentioninvolving eligible third-party purchasers.

Permitted forms of riskretentionUS risk retention requirements allow asponsor to satisfy its risk retentionobligation by retaining an eligible verticalinterest (“EVI”), an eligible horizontalresidual interest (“EHRI”), or acombination of these two forms. WhileEHRI may be more cost effective thanEVI, some sponsors of RMBS havefound EVI easier to comply with,because the required fair valuecalculations and related disclosureobligations (applicable only to EHRI) haveproven difficult in practice. The federalregulators have also adopted tailoredalternative risk retention options forspecific types of asset classes, such asrevolving pool securitisations and asset-backed commercial paper. Thesealternatives, however, do not include anyrepresentative sample method.

Vertical risk retentionIf the sponsor chooses to retain risk usingan EVI, the sponsor must retain either apercentage interest in each class of theABS interests issued as part of thesecuritisation transaction or a singlevertical security that entitles the holder toa specified percentage of the amountspaid on each other class of ABS. Forexample, if four classes of ABS interestsare issued in a securitisation transaction,the sponsor would satisfy its riskretention obligation by retaining fivepercent of each of the four classes. If thesponsor were to retain four percent ofthree classes and seven percent of thefourth class, it would be deemed to onlybe retaining a four percent interest (butnote the option to hold a hybrid riskretention interest described below). Inselecting between the two options, asponsor planning to use the EVI ascollateral for a full recourse loan maywant to consider whether potentiallenders would have a strong preferencefor one form of EVI over the other.

Horizontal risk retention and eligiblehorizontal cash reserve accountsAn EHRI may be the most junior class ofABS interests in the issuing entity ormultiple contiguous classes representingthe first loss position in the securitisationtransaction. On any payment date onwhich the issuer has insufficient funds topay all interest or principal due, anyresulting shortfall must reduce amountspayable to the EHRI prior to anyreduction in the amounts payable to anyother ABS interest (whether through lossallocation, operation or priority ofpayments or other contractual provision).

The percentage of risk retention credit foran EHRI is determined by reference tothe fair value of all ABS interests issuedas part of the securitisation transaction,using US GAAP. In adopting the

implementing regulations, US regulatorsspecifically declined to permit non-USsecuritisers to use any alternative fairvalue measurement methods that wouldbe permitted under IFRS or home countryGAAP. Sponsors who use EHRI to satisfytheir risk retention obligations are subjectto extensive disclosure requirementsregarding key information about themethodologies and assumptions thatthey use to calculate the amount of theireligible horizontal residual interests inaccordance with fair value standards.They must provide these disclosures toinvestors at two points in time: (1) areasonable period of time prior to the saleof ABS; and (2) at a reasonable time afterthe closing of the transaction. In RMBStransactions, the fair value determinationand disclosure requirement have beenchallenging to comply with, leading somesponsors to rely on EVI to satisfy their riskretention obligations.

Instead of retaining all or a portion of thecredit risk in the form of an EHRI, asponsor may elect to establish and fundan eligible horizontal cash reserveaccount (“EHCRA”). The risk retentionpercentage attributable to the cash in anEHCRA would be determined withreference to the fair value of all ABSinterests issued in the securitisationtransaction. This option is attractive fortypes of securitisation that typicallyinclude cash reserve accounts. To qualify,the account must be held by a trustee inthe name and for the benefit of the issuer,and amounts in the account can only beinvested in cash and cash equivalents.Amounts may be released from anEHCRA to:

n satisfy payments on ABS interests inthe issuer on any payment data onwhich the issuer has insufficient fundsfrom any source to satisfy an amountdue on any ABS interest; or



n pay critical expenses of the trust to aperson not affiliated with the sponsor,which payments must be unrelated tocredit risk, on any payment date onwhich the issuer has insufficient fundsfrom any source to pay suchexpenses and such expenses wouldotherwise be paid prior to anypayments to holders of ABS interests.

The implementing regulations do notaffirmatively require that the reserve fundsbe used to cover all types of paymentshortfalls. Accordingly, an EHCRA may bestructured to only cover a subset ofshortfalls – such as only shortfalls oninterest payments on a senior tranche ofABS interests.

Hybrid risk retentionA sponsor may choose to retain anycombination of EVI and EHRI as long asthe sum of the percentage of the EVI plusthe percentage of the fair value of theEHRI is no less than five percent. Forexample, if a sponsor elects hybrid riskretention and retains a single verticalsecurity representing three percent of thecash flows paid on each class of ABSinterests (other than the vertical securityitself), then that sponsor would also needto hold at a minimum an EHRI with a fairvalue (determined in accordance with USGAAP) of two percent of all the ABSinterest in the issuer.

Third-party risk retention option forCMBS transactionsIn the US market, it is common in CMBStransactions for third-party purchasers topurchase of a first-loss position (known asa B-piece). In recognition of this marketpractice, the Dodd-Frank Act gave federalregulators authority to create a third-partyrisk retention option for CMBStransactions. Under the implementingregulations, either one or two (but no morethan two) eligible third-party purchasers

will be permitted to satisfy the riskretention requirement by acquiring anEHRI. If there are two third-partypurchasers, neither third-party purchaser’slosses may be subordinate to the other’slosses. In cases where credit risk isretained by an eligible third-partypurchaser, the sponsor will neverthelessremain responsible for ongoing compliancewith US risk retention requirements.

The two third-party purchaser limit andthe inability of a third-party purchaser totake advantage of risk retention in theform of an EVI may deter use of thisoption. Traditional B-piece buyers maynot have sufficient capital to retain EHRIin amounts likely to be much larger thanthey have historically purchased. Inaddition, CMBS lenders may not bewilling to take on liability for non-compliance by a B-piece investor withthe risk retention requirements. As aresult, the CMBS market is stilldeveloping solutions, such as traditionalB-piece purchasers buying loans directlyfrom CMBS lenders and acting as theissuing entity.

Exemptions from US creditrisk retention requirementsExemptions are available for qualifyingnon-US securitisations as well as forsecuritisation transactions collateralisedby residential mortgages, pass-throughresecuritisations or seasoned loans thatmeet specified criteria.

Safe harbour for non-US transactionsIn implementing the risk retentionprovisions of the Dodd-Frank Act, thefederal agencies adopted a narrow “safeharbour” provision for predominantlynon-US transactions. Notably,securitsation transactions involving USissuers or US sponsors are not eligible forthis exemption. The implementing

regulations exclude from US risk retentionrequirements transactions that meet all ofthe following conditions:

n the transaction is not required to beregistered and is not registered underthe US Securities Act of 1933,as amended;

n neither the sponsor nor the issuingentity is chartered, incorporated orestablished under US law;

n no more than 10% of the value of allclasses of ABS interests in thesecuritisation transaction (including theretained interests) are sold ortransferred to US persons or for theaccount or benefit of US persons; and

n no more than 25% of the assetsunderlying the ABS issue wereacquired from a majority ownedaffiliates of the sponsor or issuingentity that is chartered, incorporatedor organised under US law or from anunincorporated branch or office of theissuing entity that is located in theUnited States.

Because transfers to US persons areincluded in the 10% limitation for this safeharbour, some uncertainty remains abouthow this safe harbour will be applied inpractice. In the near term, it would beprudent for market participants to seekadvice regarding the availability of thissafe harbour for Regulation Stransactions that contemplate offshoreoffers to US persons.

In the absence of a substitutedcompliance regime, the relatively narrowscope of the foreign safe harbourprovision may have a negative effect onnon-US sponsors that seek USinvestors because they may need tosatisfy risk retention requirements of twojurisdictions (their home country and theUnited States).



Asset-specific exemptions The implementing regulations provideseveral exemptions that are tailored forspecific asset classes. For example,qualifying resecuritisations are exemptfrom risk retention if:

n the resulting ABS interests consistonly of a single class and provides fora pass through of all principal andinterest payments received on theunderlying ABS interests (net of issuerexpenses); and

n the underlying ABS interests wereissued in compliance with US creditrisk retention requirements or anapplicable exemption.

The implementing rules also provide anexemption from risk retention forsecuritisations collateralised solely byservicing assets and seasoned loans thathave not been modified since theirorigination or been delinquent for 30 daysor more. For purposes of this exception,“seasoned loans” includes:

n residential mortgage loans that havebeen outstanding and performing foreither: (1) the longer of five years or theperiod until the outstanding balance ofthe loan has been reduced to 25% ofthe original principal balance or (2) atleast seven years; and

n any loan that is not a residentialmortgage loan and that has beenoutstanding and performing for the

longer of either: (1) two years; or(2) the period until the outstandingprincipal balance of the loan has beenreduced to 33% of the originalprincipal balance.

Similarly, auto loans that meet a specifiedset of conditions (including fixed interestrates, fixed interest payments, and termsand borrower debt-to-income ratios notto exceed specified maxiumums) (knownas qualifying auto loans or “QALs”) thatserve as collateral in an auto loan ABStransaction are exempt from US creditrisk retention requirements. Loans relatedto recreational vehicles, business vehiclesand automobile leases are not eligible asQALs. QALs are also subject toevaluation, certification and repurchaserequirements under the final rules.

An exemption is also available for CMBStransactions that are backed by qualifiedcommercial real estate (“QCRE”) loansthat meet a specified set of conditions(including fixed interest rate, debt servicecoverage ratio requirements that vary bytype of loan, ten-year minimum maturity,and loan-to-value ratio maximums).Interest-only loans or interest-only periodloans will not qualify as QCRE loans.These loans are also subject to evaluation,certification and repurchase requirements.In addition, an exemption from US riskretention obligations is provided forsecuritisations involving high-qualityresidential mortgages. While other

categories of non-US originated loans mayhave trouble qualifying for potentiallyrelevant risk retention exceptions as apractical matter, “qualifying residentialmortgages” are the only category ofqualifying loan exception for which federalregulators have indicated that theirstatutory authority to implement anexception is implicitly restricted toUS-originated assets.

ConclusionThe federal regulators designed theUS credit risk retention requirementsto incorporate a degree of flexibilityto try to accommodate issuers thatneed to comply with both non-USand US regulatory requirements.US risk retention requirementsalready apply to RMBS transactions,and other types of securitisationtransactions will be required tocomply as of 24 December 2016.Compliance experience in the RMBSmarket since the effectiveness of theimplementing regulations will informapproaches to risk retentionstructuring for the other types ofABS transactions in the future.Experience to date indicates that inpractice compliance will bechallenging in many asset classes.

7. EU and US ComparativeRisk Retention: can theywork together?



IntroductionThe initial introduction in 2011 of “skin inthe game” requirements in the EU wasunder Article 122a for bank investors insecuritisation transactions. Those ruleswere updated in the CapitalRequirements Regulations (“CRR”) in2013 and very similar rules weresubsequently rolled-out for alternativeinvestment fund managers via regulations(“AIFMR”) under the AlternativeInvestment Fund Managers Directive in2014 and for insurers via the Solvency IIDelegated Act (“Solvency II”) in 2015.After the briefest of pauses for thought,EU policy makers have now embarked ona drive to consolidate and rationalisethese rules under the SecuritisationRegulation (not only in the risk retentionspace, but more broadly, as set outearlier in this publication).

In parallel with these developments in theEU, the US has introduced broadly similarrisk retention requirements for securitisers(but not for investors) via Regulation RR,which became effective for residentialmortgage-backed securities (“RMBS”) inDecember 2015 and will become effectivefor other asset classes of asset-backedsecurities (“ABS”) in December 2016.

This article seeks to provide an update onthe developments in EU risk retention, thegeneral points to note in relation to thenew US risk retention rules and ahigh-level comparison of these regimesrelevant for EU ABS issued into the US.

Europe and theSecuritisation Regulation Existing positionAs anyone involved in the Europeansecuritisation industry will be aware, manyof the regulations affecting securitisationhave been aimed at various institutions intheir capacity as investors, rather thantaking the US approach of focussing solelyon “securitisers”. The result of thatapproach has been the introduction ofrules on risk retention and investor duediligence (and capital, where appropriate)in the sectoral legislation of a number ofdifferent industries, including the CRR forcredit institutions and investment firms,Solvency II for insurance and reinsuranceundertakings and the AIFMR for alternativeinvestment fund managers. This has beenproblematic because the obligationsimposed under each of these regimes areworded slightly differently, often for noobvious reason. Further, the relevantregulators for investors under theseregimes have been different, increasing therisk of rules theoretically meant to achievesimilar goals producing differing, andpotentially conflicting, requirements inpractice. At this stage, market participantshave become broadly comfortable that thedifferent regimes are meant to beinterpreted consistently, but the residualrisk of differing requirements remains.

Securitisation RegulationThe proposed new EU risk retention ruleswill have a number of novel features

compared to the existing CRR, AIFMRand Solvency II rules. The two principalchanges are the introduction of a dualdirect/indirect approach and the exclusionof certain originators from being riskretention holders. In addition to thechanges that are obvious from theproposed Securitisation Regulation itself,a new set of regulatory technicalstandards (“RTS”) will be required oncethe new regulation comes into force.These will replace the existing riskretention RTS in force under the CRR –there being none under AIFMR or underSolvency II – and may introduce furtherchanges to the risk retention regime inaddition to those described below.

Because EU risk retention rules havehistorically been focussed almost entirelyon institutional investors, (the so-called“indirect approach”) it has been on them tocheck that transactions comply, regardlessof where any of the other transactionparties are based. Likewise, failure tocomply led to penalties (usually in capitalrisk weights) principally on investors. Theflipside of this has been that EU originators,sponsors and original lenders puttingtogether transactions have been able toignore the EU risk retention rules if theirinvestor base has been unregulatedinvestors or investors outside the EU.

Under the proposed SecuritisationRegulation, EU originators, sponsors andoriginal lenders would have a directobligation to retain the familiar 5% net

The EU and the US both have 5% risk retention rules applicable to securitisations. Bothare intended to make sure the people putting together transactions keep some “skin in thegame” and both are intended to put paid to the originate-to-distribute model ofsecuritisation. So complying with both should be simple, right? wrong. In this article, wetake a comparative look at these two risk retention regimes and discuss where they worktogether seamlessly – and where market participants are likely to run into challenges.



economic interest. This is in addition to theobligation on EU institutional investors tocheck as part of their regulatory duediligence that the retention obligation isbeing met. The new regulation makes clearthat the retention obligation need only befulfilled by one party and that, failingagreement for the sponsor or originallender to retain, the obligation falls on theoriginator. This, of course, does not removeall ambiguity, as a number of transactionswill have multiple entities that would meetthe definition of an “originator”.

The second major change to theretention regime is that an originatorentity will not be permitted to act as aretention holder where it “has beenestablished or operates for the solepurpose of securitising exposures”. Thisis a modification from a previous versionof the new rule that suggested the testwould be a “primary purpose” test, ratherthan a “sole purpose” test. The versioneventually proposed is clearly moreappropriate and workable for industry.

In addition to these two major changes,there are a number of other helpful minorchanges to the regime that appear fromthe face of the proposed SecuritisationRegulation. These include:

n the amendment of the “originatorinterest” retention option to reflect theexisting practice that it can be usedfor any revolving securitisation (theprevious text suggested that it wasjust for securitisations of revolvingexposures); and

n the amendment of the rules concerningretention on a consolidated basis sothat it no longer requires the exposuresto have been originated by severaldifferent entities within the group.

Unfortunately, some changes hoped forby industry do not appear to have found

favour with the Commission. Chief amongthese were the extension of retention ona consolidated basis beyond EUregulated institutions and an adaptationof the retention regime to allow it to fitmore comfortably with managed CLOs.

As mentioned above, a degree ofuncertainty will remain even after the newSecuritisation Regulation is approved,because new RTS are required to beformulated to add more detail to theframework set out in the regulation.These RTS will need to be agreed by theEuropean Banking Authority (the “EBA”),the European Securities and MarketsAuthority (“ESMA”) and the EuropeanInsurance and Occupational PensionsAuthority (“EIOPA”) before beingadopted by the European Commissionand will apply to all institutional investors,thereby preserving the single regimeacross sectors that is a principal purposeof the new regime.

US risk retention underRegulation RRWhile the EU was an early adopter in therisk retention field, as is typical for USregulation – and especially so forregulations that need to be jointly craftedby multiple agencies with differentagendas, interests, concerns andconstituencies – the US was fashionablylate to the party. In October 2014, aftertwo proposed rulemakings (and theirseparate comment periods) and generallykeeping US securitisation marketparticipants in limbo for a little over threeyears, six US regulators jointly adoptedRegulation RR in order to implement thecredit risk retention mandates of theDodd-Frank Act. The basic thrust of theregulation is that a “securitiser” (or amajority owned affiliate of a “securitiser”)of an asset-backed securities transactionis required to retain a portion of the credit

risk of the transaction or, in certain cases,allocate all or some of that credit risk toone or more significant originators (byasset concentration) of the securitisedassets. Regulation RR is focused solelyon securitisers and does not provide foran indirect, investor-based approach.

Under the regulation, a “securitiser”includes a securitisation “sponsor”, definedas “a person who organises and initiates asecuritisation transaction by selling ortransferring assets, either directly orindirectly, including through an affiliate” toan issuer. In general, we expect that theemphasis on “securitiser” in Regulation RRwill broadly align with the emphasis on“originator, sponsor or original lender” in theSecuritisation Regulation, but there may becases where the regimes point to differentpersons as the party to retain, which willneed to be reconciled in order to effect across-border securitisation in the EU andthe US. Although for most EU transactionsthis is not expected to cause issues, in themore bespoke portfolio financing arena,there could be instances of a originator ororiginal lender who is not a “sponsor” forUS purposes retaining which do not meetthe US rules (although the tightening of therules around SPV retention may go someway towards aligning the EU position withthat of the US).

In the event that a transaction includesmultiple sponsors, the sponsors arejointly responsible for ensuring that atleast one of them or one of their majorityowned affiliates retains the entire requiredcredit risk, so as to not dilute theeconomic risk being retained. This is alsoan area of potential conflict with EU rules,which are drafted on the basis thatpro rata retention by all retainers of agiven type (originator, sponsor or originallender) is the base position where thereare multiple originators, sponsors ororiginal lenders. That said, in practice



most EU transactions fit into one of theexemptions that allows risk retention by asingle entity, meaning the practicaldifficulties in this area should be limited.

Regulation RR provides for three“standard” methods of retention that willbe available to the sponsors of mostsecuritisation transactions, and well as anumber of “special” methods for specifictransaction types. Below is a summary ofthe standard methods and one specialmethod (for revolving pool securitisations)that is especially relevant for EU/UScross-border securitisations.

n Vertical: An “eligible vertical interest”(an “EVI”) of at least 5% of each classof securities (both those sold toinvestors and those retained by thesponsor or other affiliates ofthe sponsor).

n Horizontal: An “eligible horizontalresidual interest” (an “EHRI”) of atleast 5% of the fair value of allsecurities (both those sold toinvestors and those retained by thesponsor or other affiliates of thesponsor), determined in accordancewith US GAAP as of the closing dateof the transaction; an EHRI must be afirst loss piece, meaning it must havethe lowest priority of payment ofprincipal and interest.

n Combined vertical/horizontal(“L-shaped retention”): A combinationof an EVI and an EHRI where the sumof the percentage of the fair value ofthe EHRI and the percentage of theEVI equals at least 5%.

n Special method for revolving poolsecuritisations: A “seller’s interest”(subject to somewhat technicalrequirements which may notnecessarily fully align with those of an“originator interests” under EU rules)of at least 5% of the outstanding

balance of all securities of each seriesissued by the revolving securitisationstructure to investors.

The test for an EHRI is based on 5% offair value of the securities, while the testfor an EVI is based on 5% of unpaidprincipal balance or percentage interest.In addition, the disclosure document fora transaction relying on EHRI retentionrequires extensive and detaileddisclosure on the fair value calculationand the methodology for the calculation,including all assumptions made and thereasons for those assumptions. Nocomparable disclosure is required for atransaction relying on EVI retention. Sowhile the consensus of most USsecuritisers is that EHRI retention is moreadvantageous from an economicstandpoint, EVI retention is far easier tocomply with. As a result, the first fewtransactions that came to market in theUS in early 2016 relied on EVI retentionprincipally because market participantshad not yet worked their way through thecalculation of fair value and/or how toadequately disclose it. However, sinceMarch 2016, a number of UStransactions have come to market relyingon EHRI retention, so it appears that themarket (at least for RMBS) has workedits way through one of the morechallenging aspects of the regulation.

Another feature of Regulation RR is thateach method of retention includesopportunities for a sponsor to offset itsrequired risk retention. For example, if atransaction includes an originator that hasoriginated at least 20% of the securitisedassets, the sponsor may allocate aportion of the required risk retention tothat originator, though the sponsor willremain responsible for risk retentioncompliance on that transaction. In arevolving structure, a sponsor maysubtract the amount held in principal

accumulation account from theoutstanding balance of all securities ofeach series issued by the revolvingsecuritisation structure to investors andcalculate the required 5% on thatreduced amount (although this will not bean option for transactions that also needto comply with EU rules). Also forrevolving structures, a sponsor may holda seller’s interest of less than 5% (forexample, 3%) if it also holds acorresponding residual interest (forexample, 2%) in each series issued bythe revolving structure after the effectivedate of the rule that would be an EHRI ifthe sponsor was not also holding asubordinated seller’s interest. This latteroption may be especially helpful torevolving structures that include seriesissued both before and after the effectivedate of Regulation RR. However it isworth noting that such L-shapedretention is not permitted under the EUrules and will therefore not be of use indual-compliance transactions.

In terms of the remaining EU methods ofretention, both the original andre-proposed versions of Regulation RRincluded a “representative sample”option, but this was not included in thefinal rule as it was considered difficult toimplement in a way that would not resultin costs outweighing benefits. An optionto hold a first loss piece in everyindividual securitised asset wasnever proposed.

One of the overarching concerns ofRegulation RR is that the interests of thesecuritiser and investors should align.Therefore, a securitser’s holding of creditrisk should actually mean something andincentivise better transactions, since thesecuritiser would be bearing a portion ofthe credit risk traditionally shifted toinvestors. To that end, Regulation RRrestricts the ability of the sponsor to



hedge, finance or transfer the requiredcredit risk during the related requiredretention period to any person other thana majority owned affiliate of the sponsor.For RMBS, the retention period runs forfive years after closing or until theprincipal balance of the securitised assetshas been reduced to 25% of the balanceat closing, whichever is later. For all otherABS, the retention period runs for twoyears after closing or until the principalbalance of the securitised assets hasbeen reduced to 33% of the balance atclosing, whichever is later.

During the retention period, neither thesponsor (or a majority owned affiliateholding any required credit risk) nor theissuer may engage in any hedgingtransactions if payments on the hedgeinstrument are “materially related” to therequired credit risk and the hedge wouldlimit the financial exposure of the sponsor

(or such majority owned affiliate) to therequired credit risk (“ProhibitedHedging”). Similarly, the sponsor (or anymajority owned affiliate) may not pledgeany required credit risk as collateral for afinancing unless that financing is fullrecourse to the sponsor (or such majorityowned affiliate).

Side-by-side comparison ofEU and US risk retentionAt the date of publication there are threerisk retention regimes in Europe (withsubstantially similar requirements) andanother in the US. Assuming theintroduction of the SecuritisationRegulation in due course, Europe willreduce its three regimes to one, howeverindustry participants will still need tonavigate the differences between Europeand the United States in cross-bordertransactions. In the European RMBS

space this is already an issue thatEuropean sponsors are grappling with,and other asset classes that frequentlyuse Rule 144a placements into the USwill join in December this year. Whileapproaches to these differences will ofcourse change over time, major Europeanmarket participants in the Rule 144amarket have, to our knowledge, foundthat dual compliance is possible andwhat they are already doing under theCRR, AIFMR and Solvency II can work forUS purposes – but, as ever, the devil is inthe detail.

While this exercise will of course need tobe updated for any changes to theSecuritisation Regulation before it isadopted, and for the risk retention RTSwhen they are adopted, we expect thatdual compliance will remain workable, asthe table below seeks to demonstrate.

Feature Draft Securitisation Regulation Regulation RR Comparative notes

Risk Retention Method

Vertical No change expected from the CRR,Solvency II and AIFMR regimes.

The retention of no less than 5% of thenominal value of each of the tranchessold or transferred to investors.

EVI of 5% of each classsecurities (both sold toinvestors or retained).

Both the Securitisation Regulationand Regulation RR generally have thesame vertical requirements and seemto be the most compatible for EU/UScross-border transactions.

Horizontal No change expected from the CRR,Solvency II and AIFMR regimes.

First loss tranche (sized at 5% ofthe nominal value of thesecuritised exposures).

EHRI of 5% of the fair valueof all securities.

The European test is based on thenominal value of the underlyingexposures (assets), where the US testis based on the fair value of thesecurities (liabilities), which may leadto a mismatch in the amount ofretention required under the tworegimes, even though both arenotionally 5% “first loss” pieces.




Risk Retention Method

Alternative methodfor revolvingsecuritisations

No material change expected from theCRR, Solvency II and AIFMR regimes.

Originator’s interest of no less than5% of nominal value of thesecuritised exposures.

Seller’s interest of at least5% of the outstandingbalance of all securities ofeach series issued by therevolver to investors,subject to certain offsetoptions more fullydescribed above.

Again, there is an asset/liabilitymismatch in the tests which maycause a divergence in the calculationof the 5% under the US and EU rules.That will result in the ‘lowest commondenominator’ approach being usedfor dual-compliance. The detailaround the use of the ‘seller share’retention method under the US dealsmeans that detailed complianceanalysis will need to be undertakenfor UK master trusts to ensure theyare Regulation RR compliant.

Randomlyselectedexposures

No change expected from the CRR,Solvency II and AIFMR regimes.

Randomly selected exposures worthat least 5% of the nominal value of allsecuritised exposures. These are to beheld outside the deal and the use ofthis technique is limited to pools ofmore than 100 exposures.

Not applicable. This option will not be available forEU/US cross-border transactions.

First loss exposureof every exposure


The retention of a first loss exposure ofnot less than 5% of every securitisedexposure in the securitisation.

Not applicable. This option will not be available forEU/US cross-border transactions.

Combinedvertical/horizontalor “L-shaped”retention


This type of retention is not permittedunder European rules.

A combination of an EVIand an EHRI where thesum of the percentage ofthe fair value of the EHRIand the percentage of theEVI equals at least 5%.

This option will not be available forEU/US cross-border transactions,unless the retainer opts to holdvertically or horizontally in an amountthat meets the 5% minimum ascalculated under the relevant EU andUS rules. This is clearly economicallyunattractive if legal requirements arethe only reason to retain the risk.




Ancillary rules relating to risk retention

Scope oftransactionssubject to riskretentionrequirement

No change from existing legislation.Deals are subject to risk retentionrequirements if they are“securitisations”.

For these purposes, “securitisation”means a transaction or scheme,whereby the credit risk associatedwith an exposure or pool of exposuresis tranched, having both of thefollowing characteristics: (a) paymentsin the transaction or scheme aredependent upon the performance ofthe exposures or pool of exposures;(b) the subordination of tranchesdetermines the distribution of lossesduring the ongoing life of thetransaction or scheme.

Risk retention is required inrespect of “asset-backedsecurities”. These aredefined under the USsecurities laws generally asa fixed-income or othersecurity collateralised byany type of self-liquidatingfinancial asset that allowsthe holder of the security toreceive payments thatdepend primarily on cashflow from the asset.

Under US regime, a single-tranchetransaction is subject to risk retentionso long as the resulting bond meetsthe definition of an asset-backedsecurity. Therefore, certain structures(e.g. repackagings) that might not besecuritisations under the EU regimewould result in asset-backedsecurities under the US rules andwould thus need to comply withRegulation RR, if issued into the US.

Party to retain Originator, sponsor or original lendernow under a direct obligation to retain,in addition to the obligation on EUinstitutional investors to check as partof their regulatory due diligence thatthe retention requirement is being met.No splitting of retention among typesof retainer (sponsor vs. originator vsoriginal lender), but base position ispro rata retention among retainers ofa given type unless anexemption applies.

“Securitiser” (typically thesponsor—see below) toretain; in certain cases,sponsor may offset EVI orEHRI (or combination) byallocating a portion of theEVI or EHRI (orcombination) to anoriginator that hasoriginated at least 20% ofthe securitised assets, butsponsor will remainresponsible for riskretention compliance.

The regime in the EU is now movingto the direct approach adopted in theUS. In the EU, however, the obligationon institutional investors to check isstill present and will continue to serveas a check and balance on thecompliance by the originator, sponsoror original lender.

Originators,sponsors andoriginal lenders vssecuritiser

No change in the definitions of theinstitutions who are eligible retainers.A new prohibition on originatorsretaining where they wereestablished solely to securitiseexposures is introduced by theSecuritisation Regulation.

“Securitiser” includes asecuritisation “sponsor”,defined as “a person whoorganises and initiates asecuritisation transactionby selling or transferringassets, either directly orindirectly, includingthrough an affiliate” toan issuer.

In many cases, the US and EU ruleswill point to the same persons as theparty to retain. However, there remainsubtle differences that mean in sometypes of transactions (e.g. managedCLOs) cross-border EU/USsecuritisations will be difficult.




Ancillary rules relating to risk retention

Restrictions ondealing

There is a prohibition on credit riskmitigation or hedging in respect of theretained interest. Further detailed rulesare to be developed by EBA inconjunction with ESMA and EIOPA inthis respect.

No transfer of retainedinterest to any person otherthan a majority ownedaffiliate; no ProhibitedHedging of retained interest;no pledge of retainedinterest as collateral for afinancing unless financing isfull recourse to the sponsoror such majorityowned affiliate.

It is expected that the regimes willultimately be broadly aligned here,however the detailed rules to bedeveloped by the Europeanregulators will ultimately determinethis from the European side and thereis relatively little visibility on thatfor now.

Duration ofretention

No change – retention is required forthe full life of the transaction.

RMBS: Five years afterclosing or until the principalbalance of the securitisedassets has been reducedto 25% of the balance atclosing, whichever is later(or, the life of thetransaction, if shorter).

Other ABS: Two years afterclosing or until the principalbalance of the securitisedassets has been reducedto 33% of the balance atclosing, whichever is later(or, the life of thetransaction, if shorter).

Life of transaction forrevolving poolsecuritisation relying onseller’s interest retention.

For dual compliance transactions, theretention will need to be done to thepotentially longer-dated EUrequirements. For example, a 7-yearterm RMBS, under the US rules, mayonly need to have risk retention inplace for the first 5 years (if that timeis longer than the 25% “factor-down”). Under the EU regime,retention is required until the fullsecuritisation debt is redeemed.

ConclusionThere remain areas of uncertainty about how the comparative regimes will develop, but the broad picture is relatively clear. Since theSecuritisation Regulation is still at a relatively early stage, changes in the text of the regulation itself as well as the further detail to beadded by regulatory technical standards once the regulation is finally in place will be important. Frequent sponsors of ABS placed toboth EU institutional investors and those in the US have already had to grapple with compliance with the three current EU regimesand Regulation RR on the RMBS front. Other classes of ABS, such as those backed by credit card receivables, will join later on thisyear. For sponsors of ABS in the US, the implications of Regulation RR are still being felt by structurers and as further non-RMBSasset classes join the party at the end of the year further issues will inevitably come up. Overall, the industry is successfully adaptingto the requirements and it appears as though these will settle with time.

8. The EU Covered Bond Framework:towards a 29th regime?

IntroductionThe ball is back in the EU Commission’scourt. The Commission launched itsconsultation paper on a possiblepan-European covered bond framework inSeptember 2015, and closed it on January2015. In the meantime, responses came infrom a vast array of market participantsfrom across the EU Member States. Nowthat these are in, and the EU Commissionis considering next steps, now seems asgood a time as any to assess what mightbe the ultimate outcome.

In doing this, it is important at the outsetto consider the context in which theconsultation was set up. Coming as partof the Capital Markets Union (“CMU”)project, it is no surprise that the keyquestion posed by the consultation iswhether further integration in theEuropean covered bond market isdesirable. Integration is, after all, the nameof the game in the wider CMU project.

Having one eye on the broader goals ofthe CMU project helps perhaps to explainsome of the questions posed, and someof theories considered, by theCommission. Certainly, the tone of theconsultation paper appears to pushintegration a little heavy-handedly in someplaces. Doubtless this is partly borne outof a desire to provoke as wide-ranging aset of views as possible, but this must bein part down to the CMU project: greaterintegration and the creation, as far aspossible, of a Europe-wide level playingfield in the capital markets across the

member states, of which the coveredbond market is a subset.

The key questions for covered bondsare, first, how much integration andharmonisation does the market reallyneed and; second, to the extent we doneed it, what legislative form is it likely totake. Two key themes have emergedfrom the responses that indicate thelikely direction of travel. First, as the titlethis article suggests, there is a cautionagainst making wholesale changes to aregulatory framework that already workswell. Secondly, the consultation and theresponses it has generated haveindicated an appetite for harmonisationin certain areas. And therein lies thebalancing act for any new legislation:to integrate where necessary, but not totry to fix what isn’t broken.

Background – is there a problem? In its CMU Green Paper, the Commissionmade clear what it viewed as thefundamental problem: “capital marketstoday remain fragmented and are typicallyorganised along national lines”, noting aswell that “the degree of financial marketintegration across the EU has declinedsince the crisis, with banks and investorsretreating to home markets”. Coveredbonds were no exception to thisperceived market fragmentation.

Thus Part I of the consultation paperanalyzed this post-crisis retrenchmentspecifically in the covered bondmarkets and considered the possible

causes. Noting that, pre-crisis, coveredbond yields suggested a relativelyhomogeneous product acrossjurisdictions, the Commission suggestedthe factors that may have caused thejurisdictional fragmentation post-crisis.One of these was that the regulatoryregime applicable to covered bondswas organised on national, rather thanpan-European, lines.

Thus the EU Commission invitedparticipants to consider whether therehad been a possible “stigmatisation” ofthe covered bond markets in worst-hitMember States resulting from the specificlegal regime applicable to covered bondsin them. The key question was thereforethis: was the fragmentation alongjurisdictional lines a function of thediffering legal regimes of the individualMember States concerned? Clearly, if theanswer to this question is an unequivocalyes, there is a ready-made case fordirectly effective harmonising legislationthat would in time supersede the regimesof the individual member states.

In response to this two points can bemade. First of all, the overwhelmingresponse of the respondents to theconsultation was a resounding no.A comparison between covered bondyields and sovereign bond yields of someof the affected member states sees analmost perfect correspondence. Thisleads to the conclusion that the health ofthe sovereign was the key factor ratherthan any concerns over the legal regime.



Along with its initial CMU proposals, the EU Commission launched a consultation on apossible EU covered bond framework, contemplating the possibility of anything from noaction to an eventual move to a directly legislated, EU-level covered bond regime as analternative to the national regimes in each EU Member State. In this article, we discussthe consultation, the feedback it received and the likely outcomes of the consultation.



This is hardly surprising given the intrinsiclink between the health of the sovereign,the health of the banking system andcorrespondingly the perception ofsovereign support to the issuer bank.

The second point is that these samelegal differences existed during thepre-crisis period when there was nosuch divergence in covered bondperformance. As we note below, thegeneral market view seems to be almostthe opposite of the Commission’shypothesis on this point: the differencesin the underlying legal regimes, and theway that the covered bond regulationshave developed around them, are a keypart of its historic strength.

The question is an important one,though, because the extent to which youpoint the finger at divergences in nationalsupervisory regimes and nationallegislation as being the problem dictatesthe extent to which European legislationthat attempts to eliminate suchdiscrepancies will be the solution. But theresponses were fairly emphatic: thereis no blame to be attached to theseparateness of the national regulatoryregimes; and there is consequently noappetite for attempting to replace thesenational regimes with a pan-Europeanone (the so-called 29th regime – one ofthe suggestions put forward by the EUCommission). The view of the market inthe responses has been loud and clear inthis respect: such a new regime wouldsimply increase confusion and complexity.

The case for harmonisationHowever, rejecting the 29th regime is notto say that some degree of greaterharmonisation in the covered bond spacewould not be desirable, and this is why theconsultation as a whole has been warmlywelcomed by the market. This is because

industry rumblings about harmonisationhave been going on for a while, andspecific analysis on this point wasconducted by the EBA in its 2014 report.The EBA report explored jurisdictionaldivergences in the covered bondregulations of each EU member states indetail and made various recommendationsas to the areas that could, potentially,benefit from harmonisation. These includethe different models of supervision ofcovered bond issuers and programmes;divergence in terms of the eligibility criteriafor the cover pool assets (e.g. in terms ofvaluation and LTV); differing approacheson measures to manage mismatchesbetween cover assets and liabilities; anddiffering standards in terms oftransparency. All of these elements arementioned in the Commission’sconsultation paper. So to an extent theconsultation can also be seen as thelogical next step of the EBA’s work. This ishelpful because it provides clues as to theareas the Commission is likely to focus onin any harmonising legislation as well as aninsight into where the market feels thegaps lie at the moment.

The current regulatory environmentAs noted above, direct regulation ofcovered bonds in the EU is currentlycarried out entirely according to thenational laws of the individual memberstates, not according to EU-wide rules. Tothe extent there can be said pan-Europeanregulation of covered bonds, it is indirect;through the prudential treatment ofcovered bonds that applies as a result of,for example, the UCITS Directive, theCapital Requirements Regulation (“CRR”),Solvency II and the Liquidity CoverageRatio (“LCR”) legislation. In this way, EUlaw currently prescribes criteria thatcovered bonds need to satisfy in order forthe relevant preferential regulatorytreatment to be conferred. Thus, currently,the only way that there can be said to be

EU-wide legislation that defines theregulated covered bond product is in thevery legislation that is supposed to set outthe benefits for being so.

Because the concept of a regulatedcovered bond is a meaningless onewithout the preferential treatment (e.g. interms of capital treatment under Article129 of the CRR or eligibility as highquality liquid assets under the LCR) thatregulated status confers, the legislationthat confers the preferential treatment(primarily the UCITS Directive and theCRR) is in fact the only legislation thatattempts in any way to define the producton a pan-European basis.

There could therefore be said to be alacuna, or at the very least a degree ofcircularity, in the current framework.To “correct” this would requirepan-European legislation that, taking intoaccount the existing national frameworks,actually seeks to define what a Europeanregulated covered bond is; that links theregulatory regimes (national) to theprudential one (pan-European). As theCommission puts it in the consultationpaper: “it may be appropriate to go beyondthe narrow scope of prudential regulation…and pursue a more ambitious reformagenda for convergence of national lawstowards a truly integrated andcomprehensible covered bond framework”.

How would harmonisationbe achieved?As we have noted above, the mostextreme legislative tool for harmonisingthe EU covered bond regimes, theso-called “29th regime”, looks destinedfor the cuttings floor. The other, lessextreme options suggested by theCommission include achievingharmonisation without any legislation atall – through market-led, voluntaryconvergence initiatives. A successful


example of this is the transparencytemplate developed by the EuropeanCovered Bond Council and now beingadopted by some European issuers.

No doubt industry and market-ledinitiatives will continue to develop.However, many of the responses alsoindicate enthusiasm towards somethingmore legislative in nature. Whilst there isclearly no appetite for replacing orsuperseding the existing nationalregimes, the consultation has left openthe possibility of some form of pan-European legislation that seeks to fill thegap identified above; to take the unifyingthreads of the national regimes anddefine the product on the EU level,leaving the prudential regulations to dotheir main job of setting out thepreferential treatment flowing from thatstatus. Any such directive might well useas a starting point the current criteria setout in Article 54 of the UCITS Directiveand Article 129 of the CRR.

What would any harmonisingdirective cover?As to what such a directive might cover,the consultation considers a numberof elements originally identified in theEBA report. These include the definitionof a covered bond, the segregationof assets, the administration of thecover pool post-insolvency of the issuer,the eligibility requirements for coverpool assets (including LTV) andtransparency requirements.

Clearly, there are elements of the abovethat are more easily codified into Europeanlegislation than others. For example, itwould be easy enough to set out a newdefinition of a covered bond (that couldreplace that set out currently at Article 54of the UCITS Directive); it would perhapsbe beneficial to set out a uniform set ofminimum standards for national supervisors

and even cover pool monitors; and it wouldbe no doubt welcomed by the industry toset out in law a directly applicable set oftransparency standards. It may also bepossible to set out a minimum set ofeligibility criteria for the overcollateralisation,as well as certain eligibility criteriaapplicable to the cover pool assetsthemselves, for example in relation to LTV.

But here is where the balancing actidentified above needs to be carried out.Any such harmonising directive wouldultimately need to acknowledge that inmany other aspects there can be noone size fits all approach. For example, themethod of asset segregation is dependenton whether there exists a dedicatedcovered bond law that achieves this orwhether the true sale method is employed.This varies from jurisdiction to jurisdiction.In addition, the question of whether thesegregation of assets would be upheld inan insolvency of the bank issuer is amatter for the individual insolvency laws ofeach Member State; there is no European-level substantive insolvency law currently inexistence or indeed on the short- tomedium-term horizon. Until there is, thisaspect cannot be harmonised.

Taking another example, in relation toresidential mortgage deals, mattersrelating to the administration andenforcement of the cover pool assets willbe governed by the property laws of therelevant Member State, and propertylaws are likely to be among the mostdeep-rooted national laws, with little or noprospect of EU-wide harmonisation.There may also be perceived divergencesin the resolution regimes in individualmember states that mean that issuers incertain jurisdictions are perceived to havegreater sovereign support than in others.

Covered bond regulations in each memberstate have been built around existing

well-established laws; indeed, that is partof the historic strength of covered bondproduct. Any harmonising legislation wouldneed to tread very carefully around thesefundamentals. Furthermore, on a moremacro-economic level, there will remain thejurisdictional divergences that saw thepost-crisis jurisdictional fragmentation incovered bond markets. The strength of thesovereign and the banking system willalways and unavoidably be factors forinvestors. This will be the case irrespectiveof any harmonising legislation.

ConclusionThe EU Commission’s consultation ona possible harmonising framework hasbeen commendably broad in its scopeand warmly welcomed by the market.To its great credit, it has sought tocanvas as broad a range of opinion aspossible from market participants. Inturn, market participants haveresponded in their droves, providingthe Commission with a vast array ofviews through which to sift. Given thethoroughness with which they haveapproached the exercise, and theamount of feedback they havegathered, it may take some time forconcrete proposals to emerge.

The early signs are encouraging: themarket has indicated loudly that “if itain’t broke, don’t fix it”, and theCommission has confirmedsubsequently that no radical overhaulwill be forthcoming. All the indicationsare that the Commission will view theharmonisation exercise as means offixing what can be fixed and will buildon the EBA analysis in this respect,while at the same time preserving thelegal fundamentals that underpin eachnational covered bond regime andwhich form the bedrock of itscontinuing success.


9. The Next Step in ‘Step-In’ Risk:the BCBS considers the position



The consultation paper provides a‘conceptual framework’ and is intendedto elicit comments from the industry.A Quantitative Impact Study (“QIS”) isbeing conducted in the H1 2016. Basedon information obtained from both theseinitiatives, the BCBS will produce a finalframework, although no timeframe hasbeen given for this.

In this article, we outline the keyelements of the proposed frameworkand highlight some of the reaction to itfrom the market. It is too early to saywhat the final framework will look like,or indeed whether the BCBS willaccept the suggestion from somequarters that it should not proceed withthe framework in light of the otheraccounting and regulatory reforms thathave taken place or are planned.Clearly the outcome of the QIS will becrucial, as the proposals, should theyultimately lead to higher capitalcharges, could have a broad andsignificant impact on the financialsector and the broader economy.

Background to theproposed frameworkThe framework on step-in risk is part ofthe Financial Stability Board agenda todevelop policies aimed at reducing risk inthe so-called ‘shadow banking’ sectorand, in particular, mitigating risks in banksinteractions with shadow banks.Accounting and regulatory reforms havebeen introduced since the financial crisiswhich the BCBS think reduce thelikelihood of a bank stepping in to providefinancial support, but they conclude thatthe risk has not been completelyeliminated. For this reason, the BCBSconsiders that additional work iswarranted. Ironically, however, somecommentators believe that the proposalswill make it more likely that investors willthink a bank willing to step in to supportan entity, arguing that the frameworkgives an implied commitment to support.Having to hold capital reserves in case abank has to step in could potentially givean investor the impression that the bankwould actually step in. This, of course, isthe opposite of what is intended.

Identifying step-in riskUnder the proposed framework, bankswould conduct an assessment of itscontractual and non-contractualcommitments with unconsolidated entitiesin order to evaluate whether a significantstep-in risk exists. The proposals apply tounconsolidated entities, specifically thoseentities that are outside the scope ofregulatory consolidation. The proposalshave been criticised for the confusing useof the concepts of ‘regulatoryconsolidation’ and ‘accountingconsolidation’ and the requirement tofocus on entities outside the scope ofregulatory consolidation has causedconsternation in some corners of themarket, as many believe that, followingthe regulatory reforms that have been putin place post-crisis, there are unlikely tobe a significant number of unconsolidatedentities that could pose a material andsystemic risk to the financial system.

As an initial step, the BCBS expects thatbanks should determine whether an entityshould be consolidated and, if so, apply

The Basel Committee on Banking Supervision (“BCBS”) is considering industryresponses to its December 2015 consultation paper on the identification andmeasurement of ‘step-in risk’ – the risk that a bank may provide financial support toan entity, even if it is not bound to do so under a contract, if that entity experiencesfinancial stress.

The consultation paper is the first step towards a final framework on step-in risk,which would affect a range of sectors, including securitisation. The application ofstep-in risk to securitisation is, obviously, to control the risk that banks will step in tosupport their transactions in order to protect their market reputations. What is notclear, is why step-in risk regulation is needed for securitisation, in the context oflongstanding, nuanced and reasonably well-understood implicit support rules.



the applicable accounting and regulatorystandards. If the bank concludes that anentity should not be consolidated, thebank should go on to assess whether a‘significant’ step-in risk occurs. This isdone with reference to primary ‘step-inindicators’. When a bank’s relationshipwith an entity meets one of the primaryindicators, there is a presumption thatstep-in risk is present.

The presumption that there is significantstep-in risk may be rebutted if the bank

can successfully argue that the step-inrisk has been reduced or eliminated.Secondary indicators are included in theproposed framework with the intentionthat they be used by supervisors inconsidering whether a banks’ argumentthat a particular step-in risk has beenmitigated has been successful.

As well as the existence of indicators,supervisors may use their own judgementto determine whether step-in risk ispresent on a case-by-case basis, such as

when a bank’s recovery and/or resolutionplans indicate that it would safeguardparticular non-owned entities.

The indicators have been criticised bythe many in the market as being toobroad and imprecise, and that as aresult, the framework would be difficultto implement globally in a coherentmanner. Many point out that, becausethe indicators are broad, thedetermination made by a bank or aregulator on whether an indicator hasbeen met is subjective and likely to vary,leading to an inconsistent treatment ofsimilar potential exposures. This haslead some respondents to call for achange in approach, to prohibit step-inunless there is approval from a bankingsupervisor or systemic risk regulator, forinstance. Prudential measures couldthen be applied to cases where actualstep-in occurs, which would bepreferable to anticipating that it will takeplace in all circumstances.

Measuring step-in riskOnce an entity is identified as posing astep-in risk to a bank, the next step is themeasure that risk and the BCBS envisagethree different approaches for this – thefull consolidation approach, theproportionate consolidation approach andthe conversion approach. Which one isused will depend on the extent of therelationship between the bank and theentity, although the consultation paperincludes a ‘map’, showing whichapproach should be used for a particularindictor. Importantly, the BCBS is still todecide whether the proposals fall withinPillar 1 and/or Pillar 2 of the Baselframework i.e. whether minimum capitalrequirements are necessary or whetherthe risk should be subject to supervisoryreview. There is strong consensus in themarket that, if indeed the proposal is to

n Full Sponsor;

• full upfront facilities; and

• decision-making.

n Sponsor:

• Partial upfront facilities,

• decision-making, and

• majority, or only providerof facilities

n Sponsor:


• decision-making, and

• where not majority or onlyprovider of facilities.

n Sponsor:


• no decision-making, and

• majority or only providerof facilities.

n Sponsor:


• no decision-making, and

• where not majority or onlyprovider of facilities.

n Sponsor:

• Decision-maker,

• but no upfront facilities.

n Dominant influence:

• Capital ties > 50%, or

• no capital ties but ability toremove and appoint board ofdirectors or to exercise adominant influence as aconsequence of contractual,organisational or financialrelations.

n Significant influence:

• Capital ties >20% and < 50%,or

• Has the power to exercise asignificant influence over themanagement.

n Significant influence:

• Capital ties < 20%, but

• Has the power to exercise asignificant influence over themanagement.

n External credit rating based on abank’s own rating.

n Exclusive critical services provider.

Primary Indicators



proceed at all, the supervision of step-inrisk should be under Pillar 2 and not bysetting additional capital charges.

Collective rebuttalsOne of the most controversial proposalsis the presumption of step-in risk if anindicator is present. However, theframework contemplates that thepresumption can be rebutted, either byan individual bank or collectively for ajurisdiction and provides examples of“collective rebuttals”. If a supervisor issatisfied that step-in risks are mitigatedby existing public policy that isenforceable by law they will not berequired to apply the framework. Theproposal sets out some criteria that couldbe used to establish a collective rebuttale.g. if a bank has been ring-fenced or ifthere is existing law or regulation whichprohibits banks or other financial entitiesfrom providing non-contractual supportfor non-balance sheet entities e.g. the US

Volcker Rule prohibition on banksproviding financial support.

Despite the possibility of rebuttal,however, many in the industry think thatthe presumption of significant step-in riskbeing present if one of the indictors ismet is inappropriate. Many think theindicators are too broad and impreciseand that it should not be assumed that abank will step-in in every circumstance,making the point that actual step-in mightbe a remote possibility, depending on theparticular circumstance, especially in lightof the reforms that have taken placesince the financial crisis.

Asset management andfunds under managementSpecial consideration is given to theasset management industry as the BCBSbelieves that step-in risk may where abank steps-in to support unconsolidatedasset managers and unconsolidatedfunds (e.g. where a banking group

provides credit enhancement to a fund)and where a bank owns an assetmanager (and therefore consolidates it)but where there are unconsolidated fundsmanaged by the asset manager whichthe bank might step-in to support, ‘as anexceptional measure’.

The focus on asset management is inlarge part due to the support given bybanks to money market funds (“MMFs”)during the financial crisis. Severalrespondents have pointed out that, whilethis did occur during the crisis, suchintervention was rare and likely to be evenless in the future due to the regulatoryreforms on MMFs which have beenintroduced or which are in the pipeline,particularly in the US and the EU. Inaddition, respondents point to the agencynature of asset management, whichresults in their being no risk on thebalance sheet of the asset manager, thefact that the asset management industryis highly regulated and that many of theconcepts underpinning the framework,such as ‘sponsor’, originally introducedinto the Basel framework in relation tosecuritisation activity, do not sit well withfunds and asset management context.

Joint venturesSpecial consideration is given to jointventures where the provisional view of theBCBS is that there should be proportionalconsolidation e.g. 50/50 for a jointventure between two between twobanks, although the BCBS is seekingviews on this.

Reaction to the proposalsIn total, the BCBS received 33 responsesto the consultation paper from a range ofstakeholders. Some respondents weresupportive of the proposals, thinking ita ‘sound and simple foundation’ for thedevelopment of a framework to account

Secondary Indicatorsn Branding

n Purpose and the overall design of the entity structure

n Major economic dependence of the entity on the bank

n Originator incentives

n Whether the bank enjoys/assumes the majority of the risk and rewards

n Implicit recourse

n The extent of the bank’s dependency on a particular market (funding source)

n Investor expectations of returns from their investments

n Composition of the investor base

n Investor ability to bear losses on their investing instruments

n Investor ability to freely dispose of their financial instruments

n Assessment of IFRS 12 disclosure

n Entity is subject to being safeguarded for its continuity of critical functions inaccordance with the bank’s recovery and/or resolution plans



for step-in risk, and even asking foradditional indicators, although themajority of respondents, which weremainly from the industry, raised concernsabout the direction of travel.

Chief amongst the concerns was thatthe proposals are a ‘blunt instrument’, andthat applying a one-size fits all approach tostep-in risk, with reference to a set ofbroad and sometimes unclear set ofindicators, would result in anoverestimation of step-in risk, and failto take into consideration the facts andnuances of a particular situation. In somesectors of the market, this appears to be aretrograde step. In the securitisation sectorfor example, rules on implicit support haveexisted for some time, devised as risksensitive and nuanced rules which appearto be at odds with the broad approachcontemplated by the proposals. Quiteapart from step-in risk being a bluntinstrument, there is a question mark onwhy the proposal should coversecuritisation at all, given that theconcerns the proposal seeks to addressare dealt with comprehensively by theimplicit support rules which already exist.

Although the consultation paper doesrefer to the regulatory and accountingreforms that have taken place since thefinancial crisis, changes to the Basel IIIreforms and the Revised SecuritisationFramework for example, the BCBS hasconcluded that “these initiatives, inaggregate, have reduced the likelihood ofa bank stepping in to provide financialsupport but that this step-in risk mightnot have been completely eliminated”.Some respondents felt that the BCBShas insufficiently explained where theythink they deficiencies lie, especially withregards to the Pillar 2 framework, andthat, in any event, the cumulative impactof the reforms are not yet known. Othersbelieved strongly that, as a result of theaccounting and regulatory reforms thathave been introduced, both at a globallevel through changes to the BaselFramework and in individual jurisdictionssuch as the US through the Volcker Ruleand the UK through ring-fencinglegislation, that step-in risk ‘is residual’.As a result, it is argued, imposing yetmore prudential measures is notwarranted and would likely have anegative impact on market liquidity and

the broader economy. Indeed the effectof the proposals might actually bedetrimental to the aims of other policymakers. If securitisations were tobecome more expensive, for example,banks may be deterred which wouldundermine attempts to revive Europeansecuritisation markets, one of the mainplanks on the European Union’s CapitalMarkets Union project.

Next stepsThe consultation period closed on17 March 2016 and, at the time ofwriting, the BCBS has not responded tothe feedback it has received.Simultaneously with the consultation, theBCBS has been conducting aQuantitative Impact Study which will runthrough to the middle of 2016 and thefinal framework will reflect the feedbackreceived from both the QIS and theconsultation. Consequently, we do notknow what the final framework will looklike, or when it will be introduced. Clearlythe results of the QIS will be particularlyimportant, the current proposals couldhave a wide ranging and high impact.



Step-in risk: part of theshadow banking agendaThe BCBS proposals on step-in risk arein response to the FSB policy measuresto address risks to financial stabilitycaused by ‘shadow banking’, which ithas defined as ‘credit intermediationinvolving entities fully or partly outsidethe regular banking system’. The FSBhas developed policies in five areaswhere oversight and regulation needs tobe strengthened to reduce shadowbanking risks, one such area beingmitigating risks in banks’ interaction withshadow banking entities. In this context,the BCBS was requested by the FSB tolook at the scope of consolidation and, ifrisks have not been eliminated bymeasures already taken, to extend theperimeter for prudential regulation toentities which are currentlyunconsolidated. The step-in riskproposals are part of that exercise.

Since the FSB’s November 2015Progress Report on TransformingShadow Banking into Resilient MarketBased Finance, which identified ‘step-in’risk as something the FSB will be

focussing on in 2016, and theconsultation paper itself, there havebeen no further indications of what thefinal framework will look like or when itwill be introduced. The March 2016statement from the FSB, following itsplenary meeting in Tokyo, confirmedthat work is continuing to implement thepost crisis reforms, including efforts toreform shadow banking into resilientmarket-based financing. The nextprogress report from the FSB isexpected in the Autumn and we wouldexpect this to include an update of thework of the BCBS on step-in risk, if notthe final framework.

The BCBS proposed framework onstep-in risk gives special attention toasset management activities and fundsunder management. Asset managementis also on the agenda at the nextG20 Leaders Summit in Hangzhou inSeptember 2016 and the FSB isexpected to announce mid-2016 apublic consultation on policyrecommendations to address structuralvulnerabilities from asset managementactivities, with the intention of finalising

policy recommendations by the end ofthe year. It is expected that therecommendations will cover:

n funds’ liquidity mismatch

n leverage within funds

n operational risk and challenges intransferring investment mandates ina stressed situation; and

securities lending activities of assetmanagers and funds.

The FSB also encourages authorities toconsider the use of stress tests toassess the ability of funds, eitherindividually and collectively, to meet theirredemptions under stressed marketconditions. Increased information onliquidity and leverage risk in the assetmanagement sector is deemed bypolicy makers to be an essential tool forunderstanding financial stability risksacross the financial system. It suchmeasures reach fruition, it would makethe likelihood of a bank having to step-in to support an asset manager evenmore unlikely.



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Clifford Chance contacts (Global)

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Clifford Chance contacts (Global) continued

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Leng-Fong LaiPartner, TokyoT: +81 35561 6625M:+81 8013859804E: leng-fong.lai@

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Mete YeginPartner, IstanbulT: +90 212339 0012M:+90 530 412 35 00E: mete.yegin@

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Other contributors

Rebecca HoskinsProfessional Support Lawyer,New YorkT: +1 212878 3118M:+1 917 861 1507E: rebecca.hoskins@

cliffordchance.com

Jacqueline JonesSenior PSL, LondonT: +44 20 7006 2457M:+44 7957675859E: jacqueline.jones@

cliffordchance.com

Julia MachinManaging Senior PSL, LondonT: +44 20 7006 2370 M:+44 7949250928E: julia.machin@

cliffordchance.com

Andrew E. BryanSenior PSL, LondonT: +44 20 7006 2829M:+44 7950121431E: andrew.bryan@

cliffordchance.com

Robert HaganCounsel, WashingtonT: +1 202912 5161E: robert.hagan@

cliffordchance.com

Gabrielle RuizSenior PSL, LondonT: +44 20 7006 1615M:+44 7962339965 E: gabrielle.ruiz@

cliffordchance.com

William SuttonSenior Associate, LondonT: +44 20 7006 4829M:+44 7949441936E: william.sutton@

cliffordchance.com

Timothy ClearySenior Associate, LondonT: +44 20 7006 1449M:+44 7984956439 E: timothy.cleary@

cliffordchance.com

Adam CraigSenior Associate, LondonT: +44 20 7006 8862M:+44 7535414134E: adam.craig@

cliffordchance.com

Nicholas HenneberrySenior Associate, LondonT: +44 20 7006 3081M:+44 7961726346E: nicholas.henneberry@

cliffordchance.com

Julia TsybinaSenior Associate, LondonT: +44 20 7006 4368 M:+44 7946429832 E: julia.tsybina@

cliffordchance.com

Andrew E. Bryan

Adam Craig

Timothy Cleary

Robert Gross

Robert Hagan

Nicholas Henneberry

Rebecca Hoskins

Kevin Ingram

Jacqueline Jones

Julia Machin

Gareth Old

Gabrielle Ruiz

William Sutton

Julia Tsybina

We would like to thank the following people for their contributions to this publication:

Acknowledgements

© Clifford Chance, June 2016.

Clifford Chance LLP is a limited liability partnership registered in England andWales under number OC323571.

Registered office: 10 Upper Bank Street, London, E14 5JJ.

We use the word ‘partner’ to refer to a member of Clifford Chance LLP, or anemployee or consultant with equivalent standing and qualifications.

This publication does not necessarily deal with every important topic nor coverevery aspect of the topics with which it deals. It is not designed to provide legal orother advice.

If you do not wish to receive further information from Clifford Chance about eventsor legal developments which we believe may be of interest to you, please eithersend an email to [email protected] or contact our databaseadministrator by post at Clifford Chance LLP, 10 Upper Bank Street, Canary Wharf,London E14 5JJ.

www.cliffordchance.com

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