STS framework for synthetic securitizations
Key points to remember
- In July 2020, the European Commission published the STS proposal and, as part of it, the CRR proposal.
- The STS proposal introduces a specific framework for simple, transparent and standardized synthetic balance sheet securitizations (“Synthetic STS frame“).
- The compromise texts of the STS proposal and the CRR proposal were approved on December 14, 2020 and approved by the ECON committee of the European Parliament on January 14, 2021.
- A plenary debate of the European Parliament was scheduled for March 10, 2021.
- Once adopted by the Council and the European Parliament, the final text of the Synthetic STS Framework will be published in the Official Journal of the EU and the Synthetic STS Framework will enter into force on 20e day following this publication.
Strong traditional securitization market in the Netherlands
In the mid-1990s, the Dutch securitization market began to develop with the issuance of residential mortgage-backed securities. As the traditional securitization market has grown and become more sophisticated, the types of securitized financial assets have broadened. Traditional securitizations and other types of structured financial transactions have become increasingly important for Dutch banks and companies as part of their funding strategies.
Less well known in the Netherlands are synthetic securitizations, which are securitization transactions structured to allow credit institutions to manage their regulatory capital requirements. Following the establishment of a specific framework for simple, transparent and standardized synthetic balance sheet securitizations, market players expect a significant increase in synthetic securitizations in 2021.
Traditional securitizations versus synthetic securitizations
Securitizations (both traditional and synthetic) are used by originators to transfer the credit risk associated with a portfolio of assets from the originator to a third party. The essence of traditionally structured securitization transactions is that the originator transfers ownership of the underlying assets that are securitized to a failing remote special purpose entity (SPE). The SPE in turn finances the acquisition of the underlying assets by issuing notes to investors.
In a synthetic securitization, there is no such transfer, better known as a “real sale”, of the underlying assets. Instead, the (legal) ownership of the underlying assets remains with the originator and the originator contractually transfers the economic risk associated with ownership of the assets to a third party. Such a contractual arrangement may take the form of a participation, a credit default swap, a guarantee or a credit note. A synthetic securitization is based on the observation that, when they meet certain criteria, originators may derecognize certain underlying assets from their balance sheet for regulatory capital requirements.
Synthetic funded and unfunded securitizations
Transactions involving a credit derivative can be funded or unfunded. In funded synthetic securitizations, the SPE will enter into a credit protection agreement with the originator to cover a tranche of risk. Under such a credit protection agreement, the SPE undertakes to pay the principal’s losses in the event of the occurrence of a credit event (for example, default of payment or insolvency of the principal’s debtors. ‘order). In return, the originator will pay a credit protection premium to the SPE. In order to be able to cover these potential losses, the SPE will issue Credit Linked Notes (CLNs) to noteholders. The proceeds from the issuance of CLNs will be deposited into a collateral account, which will be used to pay the originator in the event of a credit event.
In an unfunded synthetic securitization, the originator will not enter into a credit protection agreement with an SPE and no upfront payment will be deposited as collateral. Instead, the originator will directly enter into a credit protection agreement with a protection buyer (for example, central governments, central banks, multilateral development banks, insurers or international organizations). Unfunded transactions could therefore lead to counterparty credit risk for originators as there is no upfront payment or collateral available.
Simple, transparent and standardized framework (STS) for synthetic securitizations
On January 1, 2019, Regulation (EU) 2017/2402 (“Securitization Regulations“) entered into force with the intention of providing a general framework for securitization across the EU. Under the Securitization Regulation, synthetic securitizations were initially excluded from the STS framework and therefore from treatment more favorable regulatory capital Synthetic securitizations could not be classified as an STS securitization and, therefore, could not benefit from the more favorable capital treatment, because one of the STS requirements is a “real sale” of the assets underlying or an assignment or transfer with the same Legal Effect.
In July 2020, the European Commission published a proposal to amend the securitization regulation (“STS proposal“) and in this regard a proposal to amend Regulation (EU) No 575/2013 (“CRR proposal“). The STS proposal introduces a specific framework for simple, transparent and standardized synthetic balance sheet securitizations (“Synthetic STS frame“) while the CRR proposal extends the more favorable treatment of regulatory capital from STS securitization exposures to synthetic securitization exposures meeting all the relevant criteria set out in the synthetic STS framework. The rationale for the STS proposal and the CRR proposal is to help the recovery from COVID-19 by making it easier for banks to use securitizations to transfer some of the risk of SME loans to investors, so they can continue to lend to SMEs.
To meet the needs of the STS synthetic framework, a new section 2a “Requirements for simple, transparent and standardized balance sheet securitizations” has been inserted. This section has been written to be consistent with the STS requirements for traditional securitizations. However, due to the differences between traditional and synthetic securitizations, Section 2a also introduces new requirements regarding, among other things, the credit protection contract and a third-party verification agent who must be appointed to perform a factual review of the accuracy and the correctness of certain aspects of credit protection when a credit event has been triggered and the use of a synthetic excess spread. In addition, when the guarantee provided is in the form of cash, it must be held either with a third-party credit institution or on deposit with the protection buyer, subject in both cases to a quality of minimum credit.
On November 10, 2020, the Committee on Economic and Monetary Affairs (“ECON Commission“) of the European Parliament adopted two reports, one for the STS proposal and the other for the CRR proposal. Subsequent decisions of the ECON Committee of 11 November 2020 to start interinstitutional negotiations were confirmed in plenary on 13 November 2020 and took place in the months that followed. Following these interinstitutional negotiations, the compromise texts of the STS proposal and the CRR proposal were approved on 14 December 2020 and approved by the ECON committee of the European Parliament January 14, 2021. A plenary debate of the European Parliament was scheduled for March 10, 2021..
Once (officially) adopted by the two European bodies (i.e. Council and European Parliament), the final text of the Synthetic STS Framework will be published in the Official Journal of the EU and the Synthetic STS Framework will come into effect. in force on 20e day following this publication.
The EU has determined that securitization can mitigate the negative economic impact of the pandemic and help recover from that impact. The STS proposal and the CRR proposal aim to preserve the ability of banks to continue to lend to businesses, in particular small and medium-sized enterprises, by updating the current regulatory framework for securitization. Within the sophisticated Dutch securitization market, some Dutch credit institutions have already explored synthetic securitizations. Following the introduction of the Synthetic STS framework, we expect many more to follow this path.