Synthetic Securitisation: the Cayman Islands PerspectiveSynthetic securitisation by financial institutions of either pools of bonds or pools of loans has become ever more popular since its inception at the beginning of the 1990’s, and increasingly these transactions are being carried out under programmes. The purpose of these deals is to release expensive regulatory capital that can then be redeployed to other areas of the financial institution’s business. This article discusses the essential elements of synthetic securitisation, and then briefly examines why the Cayman Islands is the jurisdiction of choice for this type of transaction. What
are Credit Derivatives?
A derivative is a financial product the value of which is determined by the value of an underlying asset, whilst a credit derivative is a financial product the value of which is based on the creditworthiness of a third party or group of third parties. A credit derivative allows the owner of debt assets to offset the risk of holding those assets without transferring the ownership. By transferring credit risk and reducing the need to hold associated regulatory capital, synthetic securitisation achieves the same result as more traditional forms of securitisation without many of the complexities. Types
of Credit Derivative
The
most common method by which assets are
synthetically transferred and capital relief
achieved is by way of the credit default
swap. In
return for regular payments made by the
Originator to the counterparty, the
counterparty agrees to make a payment to the
Originator upon the occurrence of a credit
event in relation to the Reference Assets.
The “Reference Assets” (being the assets referenced in the Credit
Derivative) are correlated to, though are
often not the same as the “Underlying
Assets” (being the assets held by
the Originator, in relation to which it is
seeking credit protection).
It is preferable that the Reference
Assets are publicly issued, and it is for
this reason that they often differ from the
Underlying Assets, though a high degree of
correlation between the two is needed for
the Underlying Assets to be removed from the
regulatory balance sheet.
This avoids the Originator breaching
its duty of confidentiality to borrowers,
and ensures that the requirement for
publicly available information of the
occurrence of a credit event is satisfied (see below). The
definition of a Credit Event can range from
a potential credit event to an actual
failure of the relevant Reference Entity to
pay in respect of the Reference Asset, and
can include other events of default set out
in the ISDA Master Agreement or tailored for
the individual transaction. For the event to
constitute a Credit Event, it must also
exceed a materiality threshold, and there
must be Publicly Available Information
relating to it.
On the occurrence of a Credit Event,
the contract may provide for physical
settlement of the Reference Assets to the
counterparty in return for the counterparty
paying to the Originator their par value.
Alternatively, the contract may be
cash-settled, and the counterparty would
either pay to the Originator a fixed amount,
or par less the recovery value of the
Reference Assets. Under
a Total Return Swap, the Originator will pay
to the counterparty the cashflow received on
the Reference Assets together with amounts
equal to any increase in the market value of
the Reference Assets.
The counterparty makes regular
interest-rate related payments together with
amounts equal to any decrease in market
value of the Reference Assets. On the occurrence of a Credit Event the swap
terminates, and the settlement amount is
calculated on the same basis as the
pre-credit event payments.
The effect of the Total Return Swap
is to fully transfer the entire economic
interest of holding the assets to the
counterparty. Credit
Linked Notes are instruments by which a
credit default swap or a total return swap
can be packaged into securitised form, and
they are accordingly pre-funded by the
counterparty/investor.
This technique enables investors who
are legally prohibited from entering into
derivative contracts to achieve the same
economic profile as a credit default
swap/total return swap without entering into
the derivative contract.
It enables the contract to be traded
by delivery or through book entry in the
clearing systems, rather than by novation,
and should it be required the Credit Linked
Note can be structured in this way to
benefit from the Quoted Eurobond Exemption
to avoid withholding. Regulatory
Capital Treatment
Economically,
the Originator’s exposure to the
Underlying Assets is replaced by exposure to
the counterparty, and the capital treatment
in most jurisdictions reflects this.
In broad terms and subject to the
detailed rules in the relevant jurisdiction,
if the counterparty is a Special Purpose
Company (SPC), the risk weighting will prima facie be 100%; if the
Counterparty is an OECD Bank,
20%; and if the credit derivative is
either funded by the Counterparty/investor,
or the Originator is granted a first ranking
security interest over cash or OECD
Government Bonds, the risk weighting will be
0%. Collateralised
Bond Obligations (CBO’s)
As
was first demonstrated by the JP Morgan
Bistro transaction, the above techniques can
be adopted with an SPC acting as the
counterparty to the Credit Derivative,
funded by a bond issue in the capital
markets, such that any loss that is incurred
on the Reference Assets is matched by
reduced principal payments to investors. The
credit risk on recent deals has been carved
up between different counterparties, and the
different techniques (see Regulatory
Capital Treatment above) are used to
achieve capital relief. Bank
Austria’s Amadeus transactions carved up
the credit risk associated with portfolios
of bonds comprising subordinated pieces from
ABS transactions.
The risk of the first 10 per cent of
losses on the portfolio was transferred by a
credit linked note to a Special Purpose
Company incorporated in the Cayman Islands,
Amadeus Funding 1 Limited (Amadeus). Amadeus in turn issued two series of Notes, the proceeds of
each being held in an account in the name of
Amadeus, and charged in favour of Bank
Austria.
Pursuant to the priority of payments
in the Deed of Charge, the Class B
Noteholders took risk on the first 3 per
cent of losses, and the Class A Noteholders
took the risk of the next 7 per cent of
losses on the portfolio.
The risk of loss on the final 90 per
cent of the portfolio was transferred by way
of Credit Default Swap to a third party
financial institution, and this risk in turn
was wrapped by a monoline guarantee given by
MBIA. The relevant regulatory rules were complied with: accordingly a zero per cent risk weighting was given to the tranche cash collateralised by Amadeus, while the tranche protected by the OECD Bank received a 20 per cent risk weighting. The
Benefits of Synthetic Securitisation
The
most obvious way of offsetting credit risk
is by trading the particular debt asset.
Whilst not so much the case for retail
customers, corporate banking is very much a
relationship business, and accordingly the
assignment of corporate loans is generally
considered not to be acceptable by the
banking fraternity, even if the Originator
maintains the servicing function in relation
to the loans.
The transfer of loan assets by
assignment can also give rise to withholding
tax in the event that the assignee does not
qualify as a s.840A Bank.
A bank’s common law duty of
confidentiality to its customers makes the
securitisation of loan assets, whether by
assignment or using the Rose
subparticipation structure, somewhat
troublesome. By contrast, Credit Derivatives enable the corporate relationship between the bank and its corporate borrowers to remain in tact, and by ensuring that the Reference Assets differ from the Underlying Assets, the bank’s duty of confidentiality to its Borrowers should not be breached. “True
Sale” securitisation gives rise to further
problems associated with the transfer of
ownership of the assets.
Prima facie, the transfer of debts
gives rise to the document of transfer being
a stampable instrument.
Whilst there are a number of
techniques of avoiding the payment of stamp
duty at the outset of a transaction, the
Rating Agencies require a reserve to be held
or a facility to be put in place in respect
of such liability, in the event that stamp
duty would become payable on the insolvency
of the Originator. Some
assets have non-assignability clauses
embedded into them, which the House of Lords
held in Linesta Sludge (1994)
to be binding.
The assignment of assets have a
number of formalities that need to be
complied with:
in particular, a legal assignment
requires notice to be given to the
borrowers, and the requirement for the
transfer to be in writing mitigates against
the well used “Offer and Acceptance”
route for postponing stamp duty liability on
the transfer. The use of a synthetic transfer, by contrast, avoids these issues that arise on the transfer of ownership, and generally the documentation is less complex and therefore more economical to put in place. The
Cayman Islands as Jurisdiction of Choice
The
reasons why the Cayman Islands is the
jurisdiction of choice for carrying out
CBO’s and CLO’s are well understood.
They hinge on the common law nature
of the legal system, being based on English
law, with more flexible legislation having
been introduced reacting to the requirements
of both the international financial markets
and the regulators. In
particular, the jurisdiction is
creditor-friendly, at the top of Philip
Wood’s spectrum of creditor-friendly
jurisdictions.
In the Cayman Islands, there is no
equivalent of Chapter 11 in the U.S., or
Administration or the new Voluntary
Arrangement regime (that is in the process
of being enacted pursuant to the Insolvency
Bill) in the U.K.
Whilst deals issued through SPC’s
incorporated in the United Kingdom will
shortly see the Rating Agencies impose
additional liquidity requirements arising
out of the new insolvency legislation, the
Cayman Islands offers the international
community a more robust insolvency law from
the creditors perspective. The
trust, again deriving from English law, is
another area in which Cayman Islands law
lends itself to the structured finance
community.
By separating the beneficial interest
in the shares of a special purpose company
from their legal title, a share trustee can
hold the legal title of the shares, without
the accounts of such special purpose company
being consolidated in the accounts of the
share trustee or of the Arranger.
As an alternative to the share trust
being in the form of a charitable trust, the
innovative trust legislation of the Cayman
Islands permits non-charitable purpose
trusts. These trusts (known as STAR trusts, being established
pursuant to the Special Trusts (Alternative
Regime) Law 1997) enable the Noteholders to
be the beneficiaries under the share trust,
which avoids residual profit at the maturity
of the Notes being paid away from the
transaction. The
fiscal regime with no corporation tax (or
withholding) in the Cayman Islands and the
status of the Cayman Islands as a UK
Overseas Territory ensuring that there is no
“Sovereign Ceiling” that limits the
rating of debt issued by a Cayman Islands’
company, are further essential ingredients. The professional infrastructure, and in particular the
responsiveness and expertise of the
corporate administrators in the Cayman
Islands, serves to ensure that Cayman
Islands’ companies are centrally managed
and controlled outside the United Kingdom
and are therefore not subject to U.K.
Corporation Tax. ConclusionCredit derivatives and their application in synthetic securitisation, is only the latest of an ever expanding range of derivative products which are changing the global financial landscape. The capital adequacy rules are under constant review by the Bank of International Settlements, and further changes in this area will be forthcoming, which will give rise to further developments in transaction structures. This, combined with the continued focus on return on equity, would suggest continuing development of synthetic securitisation. back to top |
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