Overview of the Recent EU Adoption of Common Rules and Framework for Securitization Transactions in Europe

As part of the Capital Markets Union action plan announced in September 2015, the European Parliament and the Council issued on Dec. 12, 2017, the regulation laying down a general framework for securitization and creating a specific framework for simple, transparent and standardized securitization (the regulation). The regulation was published in the Official Journal of the European Union on Dec. 28, 2017, and will come into force on Jan. 17, 2018. In this article, we will discuss the key aspects of the new securitization framework.

Click on the image to view the entire infographic

Grandfathering

The regulation will apply only from Jan. 1, 2019; transactions issued before this will be subject to the existing rules under the Capital Requirements regulation, the AIFM Directive and the Solvency II Directive, as appropriate.

Risk retention

Following much political debate, the regulation keeps the required level of retention of net economic risk of not less than 5% in the securitization and discloses the risk retention to investors. However, the regulation tasks the European Systemic Risk Board with continuous monitoring of developments in the securitization markets and allows for a change of this level in the future.

The retention requirement now places an indirect obligation on all “institutional investors” to ensure retention requirements are met before they invest in a securitization position. Institutional investors will include a broader group of regulated financial entities so that the rules on risk retention apply in the same way to all Institutional investors investing in securitizations.

Moreover, the definition of “originator” in the risk retention rules is amended to ensure that the originator is an entity of substance and not one created as a vehicle, which technically meets the legal definition but was established for the sole purpose of purchasing assets and securitizing them. In addition, “sponsor” is defined by reference to MiFID II, which allows investment firms to no longer be restricted to European Union – licensed MiFID entities but now include any legal person whose regular occupation or business is the provision of investment services to third parties and/or the performance of investment activities on a professional basis.

New simple, transparent and standardized (STS) criteria

The regulation provides the STS label to term securitizations and ABCP’s meeting the detailed new criteria for STS transactions. Certain legacy transactions can achieve STS status if they meet specified conditions relating to simplicity, standardization and transparency (Articles 19 to 22 of the regulation). Some of these criteria are measured at the time of issuance and some at the time of notification of STS status. The criteria for a securitization to qualify as STS include there being a homogenous asset pool, no active discretionary portfolio management and no transferable securities (other than corporate bonds that are not listed on a trading venue) in the underlying exposures.

A third party shall be authorized by the competent authority to assess the compliance of securitizations with the STS criteria. The originator, sponsor and securitization special-purpose entity (SSPE) must be established in the EU for a securitization to be STS-eligible. After the originator or sponsor has notified the European Securities and Markets Authority (ESMA) of the transaction, the transaction will appear on the ESMA list.

Re-securitization

Re-securitizations are prohibited under Article 8 of the regulation, except in limited circumstances. Those allowed are a re-securitization in order to facilitate a winding-up of an institution, its continuance as a going concern, or in order to preserve the position of investors where the underlying is nonperforming. The prior approval of the relevant competent authority will be required in both cases.

Amendment to European Market Infrastructure Regulation (EMIR)

The regulation modifies the EMIR regulation with the effect that SSPEs issuing solely STS transactions should not be subject to the clearing obligation, provided there is adequate mitigation of counterparty credit risk. In addition, the level of collateral required should take into account the specific nature of securitization arrangements and any impediments faced in exchanging collateral.

The regulation states that the requirements for “adequate mitigation of counterparty credit risk” are to be set out in regulatory technical standards (RTS) to be made under EMIR. The European Banking Authority is tasked with preparing the RTS before July 2018.

Transparency requirements

The transparency rules require that information from the originator, sponsor and SSPE be made available to newly established “securitization repositories” registered with the ESMA. The obligation to send information does not apply to private transactions (no prospectus is produced), but the prescribed information still needs to be made available to holders of a securitization position, to the competent authorities listed and, upon request, to potential investors. These requirements apply even for securitizations that do not meet the STS criteria.

Sales to retail investors

The regulation prohibits sales of securitization positions to retail investors with two exceptions: (1) If the retail investor’s financial instrument portfolio does not exceed €500,000, the seller shall ensure that securitization positions do not constitute more than 10% of the client’s financial instrument portfolio, including cash deposits, and that the initial minimum amount invested in one or more securitization positions is €10,000; or (2) the seller has conducted a suitability test confirming that the securitization position is suitable for the client.

Sanctions and penalties

Member states are required to implement appropriate administrative sanctions for infringements of the regulation, as a public statement, a temporary ban from producing STS notifications or a ban against any member of the originator’s, sponsor’s or a securitization special-purpose entities management body from exercising management functions, an order requiring the infringer to cease and desist the infringing conduct or a fine. This administrative pecuniary sanction can be up to €5,000,000 or up to 10% of annual net turnover or at least twice the amount of the benefit derived from the infringement.

Conclusion

The regulation will change the regulatory landscape for securitization transactions significantly, but some provisions must be detailed in further RTS by the European Banking Authority and the European Supervisory Authority. Within a year, we shall have a more complete securitization framework of standardized rules on due diligence, risk retention and disclosure.