Lessons learnt from “The Missing Cryptoqueen”: has cryptocurrency regulation caught up?

Read time: 4 minutes

As terms like social distancing and the second wave have permeated our lives throughout the 2020 Covid-19 pandemic, people have been forced to adapt to the new normal. It hasn’t been all bad, and an unanticipated quirk of lockdown has been the huge uptake in hobbies and personal interests as people adopt new methods of entertainment. With podcasts growing in popularity before the pandemic, they have now entered a golden age, as demand soared throughout lockdown for new content.

One podcast that has kept us engrossed in recent months, produced by Jamie Bartlett through BBC Sounds, is “The Missing Cryptoqueen” which documents the creation of OneCoin. Marketed as a Bitcoin-style cryptocurrency with an almost cult-like devotion, its creator Dr Ruja Ignatova seemingly successfully executed a multi-billion dollar scam, marketing her fictional OneCoin as a legitimate cryptocurrency, all before disappearing from view and leaving a trail of chaos in her wake. “The Missing Cryptoqueen” highlights the borderless nature of cryptoassets, and the decentralised system upon which they are built. Which prompts an important question, how are cryptocurrencies regulated?

The risk of cryptoassets are well established, with the volatility of cryptocurrencies often their biggest draw to investors. The decentralised digital foundations of cryptocurrencies makes them vulnerable to crypto crime, with often insufficient recourse in the law for victims of offences. This risk has generated a gradual, yet somewhat reactive response from governments when approaching regulation. To regulate is, after all to lend legitimacy and integrity to an asset class, signalling to the market that this investment is safe, and protected by law. Until recently, this argument has dictated a cautious approach from the UK government, generating reluctance to regulate and legitimise these financial instruments.

Despite this, cryptoassets have increasingly entered mainstream markets, no longer reserved for individuals with an interest in finance and technology, and are increasingly seen as the future of finance. Large organisations have lent legitimacy in this process; Facebook announced their own cryptocurrency, Libra, last year, and in October 2020 online payment giant PayPal joined the cryptocurrency market, permitting cryptocurrency buying, selling and shopping on the network renowned the world over as one of the safest ways to pay online. These market movements have eroded government resistance generating a surge of cryptoassets regulation.

2018 saw the UK government pledge support for cryptoassets in the form of the FCA’s cryptoassets task force, and a consultation of cryptoassets soon followed. The resulting legal statement has formed the foundation for regulation, classifying cryptoassets as property under English law despite their decentralised, intangible nature.

This classification imposes English common law and regulation upon cryptoassets and their activity. Fraud, insolvency and company legislation now monitor and control the marketing, trading and holding of cryptoassets for the first time. This process was seen in practice in the case of AA v Persons Unknown in February 2020 where the court made a direct ruling on the status of cryptocurrencies as property, granting an interim injunction over Bitcoin. Demonstrating the importance of this classification for the future of cryptoassets, as their new property status means cryptocurrencies can now form the basis of claims relating to fraud, theft, insolvency and vesting of property.

In early 2020, the UK government built upon these foundations mandating companies who conduct crypto-related activities to register with the FCA. This requirement followed a recent amendment to the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (MLRs), which appointed the FCA as cryptoassets’ official regulatory body. This development is designed to reduce money-laundering relating to cryptoassets through registration and ongoing reporting obligations.

In addition to this ongoing monitoring, more definitive action has been taken in relation to derivative instruments that reference cryptoassets. Regulated by virtue of the derivative to which they relate, effective from 6 January 2020 the FCA is imposing a ban, prohibiting the marketing and trade to retail clients, of derivatives, which reference cryptoassets within the UK. This action reflects the risks associated with cryptoassets, demonstrating that regulatory bodies are not entirely comfortable with the wide scale adoption of cryptocurrencies within the UK market. In the accompanying FCA policy statement, lack of understanding and transparency of cryptoassets were cited as justification behind this prohibition.

Ideas surrounding cryptocurrency regulation have been mooted for many years, however it seems that regulation of these innovative, fast moving instruments is finally materialising but not at the pace most would hope. ‘’The Missing Cryptoqueen’’ showed us the extent to which cryptoassets can be used as a front for Ponzi schemes, exploiting financially vulnerable people in the UK, and abroad. Regulators have found themselves having to catch up with sophisticated and marketing savvy cryptocurrency efforts – and making rogue market participants harder to task. Clearly, regulations introduced have gone a significant way to help prevent another financial crime being perpetrated without sufficient recourse in the UK.  It is now up to regulators to continue their vigilance against such schemes, all whilst allowing the legitimate cryptocurrency market to thrive.

Navigating the NPL Securitisation maze

Read time: 4 minutes 25 seconds

NPL Securitisation is a term that is very much en-vogue at the present time. Although its rise to prominence can be attributed to a number of factors, in recent weeks the chief contributor has been the European legislature steps towards amending the Securitisation Regulation and the Capital Requirements Regulation. These steps are being taken to ensure that securitisation is better placed to facilitate banks offloading NPL’s in the aftermath of the COVID-19 pandemic. In the months and years ahead, the term NPL securitisation will no doubt be bandied around a lot, but what exactly is NPL securitisation? As an attempt to de-mystify this, I thought it would be helpful to give an overview of the different types of structure.

In essence, an NPL Securitisation describes a financial structure whereby an owner of NPLs sell these to a special purpose orphan vehicle that funds such an acquisition by issuing debt securities into the capital markets. The vehicle will in turn appoint a servicing entity that will manage the NPLs on a daily basis with a fee structure that incentivises them to maximise recoveries on the underlying loans. On a broad level such a securitisation falls into two categories:

  • Primary Securitisation – which involves the seller (typically a bank) using this technology to remove NPLs from their balance sheet.
  • Secondary Securitisation – which involves an acquirer in NPLs using securitisation as a form of leverage to maximise their internal rates of return.

We will now delve into a little more detail with respect to each of these categories of NPL Securitisation.

Primary NPL Securitisation

Primary NPL structures are rightfully receiving a significant amount of attention from the regulators as this technology has been identified as having the potential to play a hugely significant role in enabling the banks to clean up their balance sheets. There are three divisions of this type of structure.

Third Party NPL Securitisation – here a securitisation structure is used to offload loans from a balance sheet with the resultant issuance being solely subscribed for by third party investors. This is of course the ideal mechanism to transfer problematic credit risk from the banking sector to the capital markets and these transactions will be of increasing importance in the coming years. More information around these types of structure are detailed in articles I recently had published in The World Financial Review (Time for securitisation to be a friend and not a foe of the NPL hit banks) and World Finance (Securitisation – the antidote for non-performing loans).

Retained NPL Securitisation – in this instance, all of the issued notes are retained by the NPL Seller on the basis that they will command a more favourable capital treatment for holding securities in lieu of the non-performing loans themselves. In other words, NPL securitisation is being used as a balance sheet management tool which may also involve a repo.

Government Backed Securitisations – these types of structure constitute the most prevalent type of NPL Securitisation in recent years although only confined to Italy (“GACS” (“Garanzia Cartolarizzazione Sofferenze”)) and Greece (“HAPS” (“Hellenic Asset Protection Scheme”)). In both jurisdictions, governments have enacted a scheme whereby they provide a guarantee for the most senior class of notes whilst at the same time the junior class of notes are sold to third party investors.

Although these are the broad categories, there are often hybrids of these structures in place in situations where issued securities are both retained by the seller as well as issued to third party investors.

Secondary NPL Securitisation

As has become customary in the NPL market, leverage has been a key ingredient for investors to boost their internal rates of return on NPLs. The predominant form of leverage to date has taken the form of loan-on-loan financing which has been provided by the seller or a third party bank either on the acquisition date itself or at a later point time. In the context of NPL securitisation what is envisaged is that in lieu of loan-on-loan financing, a securitisation takes place in order to provide a form of leverage. Indeed, if it can be demonstrated that this form of leverage is cheaper and is capable of providing greater flexibility for the investor than otherwise would be the case for a loan-on-loan financing (which I understand is the case), then these are fertile conditions for growth of activity in this space. Similarly, it is worth noting that although not strictly an NPL securitisation, there have been a number of instances in the market where investors have transformed NPLs into re-performing loans and have securitised these.

Based on this canter through the NPL securitisation maze, there are clearly many different types of NPL securitisation which have their own unique characteristics and this is before we factor in the nuances of individual structures such as whether the issuance is listed, rated, public or otherwise. To make matters even more convoluted, given that for the purposes of the Securitisation Regulation loan-on-loan financings are technically classified as a securitisation, market participants frequently refer to these types of financing as securitisations despite the fact that there is no capital markets element.

In conclusion, the NPL securitisation label is extremely broad and although the rise to prominence of this technology can be considered hugely welcome, given the amount of attention these structures are rightfully receiving as well as the infancy of the market, a concerted effort to be properly prescriptive on what NPL securitisation actually means would pay dividends for the greater good of the NPL securitisation market as a whole.

The tide has changed! Don’t wait – embrace NPL securitisation now!

Looking at the most recent data in the European Banking Authority quarterly Risk Dashboard (published on 5 October 2020), it becomes abundantly clear that COVID-19 is beginning to manifest itself in the NPL market with the cessation of the multi-year declining trend in NPL levels.  The NPL tide has clearly changed, and if you consider the new crop of NPL’s when coupled with those legacy impaired assets stemming from the global financial crisis, it becomes apparent that there will be a heightened volume of NPLs that will need to be distilled from the banks in the coming years.

It is our view that securitisation can play an instrumental role in efficiently off-loading NPLs from the balance sheets of banks (which was not really an option following the GFC), and in this vein, we explore the feasibility of this in two recently published articles:

  • The World Financial Review – “Time for securitisation to be a friend and not a foe of the NPL hit banks” –  as available to view in full here (25 September 2020)
  • World Finance – “Securitisation – the antidote for non-performing loans”  available to view in full here (5 October 2020)

Ultimately, the sooner that securitisation technology is embraced, the better this will be for not only the banks but also the economies in which they serve.

CMBS 2.0: Treatment of prepayment fees and the icing on the cake

Read time: 3 minutes 50 seconds

Fourteen years ago this September, I distinctly recall attending a conference hosted by the European CMSA that was focussed on the advent of CRE CDO’s. At the time, the emergence of these structures was seen as an extremely exciting development as it marked a natural progression for the maturing CRE finance market (following the success of the product in the US). Additionally, it showed there was an overriding need for the asset class as a means of absorbing the ever increasing numbers of B-Notes, CRE mezzanine loans, CMBS bonds and other forms of structured CRE debt that was beginning to flood the market.

Despite there being a general acceptance that this was a natural and welcome step in the evolution of European CRE finance, a number of issues were raised such as the lack of standardisation and the availability of suitable underlying collateral. The chief concern though was around prepayment risk, which was a very  real issue at that point in time on account of escalating interest rates coupled with the exponential growth of CMBS issuance that provided increasingly favourable pricing for borrowers.

Although the heightened level of prepayment risk was not cataclysmic for CMBS, this issue was construed as a fly in the ointment. From an investors perspective prepayments were certainly not welcome, especially if redemptions happened relatively soon after issuance. From the structurers point of view, given this was an issue that was very much under the spotlight, it created a structural nightmare in terms of devising how principal should be applied. This was especially true in those transactions that featured multiple loans of varying quality, a difference in interest rates and a wide geographical spread of underlying properties. The modified pro-rata application of principal repayments really went through the structuring mill, which manifested itself with some hugely complex CMBS structures as the structurer sought to ensure that principal was applied in such a way to ensure that credit enhancement erosion for the senior notes was limited, that the weighted average rate on the notes was kept in check whilst at the same time ensuring that the class X would not be adversely impacted.

In essence, prepayments were a necessary evil and were a natural by-product of the economic forces at the time. For the greater good of the product, measures were taken to mitigate prepayment risk through a combination of lock-out periods and prepayment fees. Although a useful deterrent, there are two important points to be mindful of. Firstly, there was no absolute prohibition on prepayment after the lock-out period had burned away. Secondly, prepayment fees were invariably for the sole benefit of the Class X or the loan seller as deferred consideration and thus not shared with those noteholders who suffered from the pain and inconvenience of the early redemption.

If we turn to CMBS 2.0, this in-equitable distribution of prepayment fees has sought to be addressed through noteholders now being entitled to a quantum of the prepayment fees and therefore a vast improvement from the previous status quo. Although credit should be given to CMBS 2.0 for this more equitable division of the spoils, one thing that has become clear is that how these prepayment fees are allocated varies widely:

  • Some transactions allocate a percentage (say 50 per cent.) of prepayment fees to the noteholders, where other transactions just stipulate that all amounts should be paid to the noteholders.
  • Other transactions include a detailed formula which ensures that the prepayment fees are split between the Class X and the noteholders in the same ratio as interest on the underlying collateral is applied between the two classes of investment. An enhancement to this (from the Class X perspective) has been to exclude administrative costs from the formulation, thus increasing the amount that benefits the Class X.
  • Another structural nuance (which benefits the noteholders) is that following the occurrence of a Note Acceleration Event, 100 per cent of the prepayment fees are directed to the noteholders at the detriment of the Class X.
  • A further modification has been the application of a cap to the amount of prepayment fees that a certain class of notes is entitled to receive, the quantum of which ratchets down over time.

The treatment and application of prepayment fees can therefore be said to be one of the bedrocks of innovation for CMBS 2.0. Indeed, like other aspects of CMBS which I have written about (CMBS 2.0 – Standardisation the fuel for exponential growth; CMBS 2.0 – Class X – variety is not always the spice of life; CMBS 2.0 IN FOCUS: Liquidity Facilities – the wild child of CMBS 2.0), this is yet another area of the structure that would certainly benefit from greater standardisation. Although for now CRE CDO’s have been confined to the history books of European structured CRE debt prepayment risk certainly has not, and although the equitable distribution of prepayment fees has been a huge leap in the right direction, the standardisation of this would be the icing on the cake.

CMBS 2.0 – Standardisation the fuel for exponential growth

Whether you are a supporter of using CMBS to finance commercial real estate or not, the simple fact is that it provides an efficient mechanism to transfer commercial real estate loan risk away from the banking sector, whilst at the same time providing much needed transparency to the commercial real estate lending market. In light of these hugely positive attributes, not only will CMBS continue to have a role in financing commercial real estate, but if market participants play their cards right, then we could once again witness the return of exponential growth of issuance.

The key to unlocking the latent potential of CMBS as a financing tool lies with continuing to build the trust and confidence of investors, regulators and market participants as a whole. Indeed, giant steps forward have been achieved on this front through arrangers taking heed of the structural reforms proposed by CREFC (Market Principles for Issuing European CMBS 2.0) and the investor principles of March 2013. The Securitisation Regulation has also acted as a beacon of best practice through encouraging and incentivising securitisation structures to be simple, transparent and standardised.

Although the European legislature’s decree that CMBS is not capable of qualifying as a simple, transparent and standardised securitisation and therefore able to reap the reward of some favourable regulatory capital treatment, the structuring of deals as simple, transparent and standardised should still be considered best practice. This is essential for harnessing the trust and confidence of the market that is ultimately required to fuel exponential growth.

If we turn to the recent crop of CMBS deals, it is apparent that there is a lot more standardisation than was the case prior to the Global Financial Crisis of 2007. However, if a more forensic review of these structures is undertaken and comparisons made across deals, then it becomes clear that structures are not as standardised as they could be. This is something that we have already identified with regard to Class X (CMBS 2.0 – Class X – variety is not always the spice of life), but the same could be said to be true with regard to payment waterfalls. High level observations of these variances include:

  • Although all deals have a revenue waterfall, a principal waterfall and a post enforcement waterfall, some transactions also have an intermediate waterfall which kicks in once there has been a material default on a loan. To add to the complexity, if there is a risk retention loan in place (which is not always the case), then there will also be a corresponding loan waterfall for each note waterfall, meaning some deals could have eight waterfalls where as others just three.
  • With regard to the revenue waterfalls, these do vary from one transaction to another. For example, some deals provide a separate bucket for prepayment fees where others do not. Also, in situations where there is no intermediate waterfall, there is likely to be separate buckets for the sequential application of principal and excess floating rate amounts.
  • Principal in some structures is applied pursuant to a waterfall which makes provision for work-out and liquidation fees as well as caters for surplus proceeds. Other transactions are a lot simpler and only specify what amounts of principal are due to certain classes of notes and their relevant order.
  • The application of principal varies widely, with some deals at one end of the spectrum having a straightforward modified pro-rata waterfall with cash trap proceeds being applied sequentially and the remainder amounts pro rata. At the other end of the spectrum,  sequential proceeds are actually based on the amount of principal received on a loan based on the relevant loan’s principal amount outstanding. In addition, some transactions (but definitely not the majority) provide for the reverse sequential application of certain amounts of principal.
  • With regard to liquidity support, we have seen this take a variety of forms whether by way of a reserve or a facility provided by an affiliate of the arranger or a third party (see further CMBS 2.0 IN FOCUS: Liquidity Facilities – the wild child of CMBS 2.0). Given these variances in liquidity support, this also manifests itself with different types of payment buckets across deals.
  • Finally, although all deals have the essential payment components (various administrative fees, interest, principal, pre-payment fees, excess floating rate amounts, default interest) there are also a number of additional payment buckets that differ across deals. Similarly, there are also variations to the treatment of the payment of Class X amounts, especially after these have been subordinated.

When looking at the above list, it is clear that each of the points is independent and separate. If one or more of these is adjusted (even slightly), the consequence is that when you compare one transaction against another, the payment structure can look substantially different. This is especially true if you also factor in some of the nuances that we have identified with regard to the structuring of the Class X. Although on a case by case basis taking into account the underlying collateral and the benefit of a structure, then the rationale for a particular variance does becomes apparent. The issue lies with the fact that as far as payment waterfalls go there is a lack of standardisation in European CMBS.

Given that CMBS by its very nature features underlying collateral that is not hugely granular, and that to date we have not witnessed (unlike in the US) the volume of issuances that actively encourages a more standardised and commoditised approach to structuring a deal, it is inevitable that there is a level of variance as transactions are finessed, improved and structured to cater for the unique attributes of the underlying collateral whilst at the same time maximising returns. Until we reach the point in time that there is a steady flow of issuance, structures have been tried and tested and ultimately CMBS becomes more commoditised, variance in CMBS will continue to be endemic to the asset class, albeit the magnitude of variance will likely diminish as the market continues to mature.

Market participants and structurers in particular should therefore be hugely cognizant of this lack of standardisation, and although it is correct that they should be modifying and finessing transactions to improve the overall product, such changes should not be at the detriment of investor confidence. Accordingly it is imperative that where possible, material changes should be incremental and standardisation should be actively promoted not only within CMBS programmes but also across programmes. If this can be achieved, it will improve CMBS consumer confidence and with it provide the vital fuel to spur the exponential growth that the product rightfully deserves.

India’s sovereign credit rating – stick or twist?

Read time: 3 minutes 15 seconds

In June 2020, three of the large global rating agencies – Moody’s Investors Service (“Moody’s”), Fitch Ratings (“Fitch”) and S&P Global Ratings (“S&P”) reviewed India’s sovereign credit rating. Interestingly, the agencies diverged in their approaches – Moody’s, which had previously rated India a notch higher than S&P and Fitch, downgraded India to ‘BAA3’ from ‘BAA2’ and retained a negative outlook on the rating; Fitch retained India’s sovereign ‘BBB’ rating, but changed the outlook to negative; and S&P reaffirmed India’s ‘BBB’ rating and stable outlook. Across all three agencies, India retains its investment grade rating, but may lose this standard if further downgrades are to follow in what has been a tumultuous time for global financial markets.

The negative rating actions by Moody’s and Fitch were taken in response to the COVID-19 pandemic, but were not solely motivated by it. Both rating agencies have cited India’s prolonged period of low GDP growth and growing debt burden as key reasons underpinning their decision. Moody’s and Fitch both consider that the pandemic (and especially its impact on the major commercial hubs, Mumbai and Delhi) has weakened India’s growth outlook, and expect economic activity to contract by at least 4 – 5% in 2020-21. However, Moody’s has commented that growth had been slowing even before the pandemic, and may remain significantly below potential for the foreseeable future..

Lower GDP growth will make it difficult for the Indian government to reduce its debt burden, which (as with many nations around the world) has grown significantly due to the pandemic. According to Fitch, to improve India’s rating profile the Indian government needs to implement a credible strategy to reduce its overall debt levels over the medium term, post COVID-19. However, both Fitch and Moody’s have expressed concerns over the government’s ability to effectively implement policies which can achieve this. Continued lagging growth and a failure to address government debt after the pandemic could lead to further downgrades by both agencies.

Unlike Moody’s and Fitch, S&P proposes a more positive outlook, stating that India’s GDP growth remains “above average” and the country is well placed to outperform its ‘BBB’ peers in its recovery from the pandemic. However, S&P has acknowledged that COVID-19 has intensified risks to India’s GDP growth, and warned that a lack of a meaningful recovery from 2021 onwards could prompt the agency to consider further downgrades.

From difficulties come opportunities, and against the background of India’s changing sovereign rating, foreign portfolio investors (“FPIs”) seeking higher risk and returns invested over $2.4 billion (net) in Indian capital markets in June 2020. FPIs are likely to benefit from a 10 – 15 basis points increase in longer term yields in bond markets. Shares in state-owned Indian companies may also appeal to FPIs, as Moody’s downgrade of India has caused it to downgrade a number of Indian state-run oil and gas companies to sub-investment grade despite their sound credit profiles.

As mentioned in our previous blog distressed Indian assets, which have become one of the most preferred asset classes for domestic and global investors, were also popular with FPIs in June. JM Financial Credit Alternatives has already raised over $21 million for an India-focused maiden distressed opportunities fund. Other players that have been active in this space recently include the Carlyle Group, which has partnered with SBICAP Ventures Ltd, the investment banking subsidiary of the State Bank of India, to float an India-focused distressed asset fund that could raise up to $1.5 billion.

The potential for growing returns on Indian investments comes at a time when the Reserve Bank of India is relaxing restrictions on external investment significantly. This is to attract foreign capital by making it easier and more economically attractive for FPIs to invest in India. As the tide starts to slowly turn on the COVID-19 pandemic, perhaps we will start to see appealing opportunities in new markets for FPIs looking to invest in India.

If you are interested in learning more about Reed Smith’s India Business Team and how we can help you navigate the Indian marketplace, please contact Gautam Bhattacharyya (gbhattacharyya@reedsmith.com), Bobby Majumder (bmajumder@reedsmith.com) and Nathan Menon (nmenon@reedsmith.com).

It is time for CMBS to flourish

Read time: 2 minutes 20 seconds

The economic fallout of COVID-19 will be hugely significant for the European CMBS market, as a perfect testing environment has been created to truly examine the resilience and robustness of CMBS 2.0. Indeed, the impact of COVID-19 will be a true litmus test as to whether those structural reforms that emanated from the CREFC guidelines issued in November 2012 (Market Principles for Issuing European CMBS 2.0) and the investor principles of March 2013, have been sufficient to enable CMBS to not only weather the impending economic storm but to actually flourish.

Having considered a number of potential issues imposed by the impact of COVID-19 and in turn those mitigants put in place to stave off such risks (e.g. longer tail periods, existence of special servicers, loan level caps, cleaner loan structures), market participants should be quietly confident that the product is more than capable of weathering the COVID-19 storm. A clear nod to support this proposition is that despite the macro-economic uncertainty, BAML are close to issuing a c.£390m CMBS securitisation backed by UK logistics assets (Taurus 2020-2 UK). In other words, this issuance can be considered a massive endorsement of not only the likely robustness of CMBS 2.0 but also a clear indication that there is appetite for this type of fixed income product.

The true acid test though, is whether CMBS can flourish by demonstrating that it has a much more integral role to perform in financing commercial real estate than it has played since the GFC. Although it is far too early to say, CMBS does have the following important attributes which will inevitably put it in good stead:

  • It provides an efficient mechanism to transfer commercial real estate loan risk away from the banking sector;
  • It provides investors with a more liquid alternative to the loan syndication market;
  • It brings about much needed openness and transparency to the commercial real estate lending market;
  • When compared to banks hampered by provisioning and regulatory pressure, CMBS affords special servicers a lot more flexibility to work-out and enforce loans over an extended period of time.

Taking all these points together, it is clear that CMBS exhibits a number of hugely positive features, which is especially true when it is compared against balance sheet lenders. Also, given the public commentary on the performance of CMBS loans, the asset class has the potential to play a role in educating the wider market on what actions are being taken to resolve and address issues on problematic loans. Indeed, in light of the unprecedented and dynamic nature of the COVID-19 situation, this active flow of real-time market information could prove to be invaluable to the commercial real estate lending industry as a whole.

Ultimately only time will tell how CMBS fares, but if all of the above all holds true and the asset class not only weathers the COVID-19 storm but truly flourishes, then CMBS will rightfully re-establish itself as an important finance tool and once again earn itself a proper seat at the European commercial real estate finance table.

The British Government is giving the FCA new powers to deal with tough legacy – are they actually going to help?

Read time: 5 minutes 45 seconds

The Financial Conduct Authority (FCA) is to be given new powers to make changes to the methodology of LIBOR for certain “tough legacy” contracts.

The UK Government has announced that it intends to bring forward legislation amending the Benchmarks Regulation 2016/1011 as amended by the Benchmarks (Amendment) (EU Exit) Regulations 2018, which would provide the FCA greater powers in relation to benchmarks (such as LIBOR) recognised as “critical”, in situations where these benchmarks are no longer representative and will not be restored to representativeness. Continue Reading

Can the EBA and Basel Committee proposals help banks clean up their balance sheets using NPL securitisations?

Read time: 8 minutes

At a glance

A large number of legacy non-performing loan exposures (NPLs) continue to subsist on the balance sheets of banks. Portfolios of NPLs tie up huge amounts of regulatory capital which, in turn, limits the amount of capital that banks have available to lend to the real economy. The economic aftershocks of COVID-19 will not only increase the volume of NPL’s but also bring into sharp focus the imperative for banks to offload these exposures from their balance sheets. It is highly likely that we will witness an uptick in the securitisation of NPLs in the post COVID-19 economy – but will the securitisation regulation and regulatory capital treatment of such transactions evolve to facilitate this trend? This blog explores the issues with regulatory capital treatment of NPL securitisations under the Capital Requirements Regulation (CRR) and the European Securitisation Regulation (ESR), as highlighted by the European Banking Authority (EBA). In addition, the Basel Committee has recently proposed technical amendments to its securitisations rules text, but will this stimulate the secondary market in NPLs?


European policy makers have looked favourably on the ability of securitisations to allow banks to move portfolios of NPLs off their balance sheets, freeing up regulatory capital reserves and increasing liquidity in the market.

According to the EBA, European banks have managed to halve balance sheet NPLs since 2015. However, despite this achievement, the volumes of NPL’s have remained woefully high. Meanwhile, concerns have been raised about the drag in capital as a consequence of the higher ‘provisioning’ requirements for NPLs imposed by the European Central Bank and the recently approved ‘prudential backstop’ regulation. Indeed, the recent prudential backstop regulation has sought to introduce a harmonised ‘minimum loss coverage’ requirement for the amount of money banks need to set aside to cover losses caused by future loans that turn non-performing.

In an effort to boost the NPL securitisation market, the EBA released an opinion in October 2019 (the EBA Opinion) addressing the regulatory capital treatment of NPL securitisations and proposed that capital requirements for such securitisations should be adjusted in order to remove certain constraints on banks considering securitisation structures as a means to dispose of NPL stock.

Current issues under the CRR and ESR

The EBA Opinion identifies a number of impediments to the securitisation of NPLs under both the CRR and the ESR. It recognises that there are key distinctions to be made between the nature of the securitised risk of ‘performing’ and non-performing assets. ‘Performing’ exposures see investors bear the risk of borrowers defaulting on payments (i.e. credit risk), whereas NPLs are already in default and therefore priced on an entirely different basis. More specifically, NPLs are priced based on their outstanding amount and then applying a discount to reflect anticipated future losses and adjusting to take into account the outcome of a workout or enforcement process. In other words, the net value of the NPLs can be said to be the nominal or outstanding value minus the non-refundable purchase price discount (NRRPD). Accordingly, investors in NPL securitisations bear the risk that any workout or enforcement action is insufficient to cover the net value of the NPLs.

Treatment of NPL securitisations under the CRR

The EBA Opinion highlighted that the securitisation internal ratings based approach (SEC-IRBA) method may result in more favourable regulatory capital treatment at the mezzanine and junior tranche levels of NPL securitisations compared to the securitisation of ‘performing assets’. However, when it comes to the most prevalent calculation methods used for regulatory capital requirements for credit risk to an underlying portfolio (i.e., the SEC-IRBA and the securitisation standardised approach (SEC-SA)), these methods produce significantly higher regulatory capital charges for NPL securitisations. In addition, the caps for securitisation capital weightings do not offset the NRPPD from expected losses and the exposure value of the portfolio of NPLs backing the securitisation, which results in disproportionately large capital charges.

In light of these inequitable positions, the EBA proposes a number of targeted amendments to the CRR including:

  • Defining the scope of ‘NPL securitisations’ and including, in particular, a requirement that the securitised pool comprise a mandatory minimum level of NPLs from origination/inception.
  • The desirable level of the (p)1 factor for NPL securitisations for the purposes of articles 259(1) and 261(1) of the CRR.
  • The inputs to the formulaic approaches (SEC-IRBA and SEC-SA) to better reflect the loss-absorbing effect of the NRPPD in NPL securitisations.
  • Using the net book value approach within the securitisation framework when determining attachment (A)2 and detachment (D)3 points for the setting of capital requirements for NPL securitisations.
  • An appropriate prudential treatment for pools of securitised exposures comprising both performing and NPL’s (mixed pools) for the purposes of the securitisation framework.
  • The ‘expected losses’ and ‘exposure value’ under the SEC-IRBA should be calculated net of the NRPPDs and, where applicable, in the case of the originating institution, additional specific credit risk adjustments (SCRAs).
  • Investor institutions be allowed to apply a 100 per cent risk weight cap for securitisations where the originator was permitted to apply the same, and the amount of NRPPD is at least equal to or larger than the SCRAs made by the originator.

Treatment of NPL securitisations under the ESR
The EBA opinion makes the following observations in relation to the operation of the ESR to NPL securitisations:

  • As the risk retention amount (for most of the permitted methods) is calculated based on the nominal value of the NPLs, rather than a discounted value which takes account of the loss-absorbing effect of the NRRPD, this may result in an inflated risk retention amount being required to be retained for NPL securitisations.
  • The list of permitted risk retention entities under the ESR is too narrow and focused on guarding against the ‘originate to distribute’ model which excludes other interested parties who may have an interest in the success or failure of a workout process for non-performing assets and so their interest are better aligned with the investors from acting as the risk retention entity.
  • The prescriptive credit granting requirements in article 9(3) of the ESR, which require the purchaser of an NPL portfolio to verify that (a) ‘sound’ and ‘well-defined’ criteria for credit granting were used by the original lender, and (b) the original lender applied the same criteria to the exposures to be securitised as it did to those that will not be securitised raise particular practical challenges for purchasers of NPL portfolios. For example:
    • The ESR is unclear as to whether an NPL purchaser buying an entire loan book of NPLs is permitted to treat the requirements of article 9(3) as being met – due to no comparable exposures being available in order to assess the application of the ‘sound’ and ‘well-defined’ credit granting criteria.
    • Loan books, especially ‘performing’ loan books, may have been subject to different credit granting criteria at the outset. In other words, a strict application of the article 9(3) requirements could mean that certain NPL portfolios are not capable of being securitised on the basis that no credit granting criteria have been applied to a comparable pool of loans by the original lender.

The EBA Opinion recommended the following targeted amendments to the ESR framework for NPL securitisations:

  • A specific risk retention amount calculation method for NPL securitisations that takes into account the NRRPD on the assets’ nominal value.
  • An independent servicer qualifies to discharge the retention obligation where its interests in a successful workout or enforcement process are aligned with those of the investors.
  • Article 9(1) and Article 9(3) verification and due diligence obligations are amended in respect of NPL securitisations (and other third party-originated assets securitisations).

The Basel Committee Technical Amendment on the capital treatment of NPL securitisations

On 23 June 2020, the Basel Committee published a consultation on its proposed technical amendments to the Basel Framework to address the capital treatment of NPL securitisations, recognising the “particular features that distinguish them from securitisations of performing assets” (the Technical Amendment).

The Technical Amendment establishes:

  • A standardised definition of NPL securitisations – where there is a percentage of at least 90% of defaulted assets in the portfolio at the origination cut-off date and at any subsequent date on which assets are added or removed from the underlying pool due to replenishment, restructuring or other relevant reasons. The underlying pool may only comprise of loans, loans-equivalent financial instruments or tradable instruments used for the sole purpose of loan sub-participations. It is noted that national regulators may provide for a stricter definition of an NPL securitisation.
  • The introduction of a risk weight floor of 100 per cent for all NPL securitisation exposures.
  • The introduction of a fixed 100 per cent risk weight floor for the most senior tranches of non-performing loan securitisations, where the securitisation is a traditional securitisation, and the NRPPD is equal to or larger than 50 per cent of the outstanding amount of the NPLs. The risk weight applicable to other tranches/positions should be determined by the existing hierarchy approaches or the look-through approach.
  • A ban on the use of foundation internal risk based approach parameters as inputs for the SEC-IRBA for all NPL securitisations.
  • An originator or sponsor bank may apply the current capital requirement cap to the aggregated capital requirement for its exposures to the same NPL securitisation. The same applies to an investor bank, provided, that it is using the SEC-IRBA for an exposure to the NPL securitisation.

The consultation period ends on 23 August 2020, and the proposed amendments are expected to come into effect by no later than 1 January 2023.


The EBA Opinion was a much-welcomed first step in recognising certain legal impediments in the existing regulatory framework as they apply to NPL securitisations. The mantle has been taken up by the Basel Committee in relation to the securitisation rules, but work to address all legislative impediments to the securitisation of NPLs is still at a preliminary stage and much more work still needs to be done.

Please get in touch with your usual Reed Smith contact if you have any questions or concerns regarding the issues raised in this alert.


1 i.e. the supervisory parameter.
2 i.e. the input represents the threshold at which credit losses would first be allocated to the exposure.
3 i.e. the threshold at which credit losses of principal allocated to a securitisation exposure results in a total loss of principal.


The scene is set for a deluge of NPLs

Read time: 2 minutes 20 seconds

Those readers that have followed the meteoric rise of the European non-performing loan (NPL) market from the ashes of the global financial crisis (GFC) will be very aware of the profound impact that COVID-19 has had. In the space of a few weeks a large, burgeoning market that exhibited a waterfall of transactions has been confined to a trickle as deals were pulled or left to stagnate as the market was shrouded with the malaise emanating from the pandemic.

Fortunately though, the tide has now changed with the lifting of lock-down measures, which has also bought with it the green shoots of an NPL market, with Greece being at the very forefront. Recent news of Alpha Bank (€10.6 billion – Galaxy), Piraeus Bank (€2 billion – Phoenix; €5 billion – Vega) and Pancretan Cooperative Bank (€297 million – Castor) readying multiple NPL securitisations is testament to this fact. Although these are very much welcome steps, the erstwhile market observer will be aware that there are a number of significant hurdles that the NPL market will need to overcome (especially with regard to auction processes) in order to properly kick start:

  • A recalibration of expectations around the bid-ask price
  • The ability to quantify the impact of COVID-19 when it comes to the valuation of NPLs
  • The availability of debt finance to maximise returns

As was true with the genesis of the European NPL market, these hurdles need to be overcome and the sooner this is achieved the better for not only the banks but also the respective economies in which they operate.

Despite these uncertain times, one thing that is abundantly clear is that there is everything to play for in the European NPL arena. For starters we know that  there is still significant NPL stock stemming from the GFC and that these levels will only surge once the new crop of NPLs created by the current crisis are factored in. In addition, a significant secondary NPL market, driven by the need to monetise existing NPL portfolios, is likely to emerge within a relatively short period of time.

If the reports of significant amounts of dry powder that is ready to be deployed are anything to go by, then there is certainly going to be plenty of appetite for this increased stock. Indeed, taking into account all of this against a backdrop of the fact that the European NPL market has built and developed the infrastructure required to effectively trade NPLs at scale means that the European NPL market can be said to be a very exciting proposition.

Although there are number of uncertainties at this point in time, one thing that is crystal clear is that the European NPL market has the latent potential to be much bigger and better than we have witnessed previously and therefore it is simply a matter of time until the shroud of COVID-19 is properly lifted, the floodgates are opened and a deluge of NPLs pour into the market.