The European Commission (EC) Proposal to Include Securitisation Swaps in Margining Rules Is Credit Negative. The EC proposes to amend the European Markets and Infrastructure Regulation and extend the definition of “financial counterparty” to securitisation issuers.
Consequently, future securitisation swaps involving either an issuer or counterparty in the European Union (EU) will be subject to rules requiring two-way collateral posting (i.e., margining). The proposal is credit negative for existing deals with swaps because margining requirements reduce the likelihood that counterparties could be replaced if their credit strength deteriorated.
The proposal, if implemented, would affect existing deals even though it is unlikely to apply retroactively. After the revised margining requirements begin, replacing a counterparty would require entering into a replacement swap with margining. In practice, an issuer is unlikely to trade with a new counterparty if it is required to exchange margin. Existing transactions are not structured to provide issuers with the necessary liquid funds or operational capability to post collateral. The issue would be that margining could expose bondholders to significant risks, including the diversion of transaction cash flows to margin calls and the risk of swap termination should the issuer default on its collateral posting obligations.
The proposal would increase swap counterparty credit risk in affected securitisations because the credit protection value of swap replacement provisions depends on the ease with which swap counterparties can be replaced. Securitisation swaps commonly incorporate transfer triggers and collateral triggers to protect against counterparty credit risk. A transfer trigger requires a counterparty whose credit strength has deteriorated to transfer the swap to a stronger counterparty. A collateral trigger requires a counterparty whose credit strength has deteriorated to post collateral so that the issuer can pay for a replacement swap in case the counterparty defaults. Both triggers are designed to increase the likelihood of counterparty replacement, but neither is effective when margining requirements deter issuers from entering into swaps with new counterparties.
The proposal’s negative credit effect is not limited to transactions with EU issuers. The EU margin rules would also apply to securitisation swaps between non-EU issuers and EU counterparties. Non-EU issuers without sufficient local replacement counterparties typically seek global counterparties, but would likely only consider counterparties that are not subject to margining under the counterparties’ own local rules. With prospective swap counterparties in the US already affected by margining requirements, the addition of equivalent rules for EU counterparties could materially reduce the likelihood of counterparty replacement for some issuers outside the EU and the US.
The proposal would also potentially subject securitisation swaps to requirements for central clearing. However, because the majority of securitisation swaps are not currently eligible for clearing because of their non-standard terms, we do not expect a central clearing requirement to have a material credit-negative effect in practice. Should securitisation swaps become more widely clearable, the proposal introduces a threshold hedging exposure that would have to be exceeded before margin rules apply.If the proposal is implemented, securitisation swaps for new transactions will also be affected and the new rules could give rise to reduced use of swaps to address hedging risk, or the use of alternative types of derivatives or structural features. If efficient structural solutions are found, they could be used to address credit challenges for future transactions.