This article is an extract from Global Capital, June 2019.

    Led by the pioneering sterling sector, the securitisation market is increasingly well positioned for the transition to risk-free rates (RFRs), according to HSBC.

    The transition “is by its nature a technical matter, but one with very wide ranging significance. As such it needs all market participants to take it very seriously and contribute to minimising the systemic risks. In the end, the market will settle down and overall market design should be significantly improved as a consequence of everything that is being done now,” affirms John Millward, Managing Director, Structured Finance at HSBC.

    A leading arranger of asset-backed transactions in multiple currencies, the bank acknowledges that the broad market shift away from so-called ‘IBOR’ rates such as LIBOR and, potentially, EURIBOR in the coming years will pose challenges – particularly for older securitisations that mature after the end of 2021.

    These transactions are the least likely to have anticipated the new regulatory environment in their documentation. The UK and US authorities have signalled that market participants should not rely on LIBOR rates being available beyond the year after next.

    Still, despite asset-backed securities’ complexity they are affected similarly to other debt products by the transition, HSBC argues. After all, they are generally issued under the same governing law as secured and unsecured bonds and, legacy deals aside, contain the same modification provisions.

    ‘Negative consent’

    Lately ‘negative consent’ language has become the most common approach to modification. Although this is not an automatic trigger and involves some risk, the process is less uncertain than issuers and their advisers having to seek investors’ consent through an extraordinary bondholder meeting – as they may have to on the oldest securitisations.

    “Most transactions prior to mid-2017 didn’t have any cessation language at all. Even through last year and the very early part of this year transactions have some modification language to facilitate transition, but it still requires a process which means cost, uncertainty and risks. No form of modification or cessation provision that has yet been produced is entirely mechanistic and that’s why issuance referencing RFRs directly is a better option if the market supports it,” believes Millward.

    “Many transactions will need to be reviewed case by case, which is another strong reason to issue directly on RFRs and in doing so to avoid contributing to what the FCA has termed the ‘irreducible legacy’ problem,” he adds.

    Compounding approaches

    The past nine months have seen other apparent hurdles prove more manageable than anticipated. For example, compounding approaches to applying overnight rates over longer periods – already common in Euro, sterling and US dollar derivatives – have gained traction. So too has the notion of applying a margin over the RFR to reflect the bank credit risk inherent in Ibor rates.

    In addition, Bloomberg resolved an operational limitation in its modelling system earlier this year. This allows its engine to calculate accrued interest on compounded daily SONIA ABS bonds.

    Sterling traction

    Most positively, HSBC cites the growing number of securitisations paying coupons indexed to SONIA – the Sterling Overnight Index Average compiled by the Bank of England since 2016 (and reformed last year to comply with benchmark best practice). Nearly 10 new issues now completed in the UK currency on this basis provide clear evidence of ABS issuers, investors and banks’ capacity to adopt new benchmarks without significant disruption.

    “It’s a fantastic step that the GBP market has moved so far so quickly,” says HSBC’s Millward. “We see a very strong move in favour of the SONIA compounded approach. This creates better alignment with derivative markets and reduces frictional barriers between market segments. Investors are ready, structures have been proven and we see SONIA as being the clear choice for securitisation markets going forward.”

    It helps that relatively few UK consumer assets are indexed to LIBOR compared to the US. Mortgages are more typically based on bank base rate, SVR or fixed rate, while auto loans are typically fixed rate and credit cards are on a discretionary APR rate.

    Nonetheless, the sterling sector’s progress offers a constructive model for other major currencies, HSBC believes – especially as ABS investors may also have gained experience of SONIA through purchases of covered bonds and SSA debt issued indexed to the new benchmark.

    Dollar ramp-up

    The picture in US dollars is less advanced but also positive, HSBC judges. While no securitisation in the currency has yet emerged priced against SOFR – the Secured Overnight Financing Rate calculated by the New York Federal Reserve since April 2018 – volume and liquidity on the new benchmark is beginning to rise meaningfully and market focus is increasing sharply. This is the case both in derivatives and in unsecured bonds.

    “There has been a reasonable degree of SOFR issuance already but it’s a much smaller proportion of overall USD market volume than SONIA in the GBP market. This is due to the still-limited liquidity in SOFR swaps, some market participants still waiting to see the role of term rates, and some disparities in the calculation basis between cash and derivative markets. We are starting to see swap liquidity increase – it’s grown a lot in the last month – more focus on compounded interest with a lag approach like in SONIA trades, and the authorities have been clear and consistent that markets shouldn’t be waiting for term rates – so momentum is building. We expect focus to intensify considerably over the coming months,” judges Millward.

    Accordingly, HSBC anticipates that the first SOFRindexed securitisations will be sold soon – most likely in the US domestic market at first, with crossborder transactions to follow.

    Euro variety

    The outlook for securitisation in Euros is different again, HSBC emphasises. This is because the European Central Bank (ECB) has given no explicit signal over whether EURIBOR will continue in the longer term, with the current focus on its restructuring for compliance with benchmark legislation.

    At the same time, the ECB is overseeing the overhaul of the Eurozone’s existing EONIA overnight rate (deemed incapable of reform into legislative compliance) into €TER – the Euro Short-Term Rate, which it will begin publishing this October.

    As a result, Euro market participants have placed less emphasis on transitioning away from EURIBOR. Nonetheless, securitisation players should reflect on the potential for a future change, HSBC argues.

    “Although the ECB has said that EURIBOR is likely to be retained in the medium term, there remains some uncertainty over the longer term. Consequently, it’s important that transactions incorporate some form of cessation-related fallbacks or modification language to cater for this eventuality,” believes Millward.

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