The truism “Brexit is a process rather than an event” holds good for securitisers.
More than five years ago, the referendum made huge political headlines but it did not change the law. Instead, the expiry of the Brexit implementation period at the end of 2020, when the UK left the EU single market, has been the key legal development so far. Overnight, the EU Securitisation Regulation (EUSR) stopped applying to UK-established entities, which became subject to the UK’s new “on-shored” UK Securitisation Regulation (UKSR) - with the result that originators of transactions aimed at both EU and UK investors began grappling with the question of dual compliance with both regimes. But this was never going to be the final chapter. Less than nine months later, we are now approaching another milestone which may prove even more significant: both the EU and the UK have begun the process of reforming their respective securitisation regimes and these exercises are taking place separately. These reforms will likely result in changes for all market participants - whether established in the EU or in the UK - with implications for all securitisations and particularly those with significant cross-border elements.
The EUSR and the UKSR still closely resemble each other. This close resemblance reflects the on-shoring policy objective of the UK’s European Union (Withdrawal) Act 2018, that as a general rule the same rules and laws that applied the day before the UK left the EU single market would continue to apply the day after. But they are already not exact mirror images, both sides have made some substantive changes: the UK during the on-shoring (for example, widening the definition of sponsor, trying to fix certain jurisdictional limitations) and more recently the EU has made the so-called “COVID quick-fix” changes (dealing with the treatment of pools of non-performing exposures and how to measure risk retention for them and implementing a new STS framework for synthetics).
But are the days of relative alignment between the EUSR and the UKSR numbered? A key objective of both the EU and the UK in agreeing the Trade and Cooperation Agreement (TCA), that now applies to trade between the EU and the UK, was “regulatory autonomy”, a term used repeatedly in the joint UK and EU political declaration that preceded the negotiation of the TCA. In the Prime Minister’s Christmas Eve statement announcing the conclusion of the TCA he went even further, saying: “And I don’t think it will be a bad thing if we in the UK do things differently, or a take a different approach to legislation. Because in so many ways our basic goals are the same. And in the context of this giant free trade zone that we’re jointly creating the stimulus of regulatory competition will I think benefit us both.” This suggests that now that the EU and the UK can re-write their securitisation regimes independently, that they will end up diverging further, rather than developing in broad lockstep.
There is a certainly a consensus that the EU and UK securitisation regimes badly need a reform. As the European Stability Mechanism has blogged, the data supports this view: “In 2008, the size of the EU securitisation market including the United Kingdom, was 75% that of the US. In 2020, it was just 6%”. The EUSR, which first applied from the start of 2019 in the EU (which then included the UK), is the high-water mark of a decade of cumulative post-global financial crisis reforms to the regulation of securitisation in Europe. The key ideas behind this regime – limiting securitisations to professional investors, aligning interests between originators and investors via an obligation to retain risk, requiring high standards of both due diligence and disclosure, incentivising high quality securitisation via better prudential treatment for simple, transparent and standardised (STS) securitisations - are welcome and uncontroversial. But the devil is in the detail and the implementation of these ideas has been criticised on multiple fronts. Arguably, the highly prescriptive and onerous detail of the rules represents “over-regulation” and results in a high cost of securitising without any real improvements to financial stability or investor protection. It is not difficult for market participants to find many specific faults within the EU (and thus also the on-shored UK) securitisation regimes. AFME and UK Finance, in their joint response to the UK call for evidence, is clear: “That cost, combined with the burdensome day-to-day compliance with those processes even when they are designed and in place, provides a powerful disincentive for existing securitisation investors to continue to include securitisation in their portfolios and a fortiori serves to severely limit the number of new investors willing to add it to theirs.”
If the problems are evident, so then should be the solutions. Many of the key reforming wishes of market participants in relation to both the EUSR and the UKSR can be characterised as relating to “regulatory optimum” – i.e. costs should only be imposed upon market participants by regulators to the extent that they provide a specific and proportionate benefit. For example, broad principles for disclosure and due diligence may work better than the current prescriptive templates, which contain information that investors do not actually need or that originators cannot easily provide, and risk stultifying practice at a particular point in time rather than allowing it to evolve as needs change. But “regulatory optimum” is not the only concern of market participants. Because securitisation markets are highly cross-border, UK and EU market participants ideally want to be able to transact easily with each other (and of course also with other entities around the world, including notably the US) and they do not want to be subject to a costly dual-compliance burden or any unnecessary jurisdictional limitations. For example, if the EUSR requires that EU sell-side entities provide good disclosure for their securitisations, it makes sense for UK buy-side entities to be able to invest in them on that basis, even if the precise letter of disclosure provided under the EUSR may be different from what is currently required by the UKSR in some trivial respect. Further, it does not really make sense for the UK STS regime to require originators and sponsors to be established in the UK, it makes more sense to allow them to be established anywhere in the world, provided that they meet an objective STS standard. These wishes can be characterised as relating to “regulatory interoperability”.
How can “regulatory interoperability” – amending regulation to facilitate cross-border securitisations – be achieved in practice?
The wrong answers are contained in the opinion on jurisdictional scope under the EUSR published by the Joint Committee of the European Supervisory Authorities in March. This opinion correctly identifies jurisdictional limitations that make cross-border securitisations tricky, but its views and proposals – that on any given transaction involving both EU and third country sell-side entities, that it should be the EU entity, irrespective of commercial considerations, that retains risk and is responsible for transparency, and also that EU investors should only be able to invest in securitisations originated in third countries if the relevant third country regime’s transparency framework has received an equivalence determination from the EU – would make matters worse. AFME and UK Finance are highly critical: “…we are aware of the solutions proposed by the Joint Committee of the ESAs […] and we do not support them. The significant majority of the issues they identify in respect of the EU regime are not, in our view, real market issues (either in relation to the EU or the UK), and the proposed solutions would broadly be harmful to the market without adding any additional supervisory benefits.”
Forgetting US and rest-of-the-world securitisers for the present, it might be assumed that the easiest way for EU and UK securitisers to be able to transact with each other is for the EUSR and the UKSR to remain aligned, particularly given that they are starting from (roughly) the same place. Under this view, perhaps it would make sense for the UK to wait for whatever outcome the EU reaches in reforming the EUSR, before making conforming changes to the UKSR. Theoretically this should also make equivalence determinations in both directions more likely. But recent transactional experience – undertaken on the basis of the current close alignment between the EUSR and UKSR – is that some UK originators will already not contractually commit to dual compliance (i.e. providing transparency information and retaining risk under both the EUSR and the UKSR on an on-going basis during the life of a transaction). In relation to transparency for example, this is because if one set of onerous templates under the UKSR is already a pain, another set under the EUSR (even if they differ only a fraction) is still an additional pain and in any event market participants still have to manage the theoretical risk that the content requirements of the two regimes diverge in costly ways in the future. Even a more optimistic scenario – under which both the EU and the UK create parallel equivalence regimes for, say, both STS securitisations and transparency – is fraught with problems: equivalence determinations in financial services are famously embroiled in politics and market participants would still have to manage the risk that equivalence declarations are not made or are withdrawn. Aligning the UKSR with the EUSR for the sake of alignment is therefore only of limited help.
In their responses to the EU and UK consultations, market participants are therefore being more imaginative and in some respects more radical, pushing for openness, via the removal of both direct and indirect jurisdictional limitations. For STS securitisations, they suggest that the requirements on the place of establishment of originators and sponsors (a direct jurisdictional limitation) be removed entirely. For both transparency and due diligence, their view is that policy-makers need to go back to the fundamental principles of why good transparency and due diligence are important and not be so prescriptive in the detail (an indirect jurisdictional limitation). For risk retention (which has caused fewer problems), they recommend certain tweaks to the EU and UK rules, including permitting “L-shaped” retention which is allowed in the US, which could facilitate trans-Atlantic securitisations without compromising financial stability.
This sets the scene for an interesting test case in regulatory competition between the EU and the UK. The EUSR and the UKSR share the same problems – so market participants have suggested the same solutions - but which of the EU or the UK will be most responsive to their concerns? Will the EU and the UK address the same problems in different ways? The best outcome for market participants is one in which both the EU and the UK listen to the concerns of market participants and reform accordingly, but even if only one of them does so, that would still be better than the status quo. Will the UK, currently going through the process of reviewing its future regulatory framework in financial services with a specific aim of creating an “agile regulatory regime” that can be “flexed and updated efficiently”, actually be able reform quicker than the EU? Will regulatory competition between the EU and the UK – both of them trying to achieve the best regulation with a view to encouraging securitisation – end up being a stimulus that benefits market participants? The jury is still out.