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Waiting for Munich: 5 Should Commission support ESNs?

27 August 2018
Richard Kemmish

Ahead of the Euromoney Covered Bond Forum in Munich in September, some thoughts on the topics that we will be discussing. In panel 5, a topic close to my heart: European Secured Notes.


I must admit to being biased. I have spent a lot of time studying the topic for a client and I am convinced that there is a case to be made for European Secured Notes – bonds that use techniques developed in the covered bond market to finance assets that aren’t normally eligible – increasingly the debate is focussed on loans to small and medium sized enterprises.

That doesn’t mean that I am blind to the possible objections. Recently I wrote a piece in response to Bill Thornhill’s claim that there was no need for ESNs as a funding tool. The jist of it being, traditional covered bonds will usually be better but at the margin there will be cases where ESNs make sense for some issuers, so if it will happen anyway, might as well legislate it.

Rather than repeat that argument, I’d like to focus on what form the support should take.

European law currently is remarkably light on how to structure a covered bond – given that it is an EU dominated €2.5 trillion market. All that it really does is grant certain preferential treatment for some investors who buy covered bonds that meet some criteria and establish a couple of exemptions from other EU rules to help you structure the bond.

Starting with the easier point, the exemptions, I don’t think there can be much of an objection to the idea that ESN associated derivatives should be exempt from central clearing obligations. There will never be enough of them to create the derivative market instability that the clearing obligations were designed to avoid.

It is only slightly easier to object to the idea that ESNs should be explicitly exempt from bail-in.  The resolution directive allows all secured debt to be exempt, specifically referring to ESNs in the list of exempt liabilities is a very minor technical clarification.

The tricky bit is whether investors in ESNs should be able to apply preferential treatment to the securities?

For me this boils down to two questions. What is the basis for the preferential treatment for existing covered bonds? And, can preferential treatment ever be justified without empirical data to justify it?

Preferential treatment in most pieces of EU legislation is far less important than you think it is. Most of the uplift in the treatment that covered bonds enjoy is due to their rating uplift. But this is a point that I have argued here before so I won’t reiterate it now.

Turning to the second question: do we need empirical data to justify the investor treatment? Every covered bond is different from every other covered bond. The first covered bond from a new jurisdiction gets preferential treatment on the basis of data from covered bonds in existing jurisdictions. Covered bonds with conditional pass throughs are treated based on the observed behaviour for covered bonds with soft bullet clauses. The question is whether the instrument is sufficiently different from existing instruments to require its own data gathering exercise?

I would argue that using the same technology as existing covered bonds is more important than the asset definition in determining future behaviour. The ECB agrees with me – they granted Commerzbank’s SME structured bond the same treatment in their liquidity framework as traditional covered bonds.

Finally, there is precedent. The proposed treatment of STS securitisations is based on the regulations (good) rather than the track record (non-existent). If securitisations are allowed preferential treatment without evidence, surely ESNs should be too? 

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