STS Criterion 15. Appropriate mitigation of interest rate and currency risks

Description

Appropriate mitigation of interest rate and currency risks

Content

Currency risk

Currency risk arising in the synthetic securitisation should be appropriately mitigated and measures taken to that effect should be disclosed. The protection buyer should bear no currency risk in relation to the credit protection it receives. This may be done in either of the following ways:

• the guarantee or derivative contract and, where applicable, the collateral securing the credit protection obligation should be denominated in the same currency as the underlying exposures, or
• through other appropriate arrangements, which ensure that the protection buyer does not bear any currency risk in relation to the credit protection it receives.

Interest rate risk

Interest rate risk associated with the synthetic securitisation should be mitigated and measures taken to that effect should be disclosed. The protection buyer should bear no interest rate risk in relation to the credit protection it receives. In the case of a synthetic securitisation involving an SSPE, the amount of the SSPE’s liabilities in terms of interest payments to investors at any payment date should be equal to or less than the amount of its income from the protection buyer and any collateral arrangements at such payment date.

The underlying exposures should not include derivatives, other than derivatives entered into for currency or interest-rate hedging purposes in connection with the underlying exposures. Those derivatives should be underwritten and documented according to common standards in international finance.

Rationale

Unlike in the case of traditional securitisation, in synthetic securitisation the interest and principal cash flows generated by the underlying exposures are not used to repay investors. Payments towards synthetic securitisation investors are limited to the credit risk protection premium and, as applicable, the yield from the re-investment of the collateral used in funded transactions, and the redemption of such collateral, which will be used to repay noteholders at maturity or at early termination of the contract.

However the originator (protection buyer) of synthetic transactions may: (i) face instances of under-protection due to exchange rate fluctuations in transactions where more than one currency is involved; (ii) be exposed to interest rate mismatches, itself or through the SSPE set up to issue notes to investors, where it guarantees to investors a return on the collateral received as credit risk protection beyond the payment of the due credit protection premium.

Currency risk: In synthetic securitisation transactions where the underlying exposures are denominated in a different currency than the currency in which the credit protection is denominated (i.e. the transaction currency) the risk arises that, due to exchange rate fluctuations and depending on the reference exchange rate used for converting loss amounts into protection payment amounts, the outstanding amount of the notes / available collateral / committed guarantee amount after conversion into the currency in which the underlying exposures are denominated may be reduced resulting in a diminished protection in respect of the underlying exposures. Even though the CRR provides for additional capital requirements on the originator for transactions characterised by currency mismatches, it is important that the currency risk to which STS securitisation positions are exposed is appropriately mitigated. This can be done either through the credit protection being denominated in the same currency as the underlying exposures, or by other measures such as hedges and guarantees that can fix the currency rate for the protection buyer, or by other equivalent arrangements such as for example adapting the notional amount of the portfolio to manage exchange rate fluctuations through replenishment.

Interest rate risk: Interest rate risk should be appropriately mitigated. Additional criterion 36 provides for eligible credit risk protection arrangements. The exclusion of more complex collateral and re-investment arrangements in synthetic STS securitisations further reduces the extent to which of interest rate mismatches may occur in such securitisations. Derivatives should be allowed as underlying exposures of a synthetic STS securitisation only where those derivatives are used for the single purpose of hedging the currency and interest rate risk arising from the underlying exposures that are not derivatives. For the sake of clarity, it should be highlighted that any derivative contract used to effect the credit risk transfer that gives rise to the synthetic securitisation is not to be considered an ‘underlying’ exposure of the synthetic securitisation.