UK Securitization Reform – What Fund Managers Need to Know

Dechert On Reg host Angelo Lercara is joined by Dechert’s John McGrath, Richard Pugh and Aaron Scott for a deep dive on how the new UK securitization regulations – which go into effect November 1 – will affect fund managers and market participants, how the new UK rules compare with existing EU regulations, and what investors should be doing now to prepare for the changes.

Show Notes:

Countdown to Change: UK's New Securitisation Regime Effective from 1 November 2024 – Dechert OnPoint (May 2024)

Transcript

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Hello everyone, and welcome to Dechert On Reg, the podcast where we explore the ever-changing landscape of financial regulations and the key issues that are shaping the future of asset management. I'm Angelo Lercara, partner at Dechert and co-head of our regulatory product line. And in each episode, we'll be joined by expert colleagues and guests to explore the most pressing issues in financial regulation. In today's episode, we're talking about the new UK securitization regime, which will have an impact on fund managers and other market participants. So, whether you're an industry insider or simply interested in the world of financial regulation, you don't want to miss this episode of Dechert On Reg. I'm excited to have three esteemed experts joining us who will help us understand these changes. John McGrath, Richard Pugh, and Aaron Scott are here today to discuss this topic. Let's dive in. John, Richard and Aaron. Hi, everybody. Good to have you here. Earlier this year, the UK Treasury took a significant step by publishing the Draft Securitization Amendment Regulations 2024 which, as I understand, is also known as the Draft SI Amendment. And this seems to be part of an ongoing effort to replace the retained EU securitization regulation, which was brought into UK law after Brexit. With the regulatory framework specifically designed for the UK. Aaron, before we get into the details of that regime, can you please provide some more background and why the reform is actually important and, in particular, who needs to be aware of the new regime? Sure, in terms of particularly why the amendment that came in earlier this year is important is it gives us a date to focus on. So the UK changes will come into effect on one November this year. And that sort of kicked off a few other releases of information that we received this year. So the PRA and FCA released their rulebook, which contains a lot of the detail around the new UK securitization regulation. And the PRA is one of the UK regulators, right? Yes, yeah, that's right. That's right. And one of the main things that we're looking at, as you know, how do the new UK rules compare to the EU rules that are currently in place and the EU rules that were on-shored into the UK following Brexit? I think the second party question is who needs to be aware of this? If I had it my way, everyone would be aware, so then I could increase my dinner party chat. But in reality, the securitization regulation places direct obligations on sell-side parties, they're involved in securitizations. And it also requires institutional investors when investing in securitization to conduct some due diligence before they can invest in that securitization. And so that applies both to EU sell-side parties and investors, but also UK sell-side parties and investors because the regulation was onshored following Brexit. So generally speaking, it means that if you have a securitization that has any EU or UK nexus, you need to be aware of the requirements under the reg. One thing I probably should flag at this point as well as the the definition of securitization in the regulation is probably a little bit wider than the traditional meaning of the word. So broadly speaking, there are two limits to that definition: one that you need contractual tranching of debt and the other is that the payments on that debt are dependent on the performance of an underlying pool of exposures that has credit risk. So this definition covers your traditional securitizations like CMBS RMBS CLOs, auto loans, but it also covers some more private transactions that, I think traditionally, wouldn't be seen as securitizations. So if you're a UK or an EU entity looking to invest in one of these are looking to set up one of these structures that might have some features within the definition that I just described, it's also helpful to be aware of other requirements. Interesting. What about the European Union? You know, has the EU modified its approach, since these regulations were first introduced? What's the reaction? Do you see any reaction, John? The EU changed its position shortly after Brexit not really in any way as as a reaction to Brexit. So what happened is that after the EU introduced the securitization regime, foreign originators of securitization transactions were finding it particularly difficult to fill in reporting on the asset pools and securitizations. And the EU has these incredibly detailed lists for various different types of asset like residential mortgages or commercial mortgages or sort of credit card receivables, which have literally hundreds of data fields for each assets. If you imagine a credit card transaction where you might have 10,000 underlying credit card receipts going into the deal. Each month, people say it can get up to half a billion data entries on the reporting. So it's a huge effort to undertake all of this reporting. And That's a lot, yes. Yeah, it's incredible, really. And when the reg came in, a lot of the non-EU originators just said, "Well, we're not doing this, we don't mind if we have to retain a piece of the transaction to satisfy the rules. But there's no way we're doing this immense reporting effort." And so they invented something called EU Light, which were deals that didn't do the EU reporting, but comply with other elements of the regulation. And those were kind of put together quite a lot, particularly in the CLO market. And were also bought by quite a few EU investors. In late 2022, the European Commission issued a report on the functioning of the securitization regulation, and it sort of said, like, "you guys, who are not doing the reporting, you're, like, bad people. And the regulation requires that you fill in these very detailed templates for for every transaction. So it's going to be hard for us to prosecute people who are outside of Europe. But if you're European investors buying these deals, we can come and get you. And so make sure you only buy deals that are fully compliant." And that really changed the market in Europe. After that report came out, all of a sudden, people who wanted to sell securitizations into Europe started trying to do the full reporting. And a lot of people who just thought, "Oh my God, the cost of this is just insane," decided they could do without European investors and sort of pulled out of issuing into the European market. And I think you can sort of see, in quite a lot of reports over the last few years, the US market has continued to get bigger and bigger. And the European market has kind of stayed flat or gotten smaller in some areas. And part of the feeling is that it's because of this difficulty with the data reporting that makes it unattractive to issue into Europe. So that's kind of where we are now. There are a few proposed changes to that, which maybe we can come back to later in the podcast. Yeah, that's interesting that, you know, the burden of reporting would have an impact on the development of the market in Europe versus the US. That's something very, very surprising. I think that's pretty officially acknowledged. Like, there was an ECB report earlier this year that said there are two prime problems with the market in Europe: one is the capital treatment of securitizations and the other is this reporting problem. And what about the UK? Did the UK have a specific approach or its own approach? Why says it's interesting on that one? Because, you know, like John said with the, you know, the approach the EU came out with confirmed that EU invested in non EU deals have to ensure those deals fully comply with these very complex and detailed, you know, Article Seven reporting templates. In the kind of lead up to that there has been a massive industry effort focused on both the EU regulators and the UK regulators just saying, "Look, this is just crazy asking for this level of detail for what we would call private transactions." So, you know, if you've got a loan to anyone, then the lender is the investor for the purposes of that loan. Why on earth would kind of a private loan which is secured over, say. a port of resident mortgages or auto loans or whatever it is? Or kind of corporate loans? Why does that lender need the borrower, be the borrower based in Europe or UK or elsewhere like in the States, why does it need that borrower to prepare this ridiculously detailed reporting template when the lender's gonna have its own internal credit committee, right? which will be very detailed before it lends its own money secured over these assets. It just made no sense to require a lender to produce that or to require for that level of information to be prepared. And anyway, so a lot of effort was made in kind of drawing the that kind of slightly kind of crazy scenario to the regulators. And as John said, the EU regulators said, "Oh, that's all very interesting, but very sorry, that the rules are the rules." And you know, what you got to do full reporting, even if you are lending or investing in a non EU deal, but the UK listens. And actually, when the UK, when it first incorporated and transposed the European securitization regulations into UK law, it immediately made one or two changes to the fundamental law. And one of the changes it made was on this very specific point where it said that if you're a UK investor investing in a non UK securitization, we only require you to substantively comply with a UK version of Article Seven template reporting. Now, they didn't go into what's substantively compliant meant at the time, but I think, from calls with the FCA and the PRA and her majesty's treasury, it was kind of clear that they actually have listened to what the market has said, and they got the point. And they thought for third country deals in particular, but but I think also private securitizations also, that there was no point requiring a UK investor to ensure that that deal fully complied with UK Article Seven, because by doing that, and then UK investors can't access, you know, sophisticated investors can't access a wide variety of structured finance products available outside of UK and that kind of made no sense. As long as a UK investor had done its diligence, why should that matter? So that was a very pragmatic response and immediate kind of deviation from the EU's approach. So in the latest kind of FCA and PRA rules which are published, they kind of doubled down on that approach. So they've now said, if you're a UK investor, forget about the annexes, you don't have to require the annexes to be produced in the securitization you're investing anymore. Instead, we just want you to look at the deal and to carry out a sensible level of due diligence. You know, one of those, you know, funnily enough, we want you to get some information on the underlying receivables. But there's no requirement for information to be in the kind of prescribed form. And these rules come into effect on first November, the fact that this is just kind of giving more color on what they meant by substantively comply. So it's much easier now for a UK investor can effectively ... As long as the non-UK deal is suggesting a reasonable level information, there's no issue at all with a UK investor investing it at least from an information or kind of form or template reporting perspective. Yeah, I mean, Richard, one of the interesting things about that is they haven't actually said, "Look, Let's ditch the annexes." Because the annexes are still, you know, when you look at the FCA rules, there's still a ton of pages of annexes. They just haven't specifically mentioned them in the investor due diligence section. Yeah, absolutely right. So if you're a UK originator or SPV, and you're putting together a securitization, then you still have to produce the annexes. So to date, that requirement is still there, although as we're talking about that, that may well be diluted in the future for private securitization, but that requirement is still there. But if you're the investor, then you just don't need to worry about that anymore. But that's an asset held by because we we have a lot of calls from EU clients a lot who have EU AIFMs, you know, looking to invest in non-EU paper, particularly in the US which doesn't comply with transparency rules. And we have to say, "sorry, you can't buy it," whereas a UK investor can. So I mean, that's, you know, that's a big thing we're seeing as a big, big disparity at the moment. Another thing, which also again, UK being pretty pragmatic, was helpful was there was also concern about if you're a non-UK AIFM, an alternative investment fund manager, and you are actually marketing in the UK, there was this question mark about whether you would be caught by the UK rules as an institutional investor, so have to all of the UK's investor due diligence. And again, as an example, The said, "Oh, yeah, you are caught if you're actively investing in the EU even though you're a non-EU AIFM." But the UK said, "No, you're not caught. Unless you're a UK AIFM, we're not bothered, we don't care." So that's another nice example of just the UK, just, you know, the regulators, I think listening to be honest, and being pragmatic and being flexible. Yeah, a very pragmatic approach. Makes a lot of sense. What do you think, John? Do you think the EU will be introducing further changes or will make any changes with regard to what we see from the UK or otherwise? I mean, one of the interesting things about the commission's report, and one that we find, often, quite hard to explain to clients is, at the same time when they said if you're an investor, you have to make sure there's absolutely full reporting. A large section of that report also criticized the templates that were prepared by ESMA. And said that these were, in a lot of ways just not fit for purpose. They didn't necessarily provide the investors with the information they needed, they were very difficult to fill out. You know, for the deals like the credit card deal that we mentioned, there was just so much data that it was really difficult to see what the benefit was of putting all of that together. So they were fairly critical of the templates. And they asked ESMA to go and have a look at them, and to come up with some ideas for changing them. And since they made that request, a couple of the other European regulatory bodies have sort of jumped on the bandwagon and said,"Changing these will be important," as we mentioned earlier. So ESMA did come out with a consultation paper at the very end of last year, which gave four options. Some of them were not that great, given what we've been told to do. Option 2 was to do nothing, which clearly wasn't the mission statement from the European Commission. Option 2 was to make the templates more complicated and punish you more heavily if you didn't fill in every single field which, again, seemed to not really fit with the mission statement. But it had two options, which are a little better. One was to carry out a root and branch sort of reform of the templates and really start with a blank piece of paper again. That option went down very badly with the market who were pretty reluctant to go down another two and a half year exploration of how many data fields can we create for the Dutch residential mortgage and things like that. And in a sort of joint response which EMIR and the Alternative Credit Council, SIFMA and a whole bunch of other regulatory bodies submitted, they said, "Let's just forget about option 4. It's not going to do anyone any good." But the other option put forward by ESMA looks like it is going to get some traction. It is certainly supported by all the trade bodies and it seems to have some support from some of the regulators as well, which is to say that for private securitizations, and those are securitizations that aren't listed on a main market in the EU, for those you can have a simplified form of reporting. And that will also cover, kind of by coincidence, most of the third country originated securitizations as well. So most, say, U.S. CLOs are not listed on European markets, so they'll be caught by this proposed change too. So that that looks like a good way forward. And the other thing which ESMA kind of mentioned that would be probably quite helpful to the market as they did take on board that for things like credit card securitizations, the very, very detailed report on every single person's credit card bill is not really terribly helpful to anyone. And they're going to look at trying to simplify the debt requirements for this very large revolving granular pools of assets. It's difficult to be a betting man on all of these podcasts. But if if you were I think some kind of change in that direction is probably coming. Although putting a timeline on this is pretty hard. The private credit industry is always on the move. And it can be difficult keeping pace as you navigate its most complex challenges and opportunities. And that's why Dechert created THE CRED, our new platform dedicated solely to providing legal and business insights on the private credit landscape. From the latest news to in depth analysis from the top minds in the space, THE CRED has private credit covered. To learn more and to sign up for THE CRED newsletter, visit Dechert.com. What's next for the UK, Richard? So think on that theme, I think the UK, again will probably ... it's difficult to know whether they will act before the EU acts. I mean, they've indicated that they're looking at this, I imagine they probably quite like Option 3 out of all of them, because that just involves a simplification, hopefully, just a kind of one-off notification of the private securitization. And then that sets all that kind of ongoing reporting which can be very expensive, especiallywhen the underlying receivables are bespoke. All that kind of falls away for what you call a private securitization. So as John said that would be loans and then then assets not listed on the UK regulatory market which is the London Stock Exchange. They may also go a step further and kind of do away with the requirements entirely for private securitizations because that was... when the European Commission and the ECB and all the others were kind of consulting on the European securitization regulations all those years ago, for a while they did switch up one of the draft regulatory technical standards, which came out they did actually switch off reporting entirely for private securitizations. But then they eventually backtracked, saying they didn't think they had the legal authority to do that, because they were bound by the level of context in the securitization regulations, but it's obviously always on their mind. So I wonder if the UK regulators might have switched it off entirely. Because in the moment, also there is if you do private securitization in the UK, for a UK originator or SPV, addition to the reporting requirements, you know, the annex is that they do have to notify the FCA as well. And there's quite a short form notification just saying what the deal is and a bit about the assets. I wanted to say we've already been told about it. You know, we've got the regulatory powers to ask for more information, and we want it so we switched it off entirely. But I think what they won't do, I don't think they want to do a whole new template again, right? For private securitizations, because what they are keen to avoid is if you're a UK originator, who as well as the UK market you're also looking to the EU market as well. So in practice, you're going to kind of have to comply with the EU rules anyway, if you're looking for EU liquidity. You don't want to have to have, in a UK originator, having to do their own separately completely different UK reporting for private securitization and have to do the EU one as well. Because that was just, you know what I mean? Whereas at the moment, they're both very similar. So it's not it's not too much added effort to kind of do a new EU one if you're already doing a UK one. I think having said that, though, one thing the UK regulators are a bitworried about which for some reason the European regulators don't seem that focused on is that they, as John mentioned, all of the CLOs in Europe and CMBS are listed on the Irish Gem Market. Now that would make it a private securitization under the UK rules as well as under the EU rules. And I think the UK kind of further with those deals, if you've got like a UK kind of originator, but they're listing it in a UK SPV, it'd be your listing on the Irish Gem Market. They're kind of querying whether that really is a private securitization. So I think they're a little bit concerned about that definition. And I just, there's a feeling that they may carve those kind of deals out so those deals with wouldn't be considered a private securitization. So we'll kind of still need the full reporting, which is not unfair, given that those deals are, you know, widely placed and marketed just like a normal securitization with no adjustments. Aaron, many of our listeners are, as you can imagine, fund managers. At a more practical level, what should a fund manager consider if it wants to purchase a collateralized loan obligation for a fund? I'd the first thing that the manager wants to do there as if they haven't done it already, is to produce a policy to ensure that they're complying with the DE requirements, both before the investment and on an ongoing basis. It's a shameless plug, we've produced a few of these, and we'd obviously be happy to produce more, but they usually involve an overview of the regulation, an overview of the requirements, and then checklists that need to be completed to ensure compliance on an ongoing basis. But if we're looking at this, I guess, purely from a reporting perspective, and what we've been focusing on, the investor will need to take different steps depending on whether the deal is an EU CLO, or U.S. CLO. So if we're looking at an EU CLO, then the issuer in their case will be based in the EU, it will be an EU entity. So there'll be direct obligations on their interview to provide reporting which complies with the regulation. So that makes it easy for an EU or a UK investor to satisfy its due diligence requirements there. Because it can just look to the offering circular, and there'll be a section of the offering circular saying, "Yes, the issuer is providing reporting which complies with regulation." That's slightly more difficult if we're looking at a U.S. seller. Because in this situation, no sell-side party is obligated to provide reporting which complies with the regulation. But they might choose to do so so that they can then sell to EU or UK investors and it also helps with liquidity going forward. So again, the approach then differs. So if we're looking at a U.S. CLO, and we have an EU investor trying to invest in in that CLO, they would then have to look at the offering document for that CLO to see with a deal has decided to comply and provide reports which comply with the regulation. So usually there's a legend on one of the few issue pages in the offering document, which will clearly state with our without requiriting Article Seven reporting, the required reporting. And then further down in the offering document there's also a full section which will give an overview of the of the securitization regulation, risk retention, compliance and the reporting compliance. But as Richard mentioned earlier, the UK is taking a slightly different approach, they they've said, if you're a UK investor looking to invest in a U.S. CLO, you don't need to check whether the deal provides reporting that complies with the detail templates, you just need to ensure that the deal provides substantially the same reporting, as is required under the regulation. So in our view, for U.S. CLO, that U.S. CLO provides very detailed deal reporting, which provides information on the underlying assets and all of the U.S. CLO tests. And so that dear reporting would be sufficient to pass substantially the same test so that the UK investor there wouldn't have to diligence that the deal provides specific reporting which complies with EU UK templates. Thank you, Aaron. I think you mentioned that at the beginning, the new regime is expected to be implemented in November, 1 of November, I think you said. Are we expecting any further guidance from the regulators? Or do we know everything? From the UK perspective, we now know everything. So the statutory instrument was published at the end of last year. And then there was an amendment at the start of this year, which gave us the implementation date. And now we also have the final versions of the FCA and the PRA rules which provide the meat of the regulation. So long as the existing regime is revoked on the first of November, which we're expecting it to happen, the new regime will just automatically come into play. And, and we have all the details. I guess the one outstanding point is whether, perhaps after that date, the UK then may look to make further changes regarding the reporting templates that Richard was discussing earlier. Yeah, I mean, the UK is quite interesting in the responses to the consultation paper, they picked up on a whole load of issues where they said, "We're not changing on this time. But we're going to look at this again." And there's you know, a whole range of things connected from securitizations, not just reporting, but things like how you treat non-performing loans securitizations, how you look at what an originator's securitization is how you deal with synthetic securitizations that are .. the UK sort of indicated it's open to have another think about. So I do think there'll be more coming out and also more coming out, both from Europe and the UK on the Balfour implementation and the capital treatment securitizations, which I think both countries have recognized is the other big problem. Aside from reporting, probably less interesting fund managers than banks, insurance companies. John, Richard, Aaron, a big thank you for joining us and sharing your insights with us. We really appreciated your expertise, and it's been great having you in this conversation. Thanks again. Thanks for having us. As we wrap up today's episode, I'd like to extend my thanks to our esteemed guests and colleagues for sharing their valuable insights and expertise. I would also like to thank our incredible production team. It is their dedication and hard work behind the scenes that make this podcast possible. So he's so talented producers, sound engineers, and everyone else involved in bringing this show to life. To our listeners. Thank you for tuning in to our financial regulatory podcast. We hope that you found today's episode informative and engaging. If you enjoyed the show, please consider subscribing, rating and reviewing us on your favorite podcast platform. See you next time.