Due to current market conditions we have been receiving an increasing number of enquiries from banks seeking to structure asset-backed securities (ABS) transactions in such a way that the notes issued thereunder qualify as Eligible Collateral for repo transactions with the European Central Bank (ECB) and indeed national central banks throughout Europe. By using such ABS as collateral for repo transactions, banks can effectively borrow from the ECB or national central banks on a cost effective basis. This, in turn, has greatly helped to ease liquidity problems in the European capital markets. These structures have been so popular recently that it is estimated that the ECB is currently the largest single investor in European ABS.
This note focuses on the key requirements for ABS to qualify as ECB Eligible Collateral and includes the recent updates to the eligibility criteria announced by the ECB as part of its biennial review of risk control measures and the temporary expansion of the collateral framework.
ELIGIBILITY CRITERIA FOR ABS
- Type of Asset
In order to be eligible for Eurosystem monetary policy operations, the ABS must be a debt instrument having a coupon which cannot result in a negative cash-flow. In addition, the coupon should be (i) a zero coupon; (ii) a fixed rate coupon; or (iii) a floating rate coupon. The coupon may be linked to a change in the rating of the issuer itself. Furthermore, inflation-indexed bonds can fulfil the eligibility criteria.
In addition, the cash-flow generating assets backing the ABS must:
- be legally acquired in accordance with the laws of a Member State in a manner which the Eurosystem considers to be a “true sale” of the securitised assets to the issuer and which is enforceable against any third party and is beyond the reach of the originator and its creditors, including in the event of the orginator’s insolvency;
- not consist, in whole or in part, actually or potentially, of credit linked notes or similar claims resulting from the transfer of credit risk by means of credit derivatives; and
- not consist, in whole or in part of other tranches of ABS. This eligibility criterion, has been effective from 1 March 2009 but is not immediately retrospective. ABS issued before 1 March 2009 are exempted until 1 March 2010.
The ABS may not afford rights to the principal and/or the interest that are subordinated to the rights of the holders of other debt instruments of the same issuer. Also, within a structured issue, in order to be eligible, the usual rule is that a tranche (or sub-tranche) may not be subordinated to other tranches of the same issue. A tranche (or sub-tranche) is considered not to be subordinated vis-à-vis other tranches (or sub-tranches) of the same issue, and is “senior” if, in accordance with the priority of payments applicable after the delivery of an enforcement notice, that tranche (or sub-tranche) is given priority over other tranches (or sub-tranches) in respect of receiving payment of principal and interest, or is last in incurring losses in relation to underlying assets. However, as part of the temporary expansion of the collateral framework, this requirement of non-subordination does not apply from 25 October 2008 until the end of 2009, provided that a financially sound guarantor provides an unconditional and irrevocable guarantee in respect of the ABS (and always providing that the othereligibility criteria are met). An additional haircut of 10 per cent. is applied to such ABS, with a further 5 per cent. haircut where a theoretical valuation is used.
Satisfaction of the eligibility criteria must be maintained until the redemption of the debt instrument. Also, the Eurosystem reserves the right to request from any relevant third party (such as the issuer, the originator or the arranger) any clarification and/or legal confirmation that it considers necessary to assess the eligibility of ABS. Recently, the Central Bank of Ireland has been requesting increasing amounts of information regarding transactions, even where such transactions are repeat deals that were considered eligible in the past.
The “true sale” requirement referred to above has been causing increasing difficulties in recent times. In 2008, ABS had been considered eligible once the assets directly underlying the issue of securities by the issuer had been transferred to the issuer by way of true sale in accordance with the laws of a Member State. In 2009, the Central Bank of Ireland has been requiring that all assets underlying an issue of securities (even indirectly through two-tier structures) must have been transferred by way of true sale in accordance with the laws of a Member State. Where any underlying assets have been originated in a non-Member State, it is now unclear whether these deals can ever be granted eligibility.
- Credit Standards
The ABS must meet the high credit standards specified in the European credit assessment framework rules for marketable assets. From 1 March 2009, the requirement is that the ABS have a rating of “AAA” / “Aaa” at issuance and maintain at least an A- rating over the course of their lifetime. This requirement applies only to ABS issued from 1 March 2009 and is not retrospective. The ratings of ABS must be explained in a publicly available credit-rating report (which should include an analysis of the structural and legal aspects of the ABS). Additionally, the rating agencies must publish rating reviews for ABS at least on a quarterly basis.
- Place of Issue
The ABS must be deposited/registered (issued) in the European Economic Area (EEA) with a central bank or a central securities depositary which fulfils the minimum standards established by the ECB. In case a marketable debt instrument is issued by a non-financial corporation that is not rated by an accepted external credit assessment institution, the place of issue must be the euro area.
- Settlement Procedures
The ABS must be transferable in book entry form and must be held and settled in the euro area through an account with the central banks or with a Securities Settlements System which fulfils the standards set down by the ECB.
- Acceptable Markets
The ABS must be admitted to trading on a regulated market (as defined in the Markets in Financial Instruments Directive) or traded on certain non-regulated markets as specified by the ECB. A list of acceptable non-regulated markets is published on the ECB’s website (www.ecb.int) and is normally updated annually. The main market of the Irish Stock Exchange is regarded as a regulated market.
- Type of Issuer/Guarantor
The ABS may be issued or guaranteed by central banks, public sector entities, private sector entities, or international or supra-national institutions. The usual rule is that ABS (other than covered bank bonds) issued by credit institutions are only eligible if they are admitted to trading on a regulated market. However from 22 October 2008 to the end of 2009, this rule is not applied in the case of nonregulated markets specified by the ECB for ABS which fulfil all of the other eligibility criteria. An additional haircut of 5 per cent. is imposed on such ABS.
- Currency Hedging and Liquidity Support
The General Documentation on Eurosystem Monetary Policy Instruments and Procedures provides that a counterparty may not submit ABS as collateral which is issued or guaranteed by itself or by any other entity with which it has “close links”. From 1 February 2009, the definition of “close links” has included situations where such a counterparty submits ABS as collateral when it (or a third party that has close links to it):
- enters into a currency hedge with the issuer or guarantor of the ABS; or
- provides liquidity support of more than 20 per cent. of the nominal value of the ABS.
It is important to note that the above arrangements do not preclude the ABS from eligibility, but rather they preclude the provider of the currency hedging or liquidity support, as the case may be, from submitting the ABS as collateral.
- Place of Establishment of the Issuer/Guarantor
The issuer of ABS must be established in the EEA. The guarantor (if any) must also usually be established in the EEA. It appears that if the issuer is established in the EEA then, in certain circumstances, the guarantor need not itself be established in the EEA.
- Currency of Denomination
The general rule is that ABS must be denominated in euro to be Eligible Collateral for Eurosystem credit operations. However from 14 November 2008 through to the end of 2009, marketable debt instruments denominated in currencies other than euro (namely USD, GBP and JPY) will be Eligible Collateral, provided that they are issued or settled in the euro area and provided that the issuer is established in the EEA. ABS denominated in a currency other than euro is subject to a cumulative haircut add-on of 8 per cent.
- Valuation Haircut
Previously, the ECB applied a valuation haircut of 2 per cent. to ABS which had a floating rate coupon, and a haircut of between 2 per cent. and 12 per cent. to ABS which had a fixed rate coupon. From 1 February 2009, the ECB has applied a 12 per cent. haircut on the value of all ABS (irrespective of the maturity of the ABS and whether its coupon is fixed or floating). In addition, where the ABS is assigned a theoretical value, then an additional haircut of 5 per cent. is applied directly to the theoretical value (giving a cumulative haircut of 16.4 per cent.).
PROCESS FOR APPROVAL OF ABS AS ECB ELIGIBLE COLLATERAL
ABS which are regarded as Eligible Collateral are included on the Eligible Collateral list established, maintained and published by the ECB. To be included on the Eligible Collateral list, the national central bank of the country where the securities are listed must determine whether the securities meet the ECB’s criteria and report eligible assets listed to the ECB for inclusion on the Eligible Collateral list.
Where the ABS is listed on the Irish Stock Exchange, submissions to include such ABS on the ECB’s Eligible Collateral list are made to the Central Bank of Ireland at the following address: email@example.com. Such submissions must include certain information and documents including: the offering document in respect of the ABS (i.e. prospectus/offering circular); letters of rating from the rating agencies; date of listing on the Irish Stock Exchange; rating agencies’ pre-sale reports; a short written assessment of how the security meets the ECB criteria for eligible assets; and ISIN codes. There is no prescribed application form and no application fee. In 2008, submissions were often dealt with by the Central Bank of Ireland within two weeks. In 2009, some submissions have been outstanding for over six months.
Where it is determined that the ABS meet the ECB Eligible Collateral criteria, they are automatically added to the Eligible Collateral list. The updated lists are made public each day on the ECB website (www.ecb.int).
It is possible to confirm whether the ABS are, in fact, listed by checking on the ECB website (www.ecb.int) and clicking on "Monetary Policy", then "Collateral", then, "List of Eligible Marketable Assets" and in the data access section you should click "Check Eligibility of an Asset" and you will then be prompted to enter the ISIN code for the ABS.