The central aim of the capital rules is to ensure that the protection remains robust for its anticipated duration. The permissible features can vary significantly across jurisdictions and can be subject to uncertainties (in particular, at the time of writing, in the US), but the areas summarized below represent a start.

Eligibility criteria

These define what can and cannot be included in the portfolio. Eligibility may be defined at the asset level (e.g. borrower domicile, internal rating, etc.) or the portfolio level (e.g. concentration limits by geography, sector, credit rating, etc.). Assets that breach the criteria are removed from the portfolio, and the originator cannot claim protection in respect of them. Eligibility criteria become less important if the portfolio is static and / or fully disclosed, since the portfolio does not revolve and the investor can see exactly in which loans it is participating. However, where an investor is receiving anonymized or aggregated information and / or the portfolio can revolve, the eligibility criteria are the key tool for the investor to supervise the assets on which it is taking risk.

Replenishment

Portfolios may be (i) static, in which case the day-1 portfolio is constituted and the parties come off risk as these original loans repay (in accordance with the applicable amortization scheme, described below), or (ii) replenishing, in which case the originator may elect to add new loans in place of old ones (subject to meeting the eligibility criteria). Replenishing deals can be more efficient, but put greater emphasis on the eligibility criteria and the ongoing partnership between the issuer and the investor.

Amortization schemes

When a loan successfully repays, it comes out of the portfolio. If the transaction is not replenishing at that point, this results in a permanent reduction in the outstanding portfolio size and, in turn, a commensurate reduction in aggregate tranche size; however, we need to decide which tranches to reduce and by what amount. The reduction can either be pro rata, whereby it is allocated across the tranches in proportion to their size, or sequential, whereby the reduction is allocated to the most senior outstanding tranche first (thereby keeping the investor’s junior / mezzanine tranches on risk for longer). Transactions can also switch between the two schemes.

Termination rights

Given that the regulatory rules are directed to keeping the protection in place for its anticipated term, the availability of call options and other termination events is highly restricted for both sides. Generally, it is not permitted for the issuer to lose the protection, increase its cost or curtail its term for events outside of its control. For investors, the lack of flexibility here can be particularly hard to accept, given it can prohibit termination rights that are common in similar trades (for example, issuer insolvency and even breach of agreement in certain jurisdictions). The issuer may benefit from some expressly permitted call options, such as a regulatory change event, time call and a clean-up call, though their availability varies by jurisdiction.

Loss determination / timing

Since the issuer is fundamentally using a CRT to cover its losses on its assets, the manner and timing by which the issuer initially records (and subsequently tracks) those losses is central. The investor will need to diligence this process, and the documentation will need to reflect it, while also complying with any applicable rules relating to timely payment. For this reason, many transactions provide for an initial loss immediately following the credit event, followed by a true-up once the issuer has completed its work-out procedures (potentially with refunds of over- or under-paid premium, if a discrepancy between initial and final loss results in an “incorrect” tranche size in the interim).

Cost of protection

The price of the protection agreed between the issuer and investor is crucial: the issuer cannot create an arbitrage by enjoying a capital benefit today at the expense of overly costly premiums in future. Accordingly, “high cost” credit protection is not eligible for capital relief. There are a number of potential hallmarks to identify this issue at Basel level, including where the aggregate lifetime premium paid by the issuer exceeds the maximum possible amount of the protection payments. Related, premium structures which undermine risk transfer are also not permitted.

Originator credit risk

Note that the structural features of a synthetic deal can introduce / amplify originator credit risk for the investor: unlike a true sale deal, where recourse is only to the SPV and the assets it holds, the investor will be looking to the originator for payment of coupon or fee and also, potentially, return of principal amounts. In order to minimize the extent to which the originator’s credit risk might adversely affect the transaction, the originator may be obliged to collateralize its obligations, potentially only once its credit rating is downgraded below a certain level.

Other applicable legal regimes

While the CRT product has to accommodate the requirements of the local capital rules, this does not relieve it from having to comply with other applicable law and regulation. For instance, credit linked notes will be subject to local securities legislation based on the location of the parties and the nature of the offering, derivatives may be subject to mandatory reporting, variation margin and initial margin requirements (around which it can be hard to structure), and some forms of protection contract require a license (e.g. insurance). If there is a European or UK nexus, the trades are also very likely to fall within the scope of the Securitization Regulation, with the extensive reporting, retention and due diligence obligations that that entails for both sides.

Explore more related content on credit risk (CRT) and significant risk (SRT) trades here.