Cayman Islands: Synthetic Securitisation: The Cayman Islands Perspective

Last Updated: 10 January 2002
Article by Julian Black

Most Read Contributor in Cayman Islands, September 2018

Synthetic securitisation by financial institutions of either pools of bonds or pools of loans has become ever more popular since its inception at the beginning of the 1990’s, and increasingly these transactions are being carried out under programmes. The purpose of these deals is to release expensive regulatory capital that can then be redeployed to other areas of the financial institution’s business. This article discusses the essential elements of synthetic securitisation, and then briefly examines why the Cayman Islands is the jurisdiction of choice for this type of transaction.

What are Credit Derivatives?

A derivative is a financial product the value of which is determined by the value of an underlying asset, whilst a credit derivative is a financial product the value of which is based on the creditworthiness of a third party or group of third parties. A credit derivative allows the owner of debt assets to offset the risk of holding those assets without transferring the ownership. By transferring credit risk and reducing the need to hold associated regulatory capital, synthetic securitisation achieves the same result as more traditional forms of securitisation without many of the complexities.

Types of Credit Derivative

The most common method by which assets are synthetically transferred and capital relief achieved is by way of the credit default swap. In return for regular payments made by the Originator to the counterparty, the counterparty agrees to make a payment to the Originator upon the occurrence of a credit event in relation to the Reference Assets. The "Reference Assets" (being the assets referenced in the Credit Derivative) are correlated to, though are often not the same as the "Underlying Assets" (being the assets held by the Originator, in relation to which it is seeking credit protection). It is preferable that the Reference Assets are publicly issued, and it is for this reason that they often differ from the Underlying Assets, though a high degree of correlation between the two is needed for the Underlying Assets to be removed from the regulatory balance sheet. This avoids the Originator breaching its duty of confidentiality to borrowers, and ensures that the requirement for publicly available information of the occurrence of a credit event is satisfied (see below).

The definition of a Credit Event can range from a potential credit event to an actual failure of the relevant Reference Entity to pay in respect of the Reference Asset, and can include other events of default set out in the ISDA Master Agreement or tailored for the individual transaction. For the event to constitute a Credit Event, it must also exceed a materiality threshold, and there must be Publicly Available Information relating to it. On the occurrence of a Credit Event, the contract may provide for physical settlement of the Reference Assets to the counterparty in return for the counterparty paying to the Originator their par value. Alternatively, the contract may be cash-settled, and the counterparty would either pay to the Originator a fixed amount, or par less the recovery value of the Reference Assets.

Under a Total Return Swap, the Originator will pay to the counterparty the cashflow received on the Reference Assets together with amounts equal to any increase in the market value of the Reference Assets. The counterparty makes regular interest-rate related payments together with amounts equal to any decrease in market value of the Reference Assets. On the occurrence of a Credit Event the swap terminates, and the settlement amount is calculated on the same basis as the pre-credit event payments. The effect of the Total Return Swap is to fully transfer the entire economic interest of holding the assets to the counterparty.

Credit Linked Notes are instruments by which a credit default swap or a total return swap can be packaged into securitised form, and they are accordingly pre-funded by the counterparty/investor. This technique enables investors who are legally prohibited from entering into derivative contracts to achieve the same economic profile as a credit default swap/total return swap without entering into the derivative contract. It enables the contract to be traded by delivery or through book entry in the clearing systems, rather than by novation, and should it be required the Credit Linked Note can be structured in this way to benefit from the Quoted Eurobond Exemption to avoid withholding.

Regulatory Capital Treatment

Economically, the Originator’s exposure to the Underlying Assets is replaced by exposure to the counterparty, and the capital treatment in most jurisdictions reflects this. In broad terms and subject to the detailed rules in the relevant jurisdiction, if the counterparty is a Special Purpose Company (SPC), the risk weighting will prima facie be 100%; if the Counterparty is an OECD Bank, 20%; and if the credit derivative is either funded by the Counterparty/investor, or the Originator is granted a first ranking security interest over cash or OECD Government Bonds, the risk weighting will be 0%.

Collateralised Bond Obligations (CBO’s)

As was first demonstrated by the JP Morgan Bistro transaction, the above techniques can be adopted with an SPC acting as the counterparty to the Credit Derivative, funded by a bond issue in the capital markets, such that any loss that is incurred on the Reference Assets is matched by reduced principal payments to investors.

The credit risk on recent deals has been carved up between different counterparties, and the different techniques (see Regulatory Capital Treatment above) are used to achieve capital relief.

Bank Austria’s Amadeus transactions carved up the credit risk associated with portfolios of bonds comprising subordinated pieces from ABS transactions. The risk of the first 10 per cent of losses on the portfolio was transferred by a credit linked note to a Special Purpose Company incorporated in the Cayman Islands, Amadeus Funding 1 Limited (Amadeus). Amadeus in turn issued two series of Notes, the proceeds of each being held in an account in the name of Amadeus, and charged in favour of Bank Austria. Pursuant to the priority of payments in the Deed of Charge, the Class B Noteholders took risk on the first 3 per cent of losses, and the Class A Noteholders took the risk of the next 7 per cent of losses on the portfolio. The risk of loss on the final 90 per cent of the portfolio was transferred by way of Credit Default Swap to a third party financial institution, and this risk in turn was wrapped by a monoline guarantee given by MBIA.

The relevant regulatory rules were complied with: accordingly a zero per cent risk weighting was given to the tranche cash collateralised by Amadeus, while the tranche protected by the OECD Bank received a 20 per cent risk weighting.

The Benefits of Synthetic Securitisation

The most obvious way of offsetting credit risk is by trading the particular debt asset. Whilst not so much the case for retail customers, corporate banking is very much a relationship business, and accordingly the assignment of corporate loans is generally considered not to be acceptable by the banking fraternity, even if the Originator maintains the servicing function in relation to the loans. The transfer of loan assets by assignment can also give rise to withholding tax in the event that the assignee does not qualify as a s.840A Bank. A bank’s common law duty of confidentiality to its customers makes the securitisation of loan assets, whether by assignment or using the Rose subparticipation structure, somewhat troublesome.

By contrast, Credit Derivatives enable the corporate relationship between the bank and its corporate borrowers to remain in tact, and by ensuring that the Reference Assets differ from the Underlying Assets, the bank’s duty of confidentiality to its Borrowers should not be breached.

"True Sale" securitisation gives rise to further problems associated with the transfer of ownership of the assets. Prima facie, the transfer of debts gives rise to the document of transfer being a stampable instrument. Whilst there are a number of techniques of avoiding the payment of stamp duty at the outset of a transaction, the Rating Agencies require a reserve to be held or a facility to be put in place in respect of such liability, in the event that stamp duty would become payable on the insolvency of the Originator.

Some assets have non-assignability clauses embedded into them, which the House of Lords held in Linesta Sludge (1994) to be binding. The assignment of assets have a number of formalities that need to be complied with: in particular, a legal assignment requires notice to be given to the borrowers, and the requirement for the transfer to be in writing mitigates against the well used "Offer and Acceptance" route for postponing stamp duty liability on the transfer.

The use of a synthetic transfer, by contrast, avoids these issues that arise on the transfer of ownership, and generally the documentation is less complex and therefore more economical to put in place.

The Cayman Islands as Jurisdiction of Choice

The reasons why the Cayman Islands is the jurisdiction of choice for carrying out CBO’s and CLO’s are well understood. They hinge on the common law nature of the legal system, being based on English law, with more flexible legislation having been introduced reacting to the requirements of both the international financial markets and the regulators.

In particular, the jurisdiction is creditor-friendly, at the top of Philip Wood’s spectrum of creditor-friendly jurisdictions. In the Cayman Islands, there is no equivalent of Chapter 11 in the U.S., or Administration or the new Voluntary Arrangement regime (that is in the process of being enacted pursuant to the Insolvency Bill) in the U.K. Whilst deals issued through SPC’s incorporated in the United Kingdom will shortly see the Rating Agencies impose additional liquidity requirements arising out of the new insolvency legislation, the Cayman Islands offers the international community a more robust insolvency law from the creditors perspective.

The trust, again deriving from English law, is another area in which Cayman Islands law lends itself to the structured finance community. By separating the beneficial interest in the shares of a special purpose company from their legal title, a share trustee can hold the legal title of the shares, without the accounts of such special purpose company being consolidated in the accounts of the share trustee or of the Arranger. As an alternative to the share trust being in the form of a charitable trust, the innovative trust legislation of the Cayman Islands permits non-charitable purpose trusts. These trusts (known as STAR trusts, being established pursuant to the Special Trusts (Alternative Regime) Law 1997) enable the Noteholders to be the beneficiaries under the share trust, which avoids residual profit at the maturity of the Notes being paid away from the transaction.

The fiscal regime with no corporation tax (or withholding) in the Cayman Islands and the status of the Cayman Islands as a UK Overseas Territory ensuring that there is no "Sovereign Ceiling" that limits the rating of debt issued by a Cayman Islands’ company, are further essential ingredients. The professional infrastructure, and in particular the responsiveness and expertise of the corporate administrators in the Cayman Islands, serves to ensure that Cayman Islands’ companies are centrally managed and controlled outside the United Kingdom and are therefore not subject to U.K. Corporation Tax.

Conclusion

Credit derivatives and their application in synthetic securitisation, is only the latest of an ever expanding range of derivative products which are changing the global financial landscape. The capital adequacy rules are under constant review by the Bank of International Settlements, and further changes in this area will be forthcoming, which will give rise to further developments in transaction structures. This, combined with the continued focus on return on equity, would suggest continuing development of synthetic securitisation.

 

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
Some comments from our readers…
“The articles are extremely timely and highly applicable”
“I often find critical information not available elsewhere”
“As in-house counsel, Mondaq’s service is of great value”

Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions