Recent months have heralded change on many fronts for the derivatives industry in Germany. New legislation and supervisory regulations and directives together with recent judicial decisions and developments in the fields of tax and accounting spell a time of opportunity and new challenges for market participants.
New Legislation
The Bundestag, the German parliament, passed the 4th Financial Markets Enhancement Act (4. Finanzförderungsgesetz) on March 22. The Act must still be ratified by the second chamber, the Bundesrat. That ratification was originally expected to occur in late April, but was delayed because of issues raised by provisions relating to the treatment of short selling and access to information contained in the draft legislation. A joint committee of the Bundestag and Bundesrat was appointed to resolve these issues. On May 15, the joint committee submitted its proposal and it is expected this will be accepted and ratified by the Bundesrat by early July.
The 4th Financial Markets Enhancement Act is intended to improve private investor, or consumer, protections and enhance the scope of capital markets activity in Germany. It does not seek to codify financial market law in Germany afresh, but rather purports to amend existing laws and regulations, including the Exchange Act, the Securities Trading Act, the Banking Act, the Mortgage Banks Act and the Public Mortgage Banks Act. Of principal interest to derivatives industry participants are amendments to:
* The Securities Trading Act and the Exchange Act, which abolish (or render inapplicable to derivatives) the gaming and betting defenses (Spieleinwand; Wetteinwand) set out in section 762 of the German Civil Code; the margin defense (Differenzeinwand) set out in section 764 of the German Civil Code and the futures defense (Termineinwand) set out in the Exchange Act. Instead, the Securities Trading Act will impose information duties (broadly similar to the existing--then abolished--obligationsin the Exchange Act) in respect of derivative transactions with consumers. Under the new legislation, breaches of such information duties will no longer render the relevant derivative transaction invalid, but rather subject the party in breach to liability for damages.
* Under the new legislation, derivatives will be considered to constitute 'Termingeschäfte', with that term having no precise definition and broadly interpreted to refer to transactions with some of the following characteristics (i) the opportunity to participate disproportionately in price variations with a relatively small amount of capital, (ii) the increased risk of losing the invested amount completely and
(iii) the risk of having to raise additional funds, contrary to original intentions, in order to meet obligations. Structured products will not be construed to be Termingeschäfte simply by virtue of one derivative component; each such product must be evaluated as a whole.
* The Mortgage Banks Act and the Public Mortgage Banks Act--which permit mortgage banks and public mortgage banks to engage in derivative transactions as secondary business, and not merely incidentally to other transactions, unless those derivative transactions create asymmetrical risk structures to the disadvantage of the relevant mortgage bank or public mortgage bank. A mortgage bank or public mortgage bank will now be able to include permissible derivatives, such as interest rate and currency swaps, in its cover funds for mortgage bonds (Hypothekenpfandbriefe), provided that the counterparty's claim against the bank is secured and the derivative is unaffected by the insolvency of the bank.
Of lesser substantive impact, is the adoption of the Integrated Financial Services Supervision Act on March 22, which provided for the merger of the banking, securities trading, insurance and financial services regulators on May 1. The regulator is called the Bundesanstalt für Finanzdienstleistungsaufsicht (BAFin).
In March, one of BAFin's predecessors--the Bundesaufsichtsämter für das Kreditwesen (BAKred)-- released a draft statement on the treatment of risk assets subject to synthetic securitizations under the capital adequacy rules established pursuant to the German Banking Act (the Kreditwesengesetz). The draft statement was circulated to German credit institutions and other market participants in an effort to promote industry consultation with the regulator. The BAKred had historically expressed general reservations concerning the acceptability of certain structural elements of synthetic securitizations (such as interest sub-participation) for purposes of capital relief. It had recommended prior consultation with the BAKred in respect of each synthetic securitization undertaken, but was of the impression that market participants had concluded it would no longer be necessary to involve the BAKred.
In the draft statement, BAKred indicated its intention to prepare comprehensive and generally available regulatory guidelines in relation to capital relief for synthetic securitizations. Pending these guidelines, the BAKred emphatically recommended prior consultation in respect of proposed synthetic securitizations and expressed its preliminary views on a number of structural elements of synthetic securitization transactions, which may be considered to imperil the effective transfer of risk for purposes of capital relief under the capital adequacy rules and therefore require prior discussion with the regulator, namely:
* Certain provisions permitting the removal of reference claims from a reference portfolio;
* Interest sub-participations ;
* Certain provisions permitting the early termination of a synthetic securitization structure;
* Non-standard provisions for the benefit of protection sellers.
The BAKred's draft statement clearly had the desired effect as market participants and the BAKred quickly initiated round table discussions on the subjects raised by the regulator in the draft statement. As a direct consequence of these discussions, the BAKred issued a draft checklist of requirements to be complied with by German credit institutions seeking capital relief under the capital adequacy rules through synthetic securitization structures. The draft checklist reflected an evolution in the BAKred's perspective on the troublesome aspects of synthetic securitization transactions. The process is a fluid one and, as mentioned, a definitive circular on topic is expected.
On April 12, the BAV published a draft circular (R1/2002) prescribing the requirements applicable to the investment of an insurance company's restricted assets in synthetic asset-backed securities or credit linked notes. For regulatory purposes, the assets of an insurance company fall within one of two categories: freely disposable assets and restricted assets. Restricted assets must be invested with a view to maximizing the objectives of security, profitability and risk diversification. Suitable investments for restricted assets (identified in section 54, para.1 of the Insurance Supervisory Act and the Investment Regulation) include secured debt, certain fully paid up shares and subordinated loans, certain investment fund units and certain loans.
Restricted assets may generally not be invested in derivatives pursuant to the BAV's circular (3/2000) of Oct. 19. Under circular (3/1999) issued by the BAV on Aug. 9, structured products are considered derivatives and restricted assets may only be invested in structured products if those products represent a risk comparable to the classic categories of suitable investments identified in the investment regulation. In other words, a structured product will only be considered a suitable investment for the restricted assets of an insurance company if the product contemplates a full repayment of principal and carries no obligation (on the part of an investor therein) to pay negative interest.
Synthetic ABS And CLNs
In its recent draft circular (R1/2002), the BAV has indicated that synthetic ABS and CLNs are considered to contain derivative elements and accordingly, represent suitable investments for the restricted assets of an insurance company only if the risk associated with those derivative elements is negligible. For instance, the collateral pool must exclude moveable or intangible assets (or claims related to such assets). ABS must accordingly be rated at least investment grade by one or more recognized rating agencies and the relevant collateral must be well diversified such that the default of one debtor will not trigger substantial losses (Hebelwirkung). While an insurance company's investments in ABS and CLNs may not, in the aggregate, exceed 7.5% of the guarantee fund forming part of the company's restricted assets, investments in ABS which do not meet such criteria are nevertheless permissible to a maximum of 5% of the guarantee fund. An insurance company proposing to invest in ABS or CLNs is obliged to carefully consider all risks inherent in such products, including legal and structural risks. Having once so invested, it must continue to monitor the risks of such investment and meet certain regulatory reporting requirements.
This week's Learning Curve was written by Oliver Kronat and Francesca Guolo, associates, lawyer at Clifford Chance Pünder in Frankfurt.