Bpifrance issued on Tuesday the world’s first European Secured Note, with the sale deemed a success. But where the market develops from here will depend on how regulators treat the product. Some are clamouring for regulatory recognition, but it may not be entirely desirable.
In the immediate aftermath of pricing, market experts discussed the prospect of ESN regulatory recognition and the advantages that might bring in terms of treatment under, for example, the Liquidity Coverage Ratio.
Recognition would allow some investors to hold ESNs at a lower cost of capital, increasing the buyer base and, therefore, the potential size of the market.
ESNs are a covered bond-like instrument backed by a pool of loans — in Bpifrance's case to French small and medium-sized enterprises and mid-cap companies. The notes offer investors recourse to both the issuer and the pool of assets backing the bonds.
One of the key ways ESNs differ from covered bonds is greater flexibility around what assets can be used as collateral. Covered bonds are typically backed only by mortgages or loans to public sector bodies.
What this means for banks which might buy either product is that as an unregulated instrument ESNs are subject to a 20% risk weighting, whereas tightly regulated covered bonds have a risk weighting of 10%, making the latter cheaper to own.
Some argue ESNs should get the same regulatory treatment as covered bonds. It is a compelling argument but it has its downsides.
The strict conditions that govern what assets can back a covered bond may protect investors but it also limits issuers in what they can use the instrument for, diminishing the instrument's usefulness to fund the real economy — something European Union authorities have been keen to see for years.
ESNs have more flexibility to include loans of different type and credit quality. As long as the relevant details are disclosed in the prospectus, investors can have no complaints. Helpfully, Moody's has come up with a rating methodology and fixed upon an overcollateralisation level that allows an ESN to carry, like many covered bonds, its highest credit rating of Aaa.
Secondly, only bank investors care about the Liquidity Coverage Ratio or risk weightings.
The Bpifrance deal on Tuesday went perfectly well, despite the bonds' 20% risk weighting, which made them of little interest to bank investors. Adding bank treasuries might expand the ESN investor base, but there seem to be enough buyers interested in the product for now without them.
More than 60% of Bpifrance's deal went to asset managers. The orderbook kissed €2bn before settling at €500m smaller, still twice the size of the deal. A lead manager described the demand as "strong and granular". Bank treasuries took just 15% of the bonds.
Banks are an important investor group for covered bonds but the Bpifrance deal shows ESNs can thrive without them and the regulatory recognition some people crave.
That is no bad thing. Regulatory treatment of the sort meted out to covered bonds would likely bring with it a lot of constraints on the product that it evidently does not need, limiting its use as a capital markets instrument steering funding to the real economy.
Perhaps regulation of ESNs is inevitable, but there are distinct advantages to the current, unregulated version. Issuers and investors should make the most of them before the regulators start sniffing around.