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 may bring in terms of treatment under, for example, the Liquidity Coverage Ratio. In essence, the recognition would allow some investors to hold ESNs at a lower cost of capital, increading 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 SMEs and mid-cap French companies — that offer investors recourse to both the issuer and the pool of assets backing the bonds. One of the key ways they differ from covered bonds is in the greater flexibility around what assets can be used in the collateral pool. Covered bonds are typically backed only by mortgages and loans to public sector bodies.
What this means for banks who 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 that ESNs should get the same regulatory treatment as covered bonds. It is a compelling argument but it has its down sides.
The strict conditions that govern what assets can back a covered bond may protect investors but it also limits issuers in what they can get off their balance sheet and into an ESN pool to let them 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. This is especially so now that 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 treasuries care about LCR rules. The Bpifrance deal on Tuesday went perfectly well despite the fact the bonds are subject to a 20% risk-weighting and, therefore, was of little interest to bank treasurers. 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, which was 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.
Bank treasurers are an important investor group in 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 usage 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.