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The author is Sunchit Sethi, a fifth year student at National Law University, Jodhpur.
I. Understanding Synthetic Securitisation
Securitisations refer to the creation of a pool of debt securities on the basis of an existing receivable (debt instruments as assets), by selling them as a packaged security of different risk profiles (bonds) to investors. This allows the originator to get access to future cash receivables instantly, hence often referred to as a cash securitisation, and also transfers the risk of default (or credit risk) to a third party, by taking a cut on the total receivables expected from the debtor, depending on the risk percentage of that particular receivable. India has observed multiple securitisations in the recent past, and has also caught up to its western counterparts in achieving complex transactions such as Kogta’s issuance of covered bonds or OPC’s lease equipment receivable securitisation. In this regard, the Reserve Bank of India (“RBI”) issued the Master Directions on Securitisation of Standard Assets Directions, on September 24, 2021 (“2021 MD”). The 2021 MD defines synthetic securitisations, under Part B Direction 5(y), as:
“a structure where credit risk of an underlying pool of exposures is transferred, in whole or in part, through the use of credit derivatives or credit guarantees that serve to hedge the credit risk of the portfolio which remains on the balance sheet of the lender;
Explanation: The above definition does not include the use of instruments permitted to lenders for hedging under the current regulatory instructions.” (emphasis supplied)
Other important legislations are the SEBI (Issue and Listing of Securitised Debt Instruments and Security Receipts) Regulations, 2008 (“SEBI Regulations”) and the RBI’s Guidelines on Default Loss Guarantee (DLG) in Digital Lending, 2023 (“DLG Guidelines”). As can be observed, synthetic securitisations are quite complex in terms of the packaging of the different debt products of different risk profiles, creating a new tradable security out of the same, and then creating a credit derivative, which is then sold to investors, against the hypothetically created tradable security. This allows the originator to keep the assets and the risk on its balance sheet, while also relying on the fact that in the eventuality such a risk is actualised, then the hedging derivative will be activated and the originator compensated for the same. This, therefore, ultimately leads the originator to retain their assets on their balance sheet, while transferring the credit risk of default to an investor.
II. The Regulatory Conundrum
The 2021 MD prohibits the use of synthetic securitisations, under Chapter II (General requirements for securitisation), Part A (Assets eligible for securitisation) – 6(c). Mr. R Gandhi, the Deputy Governor of the RBI, discussed the evolution of securitisations in India, starting from RBI’s first step in February 2006 as a set of Guidelines on Securitisations, which were thereafter amended in May 2012. In his speech, Mr. Gandhi stated that “complex structures” such as re-securitisations or synthetic securitisations are not allowed. Though discussed in 2015, this view of synthetic securitisations applies till date, reflected even in the DLG Guidelines of 2023.
Therefore, a reasonable inference is that the RBI believes that Indian markets, or rather Indian investors, may not assess the risk value of such instruments correctly, and there would be an overture to speculative hedging, which the RBI has separately countered through Directions issued in January 2024. Additionally, Indian markets may also be supposed to not be sophisticated enough to allow for concepts which have existed for more than two decades in western markets. In a similar vein, the RBI’s belief on the Indian investor wanes, as can also be observed from its hesitation in allowing credit card receivables, or bullet repayments, to be securitised under the 2021 MD.
A key concern in this regard is fintech’s involvement in the issue of synthetic securitisations, which can allow one to observe RBI’s categorisation of synthetic securitisation. The fintech industry, especially given its under-regulation, had started a first-loss-default-guarantee arrangement (“FLDG arrangement”) between a fintech company and a bank/NBFC. Observed in 2020-21, the RBI decided to set up a Jayant Kumar Dash Committee (“Committee”) to review digital lending by lending service providers (“LSPs”). The Committee released its report as the “Report of the Working Group on Digital Lending including Lending through Online Platforms and Mobile Apps”, on November 18, 2021 (“Committee Report”). The Committee discussed the dangers of the FLDG arrangement, describing it as a Rent-an-NBFC Model. The primary issue is that unregulated LSPs, being technological platforms and ease of user access, provide more clientele to traditional banks and NBFCs. Here, the LSP underwrites a portion of the loan, which is issued and kept on the books of the partner bank/NBFC, and the LSP provides credit enhancement, such as a first loss guarantee (payment of a pre-decided percentage of the loan in the case of default by the principal borrower), while appearing, to the borrower, that the LSP has issued the loan. This allows LSPs to assume large amounts of risk without any minimum capital requirements, and without any regulatory compliances or checks. For the bank/NBFC, it has synthetically hedged its risk, similar to a synthetic securitisation, and also referred to as Shadow Lending, by the Committee. The DLG Guidelines regulates this sort of an FLDG arrangement by stating that any such arrangement which does not conform to the requirements of Paragraph 3 of Annexure of the DLG Guidelines shall be treated as synthetic securitisation. categorising the same as a synthetic securitisation, and regulates it. The Annexure provides conditions such as the maximum limits of such guarantees, as well as registration related compliances. It, however, allows for credit enhancement to be employed by the digital lenders. Credit Enhancement has been defined under the 2021 MD as below:
“credit enhancement means a contractual arrangement in which an entity mitigates the credit risk associated with a securitisation exposure and, in substance, provides some degree of added protection to other parties to the transaction so as to mitigate the credit risk of their securitisation exposure” (emphasis supplied)
From the definition above, the following characteristics of credit enhancement may be listed:
The credit enhancement supports and complements the securitisation transaction, and is in pursuance of the same (in terms of the 2021 MD).
The credit enhancement reduces the amount of risk associated with the securitisation exposure.
Being a contractual arrangement, the credit enhancement is specifically enforceable even if the underlying reference portfolio of a securitisation transaction fails, and the securitisation is a non-recourse cash securitisation.
The credit enhancement need not be offered by the same entity which originated the reference portfolio – the terms “an entity” remain sufficiently ambiguous for an FLDG arrangement, if not specifically prohibited, to have been allowed as a measure of credit enhancement.
This definition also allows sufficient scope for contracted exposures to be hedged, with the only concern being that at present, India lacks specific regulation in relation to over-the-counter (“OTC”) hedging instruments. Contrarily, in relation to exchange traded derivatives, the NSE’s Hedge Policy for Commodity Derivatives list the types of “obligations” which may be permitted to be hedged against commodities, which does not cover securitisation exposures.
The entity to which this additional safety is provided must be the one bearing some amount of exposure in furtherance to the securitisation transaction.
Therefore, the current state of synthetic securitisation, though not allowed under the 2021 MD, is one which still remains to be a matter of transaction. Ultimately, a derivative can be provided as a credit enhancement mechanism, and still not be considered as a synthetic securitisation. All that an entity needs is a brave enough bank or NBFC which can issue such derivatives, and allow the mere hedging of a risk, albeit a securitisation risk. Modern financial instruments also allow the packaging of products in a way that though the risk (by way of third-party enforcement) may be mitigated, yet it is through a secondary chain of enforcement, than primary. This means that an NBFC can package the securitisation exposure to an index, and then create a derivative based not on the securitisation exposure, but rather on the index. The index would fluctuate and reflect the valuation of the securitisation exposure, at the most a bit delayed. The said derivative would therefore not be a part of the synthetic securitisation, especially because such a structure would fall outside the concept of hedging, and simply be considered as an OTC commodity trade. This serves as only one example of how a synthetic securitisation can be carried out outside the boundaries of what’s permitted under the 2021 MD. The FLDG arrangement is proof that given the opportunity, businesses will find such loopholes and use modern financing arrangements to escape regulations and increase their risk taking capacity.
The SEBI Regulations, interestingly enough, require that the type of securitisation of which the securitised asset is being offered on the stock exchange, must be revealed in the details of the offer document, as per Schedule V of the SEBI Regulations. In fact, the requirement of “brief description of the asset pool, including asset type” uses the examples of multiple types of securitisations, which includes the (now permitted) cash securitisations, but also synthetic, balance sheet (another common term for a specific type of synthetic securitisation) and repackaging. The 2021 MD, however, have prohibited synthetic securitisations and repackaging securitisations.
III. Concluding Remarks & Suggestions
In review of of the above, it may be observed that the present status of synthetic securitisations in India remains apparent - that a transaction termed as a synthetic securitisation isn't permitted. However, the author’s primary problem remains with this very issue of RBI’s regulatory oversight, especially given the FLDG arrangement which it remedied, and didn’t prevent – terming a modern financial transaction in specific terms does not necessarily ensure that the same understanding would apply to all transactions, especially in a field where options like credit enhancement and other forms of securitisations are available. Due to this increased sophistication in the debt financial markets, it’s also important to realise the need of a specific regulator, other than the RBI, who can look after the derivatives, structured products and the like outside of those traded on the stock exchanges, which are in any case so heavily regulated that businesses often don’t exercise those options.
It may also be noted that RBI’s failure to prevent the FLDG arrangement from being exercised, for however small a period of time it may be, shows that the same lesson must be applied to synthetic securitisations and a committee be established to review the international frameworks in relation to the same. Under the European Union’s 2017/2402 Regulations, which has now since been extended to synthetic securitisations on a limited basis (pending the finalisation of regulatory technical standards), synthetic securitisations are allowed and may be employed, given that a large number of conditions and restrictions are met. India can, for the time being, adopt such standards and increase its market sophistication by also allowing synthetic securitisations in a very restricted way, and framing regulations as and when the market participants present their innovations, adaptations, and financial mechanisms.
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