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One definition?

16 March 2016
Richard Kemmish

The covered bond market could be characterised as a large, complex  venn diagram, the circles mainly but not quite totally overlapping. Aircraft pfandbrief excluded here, lower rated bonds there, non-EEA issuers in a third place. But the vast majority of bonds conform to the vast majority of the definitions.

The main explanation for the lack of overlap between these definitions is historical; the definition in UCITS is very old and very basic, the definition in the capital directive is more modern and more proscriptive, the definition for high quality liquid asset purposes brand new and highly detailed.

Should Commission attempt to standardise these definitions? Presumably – on the basis that regulations never get more lax over time - they would do this by taking the most recent and most stringent definition and applying it across all of the older directives, regulations and technical standards.  This may yet be an outcome of the current Commission thought process.

It would certainly make life easier. Harmonisation is good for its own sake, it makes the life of investors easier. But it also contributes to market stability. If any given covered bond meets criteria A but not criteria B inevitably it will appeal to one class of investors rather than another. Whenever the ‘bio-diversity’ of an investor base decreases, volatility increases. A diverse investor base was key to the liquidity performance of covered bonds through the crisis.

On the other hand, we should not forget that the definitions that do exist currently do so for different reasons. One exists in a set of rules designed to mitigate credit risk, another to manage portfolio concentrations, yet another to guarantee the availability of liquidity. 
What metrics should be part of a common definition? Legal safeguards and eligible assets for sure. But what about minimum credit rating, size or liquidity characteristics? I foresee a risk that existing issuers, most of whom have high levels of liquidity and credit, will insist that high levels of liquidity and credit should be a criteria for membership of the club. Covered bonds in the newer jurisdictions, most of whom are smaller and most of whom are worse rated than existing issuers could effectively be excluded, no matter how much effort they put into developing a state of the art covered bond law and set of regulations. 

Not all of the definitions are owned by Commission of course. But those which aren’t, such as the rules for inclusion in a covered bond index, or in a central bank repo facility are, presumably heavily influenced by Commission’s definition. Arguably for some purposes the definitions become self-fulfilling. Most obviously, a covered bond is liquid if it is an eligible asset for liquidity purposes. Less obviously a covered bond is more likely to benefit from external support if it is characterised as meeting certain credit based criteria. 

Exclusion from the club by an inappropriate definition of the rules of entry can have far reaching implications for the future development of the market. 

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