Rise of the Cayman Islands SPVs in credit risk transfer transactions

• Credit risk transfer (CRT) transactions let banks transfer credit risk to reduce regulatory capital while retaining assets and improving balance sheet efficiency. 

• Synthetic CRTs (via CDS or CLNs) are gaining popularity in the US, enabling risk transfer without an asset sale, often using Cayman SPVs as bankruptcy-remote vehicles. 

• Walkers has over a decade of experience advising on CRT transactions, acting for both banks and investors, across multiple transaction types.

Bank credit risk transfer ('CRT') transactions, also referred to as capital relief trades or SRT transactions (which stands for 'significant risk transfer' or 'synthetic risk transfer'), are becoming increasingly popular in the United States market. 

Although CRT trades are not new and have been used in Europe for a number of years, they are gaining more attention in the U.S. as regulators and rating agencies have recognised their benefit in stress testing models and for credit ratings. Our team has been at the forefront of the CRT market for over a decade, helping clients on both sides of CRT transactions across multiple jurisdictions. Here are some of the essentials that we can share with you that we have seen from our experience across CRT transactions of different types involving Cayman vehicles.

What are CRT transactions?

The basic idea of the CRT transaction is that the bank transfers the credit risk of a defined portfolio of assets to a third party investor in order for the bank to hold less regulatory capital under the U.S. bank capital rules.

What are the types of CRT transactions?

There are two main types of CRT transactions:

1.  'Cash CRT' – the bank sells or otherwise transfers all or a portion of the assets to a third party. That third party can be an SPV, which then issues securities to investors. This is the traditional securitisation model.
2. 'Synthetic CRT' – the bank retains ownership of the underlying portfolio but transfers the exposure through a credit derivative or a guarantee. This is often referred to as synthetic securitisation and can offer better returns to the bank as opposed to the traditional securitization model. The term 'synthetic' is used as the assets remain on the bank's balance sheet. These can either be funded or unfunded. The majority of the CRT trades we see are under the funded category i.e. they are secured by certain collateral.

 

Synthetic CRT transactions – credit default swaps to achieve risk transfer

Although a variety of different instruments can be used to achieve the risk transfer, credit default swaps ('CDS') are most commonly used. 

The Bank enters into a CDS with a counterparty in relation to a certain reference portfolio of loans. The Bank, as credit protection buyer pays a fee (usually called a 'premium') to the counterparty as credit protection seller or provider.

If a 'credit event' occurs in relation to a loan in the reference portfolio, the credit protection seller must make a 'credit protection payment' to the bank to cover the loss.

Often collateral is provided upfront to the Bank to cover any credit protection payments that may need to be made by the counterparty.

The counterparty is usually an exempted company incorporated in the Cayman Islands that is on-balance sheet but structured so as to be bankruptcy remote through the issuance of 'golden shares' to a third party service provider such as Walkers Fiduciary Limited and independent directors being appointed with the ability to block bankruptcy actions. The shareholder is often a fund established in the Cayman Islands or onshore.

Synthetic CRT transactions – credit linked notes

The Bank can either issue Credit Linked Notes ('CLNs') directly or through an SPV. 

The SPV issued CLNs work as follows:

• The SPV is normally set up as an orphan entity with all shares held by a company such as Walkers Fiduciary Limited under a declaration of trust and the board of directors also being fully independent and provided by a company such as Walkers Fiduciary Limited.

• The SPV enters into a CDS with the Bank, whereby the Bank pays a premium to the SPV as a fee for offering credit protection. The SPV also issues CLNs to investors. The proceeds of CLNs are used by the SPV as collateral for the CDS and as security in relation to principal payments on the CLNs. The proceeds are usually held by a custodian. 

• If a credit events occur under the CDS, the collateral is used to make the relevant credit protection payments to the Bank and the principal balance of the CLNs is reduced by that amount. If no credit events occur the collateral is released and used to pay the principal on the CLNs.

• The interest payments on CLNs are funded by the premium paid by the Bank under the CDS and the interest earned on collateral while it is with custodian.
  
  

The Noteholders can finance the acquisition of CLNs through a loan from another bank secured by the CLNs.

As the SPV is often based in the Cayman Islands, Walkers forms the SPV and advises on all Cayman aspects of the transaction including making sure that the SPV is in compliance with all Cayman regulatory regimes, such as AML, FATCA/CRS, economic substance, beneficial ownership and ensuring CRT transactions are not within the financial services regulatory scope. Walkers Fiduciary Limited can act as share trustee, provide directors and act as registered office and administrator of the SPV.

Why are synthetic CRT transactions becoming more popular?

For the Bank, the entry into the CRT transaction reduces the amount of regulatory capital that it will have to hold against the portfolio of assets and this cost saving outweighs the costs of funding the transactions/paying the premium. It also allows the bank to transfer the credit risk only and not all the other benefits associated with the assets as the assets remain on balance sheet. The Federal Reserve has also issued guidance in September 2023 which provides more clarity to the market on the treatment of these transactions, which is supporting interest and activity.

The arbitrage for Investors entering into CRT transactions is essentially based on the regulatory capital risk weighting of these loans not accurately reflecting the commercial realities of default risk. Viewed slightly differently, in a transaction involving a well originated loan portfolio, investors gain exposure to a pool of quality loans which they may not have the infrastructure and balance sheet to originate themselves. The hope ultimately, of course, is that the fee/premium they receive for offering capital relief will outweigh any losses they will actually suffer.

Walkers' credit risk transfer and SPVs offering

We have worked on CRT transactions of different types involving Cayman vehicles so our lawyers and fiduciary teams are very familiar with structuring and the various permutations. We have a specialist derivative team within our broader securitisation and structured finance practice, meaning that we are well placed to advise on synthetic CRT transactions. Our transaction team works closely with our Regulatory and Risk Advisory practice, which is at the forefront of the changing regulatory landscape of the Cayman Islands. We also work closely with our structured insurance practice which acts on transactions which transfer, transform or repackage risk of various kinds, including credit and default risk. 

Please contact any of the team below for more information.