Tanuj Khosla

Private credit rightfully deserves the current buzz surrounding the asset class, given its merits. But the interest and inflows it is getting from all types of investors, including historically liquid multi-strategy macro-biased hedge funds, have taken attention away from a slightly related asset class ( some may argue that it is a subset ) – synthetic risk transfer ( SRT ).

Put simply, SRT refers to a financial transaction in which credit risk is transferred without selling the actual assets, typically through the use of credit derivatives.

Banks do SRTs primarily for capital relief. By transferring risk, banks reduce RWAs ( risk-weighted assets ), which in turn lowers capital requirements under Basel III and IV. This freed-up capital can then be used to create new loans, which can improve a bank’s return on equity. Even from a risk management perspective, SRTs help banks manage concentration risk or sector/geography exposure.

Banks facilitate SRTs mostly via a credit default swap ( CDS ).  A bank retains the loans on its balance sheet but purchases credit protection on a specified tranche of losses. Investors get premiums in exchange for taking on the risk of first losses. These investors are mostly hedge funds, private credit funds, and insurers who are looking for uncorrelated returns and trying to get some “free money” without posting any capital.

Offloading risk

The banks have a “reference portfolio”, which is a pool of loans that remains on the bank's books. From that, the “first-loss” tranche’s risk is sold to external investors via CDS or notes while the “senior tranche’ is retained by the bank.

For example, a bank has a US$1 billion corporate loan book, and it enters into a synthetic securitization. This is what may happen:

• Investors take on the first 5% of losses ( US$50 million ).
• Bank pays investors a premium for credit protection.
• If a default occurs, investors bear losses of up to US$50 million.
• The bank gets capital relief because that risk is offloaded.
• If no default occurs, investors pocket all the premiums without posting any capital.

Asian deals

Europe has been active in SRTs for many years now, with quite a few having a book size of multi-billion euros. However, if the industry grapevine is to be believed, Asian banks and Asian arms of global banks are now all set to re-embrace SRTs. ( There was a brief period after the Global Financial Crisis when they did some. )

Two recent SRT deals:

• DBS Bank in Singapore executed a synthetic SRT using CDS and insurance contracts to transfer credit risk on its trade finance book.
• Japan’s SMBC sold a US$375 million security, marking its first SRT tied to US$3 billion worth of credit lines, via private debt business development companies ( BDCs ), to Apollo and Carlyle.

There are plenty more in the pipeline. This is music to the ears of private debt players, especially big players, who, after investing hundreds of billions of dollars in private markets in the United States and Europe, are now looking eastwards for the next phase of growth and diversification. It serves as a good complement to their private credit portfolios while helping them deepen relationships with the banks that originate many of those private loans.

Perfect match

However, SRTs aren’t without their share of naysayers. Bank of England recently flagged the risk that SRTs might be misused to artificially lower capital requirements, promising closer oversight. Even the European Banking Authority cautioned about “circles of risk”, where banks may indirectly fund the credit risk they offload through SRTs – highlighting the need for transparency.

As private credit players have found out, Asia, while one continent, is an amalgamation of heterogeneous jurisdictions, each with its own idiosyncrasies and regulatory quirks. So, only time will tell what stance the banking regulator in each of these markets will take as SRTs grow bigger in this part of the world.

But for the foreseeable future, I see this as a “match made in heaven” between yield-hungry investors in private markets and aggressive banks looking to free up capital.

Tanuj Khosla is a senior trader ( credit portfolio manager ), global markets, at Louis Dreyfus Company.