Only two countries issue covered bonds eligible for discount at the Federal Reserve discount window: the U.S. and Germany. See, FRB Collateral Guidance. It is curious why German Jumbo Pfandbriefe are eligible. Although issuers from other countries have expressed an interest in having their covered bonds added to the list, the FED has indicated that there are other regulatory matters that must be addressed first. In particular, the Dodd-Frank Reform Act requires the banking authorities to dispense with the use of ratings in their regulations. The alternative to ratings developed by the FED will be a key element in determining the discount to be applied to securities delivered to the discount window, including covered bonds. Accordingly, the FED is not inclined to expand the list of securities acceptable at the discount window until this regulatory requirement is addressed.
In a significant development for Canadian issuers, RBC Covered bonds were granted eligibility at the European Central Bank. Therefore, banks located in the European Union that purchase RBC covered bonds can obtain funds from the ECB by pledging RBC covered bonds. This provides important liquidity to purchasers and enhances the value of the bonds. It is expected that other Canadian issuers will seek similar treatment. See, the story from Covered Bond Report on the development.
Eligibility at the Bank of England is more challenging perhaps. The BOE provides information on collateral that may be delivered to the BOE transparency requirementshere. See, the BOE Market Notice for covered bond eligibility requirements for specific information for covered bonds. The CMHC regulations do not require that loan level data be made available to investors. Accordingly, none of the Canadian issuers currently provide loan level data. The BOE has not indicated a willingness to waive this requirement for issuers from jurisdictions where such disclosure is not required. BOE eligibility greatly affects market accessibility in the Sterling market, but few non-U.K. issuers have chosen to qualify under the BOE requirements. For the U.K. issuers, BOE eligibility is important because of the heavy use of self-held covered bond issuances that are designed to take to the BOE.
It will be interesting to see if the Canadians are willing to go to the expense of providing loan level data just for Sterling market access. They have achieved ECB eligibility without providing such data.
What assets are eligible for U.S. banks for the liquidity coverage ratio under the U.S. implementation of Basel III is an important consideration. Unfortunately, it does not look like covered bonds will be included in that designation. See, Liquidity Coverage Ratio Impact on Covered Bonds. The U.S. proposal (Liquidity Coverage Ratio; see also High Quality Liquid Assets) excludes from the designation of eligible assets liabilities of other banks, to avoid contagion in the financial system. This is in sharp contrast to the situation in Europe (see MoFo client alert) where the debate is about whether covered bonds should be included as eligible assets for Level I or Level II. The impact on the pricing of covered bonds in the U.S. market will therefore likely be adverse compared to Europe.
The rule proposal has the following specific language on covered bonds:
The proposed rule likely would not permit covered bonds and securities issued by public sector entities, such as a state, local authority, or other government subdivision below the level of a sovereign (including U.S. states and municipalities) to qualify as HQLA at this time. While these assets are assigned a 20 percent risk weight under the standardized approach for risk-weighted assets in the agencies' regulatory capital rules, the agencies believe that, at this time, these assets are not liquid and readily-marketable in U.S. markets and thus do not exhibit the liquidity characteristics necessary to be included in HQLA under this proposed rule. For example, securities issued by public sector entities generally have low average daily trading volumes. Covered bonds, in particular, exhibit significant risks regarding interconnectedness and wrong-way risk among companies in the financial sector such as regulated financial companies, investment companies, and non-regulated funds.But see the discussion supporting covered bonds as high quality liquid assets for LCR purposes.
The TRACE system operated by FINRA has a significant impact on the secondary market for securities included in the TRACE system. The system reports trades in the secondary market, including price, size and timing, lending important transparency to those securities. In an important development arising out of the JOBS Act, FINRA is extending TRACE eligibility to securities issued under Rule 144A. This development will make virtually all covered bonds sold in the U.S. market TRACE eligible, improving both primary and secondary market pricing and secondary market liquidity. No longer is TRACE eligibility limited to SEC registered covered bonds.
The various bond indices play an important role in the market. See, for example, the Barclays Aggregate Index. Bonds that are index eligible generally will have better pricing in the primary market and better pricing and liquidity in the secondary market. Generally, SEC registered bonds are index eligible and bonds issued under Rule 144A are not eligible.