Understanding SRT/CRTs
A deep dive into one of the main risk management strategies in capital markets in 2024
Credit risk transfers/significant risk transfers (CRT/SRT) trades are being increasingly recognised as a core risk and capital management tool for banks and an exciting opportunity for investors.
To be clear, CRT and SRTs mean the same thing. CRT is the prevailing term in the United States. SRT is the usual label in the European market. For simplicity, we will refer to the asset class as SRT.
SRTs are an asset class that help issuers achieve capital relief across capital markets. They involve the transfer of credit risk on a portfolio of assets – typically from a bank to a third party, non-bank investor. Very often, this will be done synthetically, i.e. replicating the economic effects of transferring the assets without actually transferring them. SRTs can also come in the form of credit derivatives or guarantees, and can be tailored to meet the needs of the bank and investor, subject to regulatory protocols.
Banks, known as issuers, benefit from capital relief because they can transfer credit risk only, rather than all risks and rewards associated with the assets, and select which tranches to transfer. For example, the credit risk of a portfolio of assets, such as mortgages or corporate loans are transferred from the original holder of the assets, known as the protection buyer, to another party, known as the protection seller.
For the bank, engaging in SRT transactions reduces the capital required to be held against possible defaults, thereby enhancing the bank’s ability to offer more loans without exceeding regulatory capital thresholds. This not only improves the bank's lending capacity but also stabilizes its financial standing by diversifying and managing risk exposure more effectively. SRTs also help to ensure adequate market liquidity.
For investors, SRTs provide a leverage opportunity: they receive a premium that they hope will outweigh any losses linked to defaults. It is also a way to diversify their holdings, and access harder-to-reach portfolios. Investors may consist of large asset managers and specialised credit funds but also include multilateral development banks and supranationals, public development funds, pension funds and insurance companies. SRTs can offer above-average returns in comparison to traditional securities investments. On average, SRTs have produced annual returns of 10 per cent in the interbank market since 2014, dwarfing the 4 per cent return for high-yield bonds across the same period. However, the risk of default (on underlying loans) by the counterparty is typically higher, with variations in asset quality underpinning the SRT bundles, which can be amplified during a tougher macroeconomic environment.
SRT is not exactly a new concept. Bank risk-sharing transactions have existed for over 20 years, but the market has witnessed significant growth in the last five years thanks to a greater adoption of the instrument by banks and more supportive regulatory developments.
European banks have typically dominated global SRT markets, with estimates suggesting that Europe accounts for roughly 85 per cent. One of the main reasons for this is because its SRT market stems from a clear and robust regulatory framework, including the EU's adoption of SRT in 2006 and the harmonized supervision by the Single Supervisory Mechanism (SSM) since 2014. As a result, Europe has been able to foster an environment of stability and efficiency in its SRT market, encouraging greater adoption. Globally, the UK has currently boasts the largest market share when it comes to issuance of SRTs (22 per cent).
In addition, the implementation of Basel III has also helped fuel demand for risk transfer transactions from European banks, due to their capabilities in providing a cost-effective method of complying with enhanced capital requirements.
In contrast, the US approach to SRTs has been less prescriptive, with regulatory uncertainty hanging over some banks for some time and leaving it further behind the European market. Issuance of SRTs in the US only really began in the second half of 2023.
However, with the enforcement of higher capital requirements under the terms of Basel III for the largest banks in the US, coupled with fresh guidance being given from the Securities and Exchange Commission in the wake of the collapse of Silicon Valley Bank, fertile ground is becoming available for banks to leverage SRTs in their risk and capital management frameworks.
As a result, there is a strong expectation among capital market participants that SRT transactions will build on the solid growth that it has experienced over the past ten years.
In fact, asset manager BlackRock is envisioning a 40 per cent year-on-year increase in SRT deals globally.
However, greater adoption of SRTs in the US and overall wider capital markets industry may be slower than hoped for.
As Frank Benhamou, portfolio manager at Cheyne Capital, explains:
Some people assume, too optimistically, that the entire US market can implement SRT immediately, but a bank’s first SRT transaction can be a resource-intensive process typically taking around nine months before being streamlined for following transactions.
Therefore, we should not expect an abrupt transaction of the US SRT market but rather a steady yet still material growth.
In addition, SRTs are typically illiquid, making it difficult for investors to exit the transaction at maturity. They are not easily tradeable across secondary markets. Many SRT deals are also club deals and negotiated bilaterally and subject to mispricing risks due to complexities involved in valuing the pool of collateralised assets that underpin the SRT. As it stands, transactions are typically conducted privately, with no universal tradeable market place available to seize upon the capital efficiencies that they can provide. This is largely due to the complexity and variety of SRT transactions that can take place as outline above.
While SRTs look set to provide huge capital benefits to banking institutions, more emphasis is currently required when it comes to driving digital transformation and improving market inclusivity and accessibility. Although technological developments are improving the efficiency, transparency and security of these transactions, and securitisation transactions more generally, more precise risk assessments, trade execution consistencies, and improved access to critical information is needed for the market’s maturity. This push for transparency and efficiency is driven by the need to build trust and stability in the market, leading to increased liquidity and more competitive pricing.