Episode Transcript
Hello everyone, and welcome to another episode of LSEG Post Trade Solutions' Ahead of the Curve. I'm John Pucciarelli, I will be your host again. Synthetic risk transfers is what we're gonna be talking about today. It's been getting a lot of interest in the industry of late. Some of you who are listening to this may have seen it in industry papers, maybe some of your clients have been talking about it. It is something that has piqued our interest as well, and so we're gonna talk about that today.
If you don't know what a synthetic risk transfer is, or an SRT, which is what we're gonna probably reference to, to make it a lot easier, I have with me today, my colleague, Co-head of business development, Stuart Smith. Stuart, welcome back. Again, we've done these podcasts before. This is your first time in New York.
First time in New York. Nice to be here.
Yeah, this is the New York, version of the podcast studio, so it's, good to be here. We've done a few podcasts here.
A few, yeah.
So it's a really nice comfortable space. Hopefully you're feeling comfortable today. Synthetic risk transfers. Why don't we just jump right into it? Um, explain what they are. What, what do you mean-while we're talking about that, and we can get into the detail of how firms are using these, and then we can start diving into their purpose, their use and why it's important to us and why we're talking about it today.
Sure.
So what's an SRT?
So fundamentally, it's not a single transaction, but it's a way in which a bank is able to move some of their counterparty credit risk away from themselves and deposit that with a new investor.
And they can, for delivering that, essentially an insurance contract, they can receive back a premium, and that premium makes it worth their while to, to move this around. And that gives them more flexibility about how they run their business, which is kind of interesting, especially with some of the new constraints that banks find themselves under.
So this is, this sounds different, but it doesn't sound brand new, right? We've seen these before. Why is it becoming so significant now? I mean, it sounds like this is an insurance policy, right? I know there's capital implications. The banks are holding the risk though, yeah? And the buyers, are gaining the yield on, on whatever it is. But like, why is it significant, and can you just explain, like give us an example of a of a specific product that, you know, might, firms might be investing in now as a CRT? An SRT rather.
So probably, probably the biggest way that this is happening right now, so you're looking at banks who are issuing corporate loans. That corporate loan market is really attractive to a whole bunch of, investors who see the higher yield they can get through that-but also know it's a really tough market to get into. It's a market where you value local presence, you value local knowledge. All the infrastructure banks have built up, you know, to take on good loans and manage those good loans, that's expensive to do. That's not something a pension fund or a hedge fund really wants to invest in and do. They do find the yield attractive, though. So essentially what you're able to do is the bank is able to move part of the risk from their book to the investor, and the investor, you know, is taking that and receiving a premium from the bank every month, say, for taking on that risk. And the key thing for the bank is it reduces their RWA. So it reduces their risk-weighted assets that they then have to hold, and that is quite commonly now the limiting factor on the activity that a bank can take on. So a bank may well be in the position where they're at the limit based on what they can do based on their assets in terms of taking on more loans. So they've got corporates coming to them saying, "I've got more business for you. Can we do more business?" "No. We're done. I'm at my risk limit." They can execute one of these transactions, take that risk down, move that risk to people who wanna buy it, and then carry on doing what they're good at in issuing loans and managing them.
Okay. I mean, these sound like, CDOs of the past, and we don't wanna get into- We're not gonna compare them to what caused or potentially caused, the '08 crisis. Um, hopefully these are all lessons learned and this is really just a capital savings method for banks, right? Uh, like you said, to gain more business and, you know, for it to be attractive as a, as an investment tool for asset managers and hedge funds or even as a, as a hedging tool potentially. But how big is this market right now, and do you know, like, when it started to gain momentum? It seems like it's gaining a lot of momentum because we're hearing about them more. And I think we'll continue to hear even more about them. I don't think we're breaking ground here, but again, this is something fairly new. I know, you know, you had mentioned there was a Basel paper that was written. Yeah. But can you kind of. Like, I know I've thrown a couple things at you there, but, how big, how big is this market and, and, you know, do you know like, where, like how long it's been trading for?
So this is really a concept that became, you know, prevalent after the crisis. You know, when those, you know, charges came up for the bank, they needed these outlets. So you saw this predominantly in Europe and the UK, early days, and the US was a little bit less keen on this, so it took longer to come to fruition. Um, but really the pace has really picked up over the last four or five years.
Is that because of capital? like is it for because of further capital constraints, or do you think banks see it as, a way to- I mean, is it like all of what we've been talking about in terms of capital and opportunity, in terms of, you know, being able to finance more corporate loans, et cetera? Like is it a combo of all of that?
So I think the fact it became accepted in the US was a big deal around 2004. It allowed for big acceleration, but then also that, RWA factor is key to many banks now, and that's become the limiting factor on a large number of banks, which is, you know, driving them to look for these avenues where they can do these risk transfers. But when you look at maybe numbers, I mean, since 2016 to 2024, I think this market tripled. I think we're now looking at around about 750 billion worth of assets are backed by these kind of insurance policies. That's about 1% of the total assets held by the banks who are, you know, in this activity in North America and Europe and the UK. So this is now a pretty significant part of how banks operate and do their business, and I think that's what's piqued the interest of regulators. You know, they were kind of comfortable with the rules they put in, which maybe we can talk about, to make sure that it didn't wasn't the same as what happened in 2008, to make it a little bit safer. But the fact it's become much bigger than it was four or five years ago is just throwing out some new things that we're thinking about and new risks that maybe weren't, weren't fully understood before.
So 1% doesn't sound huge, but in, I guess, in the grand scheme of it all in aggregate, it's, it's pretty big and probably growing, right? Um, I've seen some of those numbers too. Um, you know, I guess it doesn't matter, again, to get into the, the, you know, the regulator's mind or, or to deep, deep dive into that. But, you know, we've talked about, and we'll, we'll segue into, a little bit into NBFI, non-bank- financial, intermediaries in a bit. Um, but, you know, any time they- these numbers start coming and, and it starts to creep into what they would deem significant, they're gonna start writing papers about it. They're gonna start to you know, maybe draft kind of thought pieces around it just to shed a spotlight on it, even though we're not talking about anything extremely, like, controversial here. This is, like real legitimate finance and, something that is actually beneficial for everyone involved for the most part. Obviously nothing is without risk, and we can talk a little bit about that too.
I think there's a couple of really important things that happened. So why is this not the same as, as CDOs were back in the day? Um, you know, I think a lot of lessons learned, right? So with a CDO, you could completely move that off your balance sheet as a bank, and that meant you no longer had skin in the game. So if you wrote a poor mortgage and you sold it, you were kind of protected. It wasn't your problem anymore. I think everyone acknowledged this is not- this is not the world we wanna be in. So these loans stay with the bank. They, they belong to the bank, and the bank owns them and manages them, and they have to take the first loss on any of these loan packages. So even though they've mitigated some of their risk, the first loss always sits with the bank. It's what's called the mezzanine level, the in-between amount of risk that they get, then gets sold off. That means the bank is still heavily incentivized to make sure they sign good loans with good customers and they manage them well, which is what we want banks to do.
The second thing is, is that these are real underlying assets. During the crisis, we saw a profusion of synthetics, of, of things that were derived on top of underlying assets- that made the market much bigger than it actually was in reality. Here, we're strictly talking about loans that really exist, that are out with real people. You know, this is not something that's then blowing up into something bigger than it actually is.
Yeah.
So it's very, very different situation to where we were in, in the eve of 2008, 2009.
Okay. So it's different.
Yeah.
Sounds better. Banks are. You know, they have skin in the game. They're still holding the risk. They're just not holding the capital. They're on, off-loading the capital so that they can gain more capacity to do more of this business. Um, and it sounds like, you know, it works pretty well, for the most part. What, I mean, what are some of the key risks that investors might take on when we're talking about these products? Can we talk about that?
Yeah. So I think, I mean, I love the films that look back at 2008, 2009, where they're going through the massive binders of mortgages, looking at individual mortgages and deciding which ones were good and bad. You know, it's, it's kind of the same, right? I mean, you are still buying a bundle of loans. The bank knows way more about those loans than you do, so there's a real asymmetry of information. So if you're a consumer of these things, if you're an asset manager who's buying this, you know, the onus is on you to really understand what you're buying, make sure that you've done your due diligence and you understand that, and to accept there's always gonna be an asymmetric amount of information. The bank will always know more about these products than you do. So make sure you understand that risk that you're taking on before you, you go into those transactions.
So we talk about hedge funds. Who else is taking on these risks? Who else is buying these, and is it mainly for yield and return? are they using it as just a vehicle for that, or is it other, other purposes? And are pension funds, who else?
I mean, that's, it's gotta be about yield. I mean that's the reason to take on these products.
Yeah.
You know, it's to achieve those high yields. Banks are effectively paying a premium on their funding rate to have this funded in this way because of the reduction in counterparty credit risk that they get. For the pension funds, you know, this is the kind of thing they need. They need, they need that injection of higher yield nowadays to meet their liabilities, and they have to look around for these kind of products that can do that.
Yeah. So we're talking about family offices, we're talking about pension funds, we're talking about-
I think it's specialist credit funds. But then also some of the bigger pension funds, et cetera, yeah leaning into it quite heavily.
So, we talked a little bit about lessons learned and why this is different. Um, you know, I know we've talked about NBFI, and we'll, we'll talk about that, and I think this, one of the reasons why we're talking about this topic is because it's adjacent to that.
Yeah.
It kind of adds another layer of focus onto that particular topic as well. Um, outside of what we spoke about, you know, we're talking about similarities between '08. Do you wanna dive a little bit more deeper into that, or you think you covered most of that already?
I think, I think what's, what's interesting and maybe what's similar about it is the lack of transparency. And I guess that's what a little bit has perked the interest of regulators. You know, they can now see something that's relatively large. You know, 1% doesn't sound like a big number. When you think of 1% of all assets in the world, still a chunky piece of change.
Yeah.
And they don't have a lot of transparency into how it's working, who the people who are buying them are, and how the transactions work.
Um, and therefore, you know, I think as a regulator, fundamentally looking at financial stability, there's definitely always got to be a risk there that they don't understand this. Um, so really, the, the main risk when you look at it from the bank point of view is maybe a rollover risk.
Mm-hmm. So, you know, if liquidity dries up, if assets become at a premium again, and the asset managers pull back from these deals, what happens in that situation? Um, so could the bank be left holding a loan book bigger than they can afford, and all of a sudden find that that easy access to reducing their risk is no longer open to them? And this is the classic rollover risk. And that's really the area I think regulators are kind of concerned about, and that this could turn into a place where you could see an exacerbation of a liquidity crisis. Liquidity crisis, you know, pulls back the funding, increases the demand from the bank for good assets, further draining away the liquidity.
Got it.
And I think that's the key thing that regulators are interested in and interested in getting more transparency. And I think that does link back to what we've talked about in the past around how much transparency we've got in this space.
Right. So that kind of brings us back to the NBFI talk a little bit. Really, all this is, if you put it simply, is these are not, this is I would say non-regulated areas where, where regulators in general are putting a, shining a light on, and they're looking. Like the last time we spoke, we talked about concentration. I know we've spoke about wrong way risk and a few other things. Um, but real quick, I don't want to put you on the spot. NBFI, can you just remind everyone exactly what that is? I know sometimes I hate being, like, you know, elementary and, and doing things basically- Yeah, yeah but you never know. Sometimes people are hearing this and they're like, "What's an NBFI?" So hopefully, most people know what that is who's who are listening. But just in case somebody I mean don't know what that, doesn't know what that is. So NBFI stands for non-bank financial institution.
Yeah. So really, any financial institution out there, so anyone who's not building products and selling things is, you know, focusing and dealing in money who's not a bank, is an NBFI.
Which is growing, right? It seems to be growing and growing. I've been reading, we've, we've been reading a lot of different papers and, you know, I'll give a plug to ISDA, the ISDA AGM. We're gonna be talking about that on Prime Time and on the big stage. So it's definitely a focus for, for the industry in general. And this is, this is all about, you know, what we're talking about here really is just kind of the like transfer, right? It's like capital transfer, risk transfer, over to, you know, these types of entities, and even like, I don't even know if the crypto space is part of this, but I think it is actually. Um, you know, electronic credit institutions, people who are lending money that aren't banks. I know there's been a shift back and forth between, you know, what's happened in Archegos and all these other things, but it's still persistent, and it remains, right? How do these things tie together? Does it complicate this whole discussion on NBFIs, the, these, these products at all? These SRTs?
So I guess, you know, when you're the regulator, what are you looking at? You know, nowadays, they thought they could just regulate the financial industry post-crisis by regulating the banks. These were viewed as the people who'd messed it up. Let's make them hold more money. They have a big premium, effectively, of cost in their business because they hold the public's money, and we don't want again to be in a position where we have to bail them out. That big cost that we put on those banks has then opened up this space for competitors to come in who aren't holding the public's money but are willing to do some of those services that we traditionally associate with banks. Um, so yeah, this space has grown enormously, and you've got traditional NBFI agents like pension funds. Pension funds are still pension funds. They're doing what they've always done. They're under some pressure to increase their yield. Um, but then you've got sort of a new breed of, they're swap dealers, we might call them in the US, under the SEC swap dealer rule, other firms across the globe who are filling a, a non-bank void but doing bank-like services. And a, a regulator is definitely, you know, across the globe aware of this and concerned about how that growth might affect financial stability. I think not really saying we think it is gonna affect financial stability, just saying, "You know what? We don't know."
Right.
"We've got a really good handle on the banks. We regulate those guys extremely well. We don't have the same thing in this space."
Yeah.
So now they're trying to grapple a little bit to understand what that means. What's really interesting about this piece is that it it puts a pretty direct link between the creditworthiness and the probability of survival of those entities with the banks. And if we were to see a problem in that entity space, you then have a direct link to something which the regulators care very much about, which is bank stability. And I think that's why they're quite interested to understand the size of this, the interconnectedness of this, and whether there's any circularity going on, whether there's any way in which this could form a loop that then could drive more of this business than is really needed. So it's, it is important for them to understand. I think it goes into that bigger picture of saying, "How are we going to regulate, or are we going to regulate this NBFI space? And if we do, how are we gonna do it?" Because it's really not clear how they do that. The FSB paper came out, last year. Um, a lot of open questions that sit in there around how you could implement some of the pretty radical things that they proposed within that.
Yeah, I mean, look, I'm, I'm guessing this is gonna be a topic that we're gonna continue to talk about for, for a while, especially the NBFI stuff. But this, you know, the, the synthetic risk transfer piece is, I guess sim like somewhat new to me so I wanna thank you for bringing it to my attention, because I was, you know, I found it interesting kind of just researching up and reading, reading about it. Um,In terms of, like, next steps or, you know, from your perspective, Stuart, like do you think this sounds to me like, you know, when you go from something that's opaque to something that's more transparent, to me, it always defaults to some type of reporting, some kind of disclosures, some type of regime, that is going to compel, maybe in the near future, firms to disclose or disclose more of this. I'm not aware that there is this part of the, you know, trade reporting. I don't know if this is your realm of expertise. I'll ask you anyway. I'm not aware that that's the case. Um, but if it isn't the case, I guess we can assume that that is maybe something that gets recommended next. What do you think?
I think, yeah, that's definitely the focus, right, in the papers that have come out recently, is talking about how do we increase the transparency, how do we ask people to do more reporting. There isn't the clarity that maybe there was in the past around a direct line of, this regulator will tell this person to do this, and we cover everybody. It's a little bit more messy now 'cause there are so many different entities potentially involved. But definitely transparency reporting is, is where they're looking at. I think what's really interesting, we, we've said in the past about how hard it is to be a regulator. You know, you can get all the reporting in the world, but making sense of that is, is hard work. Actually, really interestingly, agentic AI, I think, is helping some of those guys. So I think we are seeing regulators looking at that and seeing how they can make sense of some of this vast volume of data available to them. So I think a really interesting time, and I think you can, you can bet they will look for more transparency particularly into areas where you can conceive of ways that significant amounts of runway risk could exist in the industry, or direct links between different entities that could drive a liquidity crisis. These are the real hot buttons for, for regulators globally. And yeah, their answer to that is more transparency so they can apply, apply limits and controls.
Yeah. Well, SRTs definitely seem like a legitimate and growing, you know, capital optimization tool in the toolkit. Right? There's a lot of tools in the toolkit. Um, in terms of jurisdictions, like are we talking about, like, basically just Europe and the US, or is this ubiquitous? Is it across, is it in Japan? Like, do we see this in just as a global thing, or do, is it more of a US thing?
So I think predominantly was Europe and the UK was the real starting point for this.
All right. So EU and UK.
And then the US has been a little bit late to the party-
Yeah
But is, is definitely around the fastest growing area for this. Yeah, it'll be interesting once Basel III in the US comes out, which is imminent. At the time of this recording, we're recording this, it's February of 2026. I like to go back in time sometimes and look at these recordings. And I always remind myself, "You should put a date on it." Um, and we've been hearing that that's gonna, that's imminent. We keep hearing that word. Um, it'll be interesting to see if that slows this, this type of investment down, or if it accelerates it, right? Yeah we'll see. It really depends on how this all shakes out. Anything else to add to this? I mean, this is was, this has been a really interesting conversation for me, and I've definitely learned a lot, so thank you. Um, you know, is there anything else that we've missed that we wanna kinda hit before we, we close today?
No. I think that it's a definitely a space to watch. And, I think, seeing what the regulators do next with NBFI is gonna be fascinating. So let's watch this space and hope to come back in a couple months to talk about it.
Yeah, we're definitely gonna come back. We always do that. I like to kind of set, set the table, and then we're gonna come back. The last, podcast we did on, tokenization and AI, we're doing the same thing. Uh, so Stuart, thank you so much for joining me, joining us today. I really enjoyed this conversation.
Thank you so much.
Thank you.
Thank you all again for joining us here on the podcast, on Ahead of the Curve. We appreciate your time. Thanks for listening. I hope you enjoyed it. I know I did, and we'll see you again. You can find us, on Spotify, YouTube, and on lseg.com. So again, thank you for joining us, and we'll see you again soon. Thank you.
