As the number of liquidity providers to Canadian asset-backed commercial programs becomes limited, the search for alternative liquidity sources is beginning to gain ground, experts said.
"There's a limited number of players that can effectively provide liquidity," said Greg Nelson, senior vice president of structured finance at Dominion Bond Rating Service. Though the limited supply of liquidity facilities has not reached a critical point, Nelson said that market players are currently looking to find alternative sources of liquidity because "they can see that someday that may happen and they don't want there to be constraints in their business, so they're being somewhat pro-active."
In Canada, rating agencies usually require liquidity support from a financial institution equivalent to 100% of the commercial paper outstanding, to cover for a commercial paper market disruption. The liquidity support for the conduit programs usually comes from the country's top five banks: Royal Bank of Canada, Bank of Montreal, Toronto Dominion Bank, CIBC, and Bank of Nova Scotia. (National Bank of Canada, the country's sixth largest bank, recently joined the roster of Canadian liquidity providers.) However, there is a diminishing supply, driven in part by competition.
"The banks are still going to provide liquidity for their own programs but there's a reluctance to provide liquidity for competing programs," said Don Scott, executive director of the Canadian securitization group at CIBC World Markets.
Moreover, Scott added that the dominance of these financial institutions has caused other possible liquidity providers, such as U.S. banks, not to enter the market.
In the past, some Schedule 2 banks were sources of liquidity for the conduits. However, some of them have withdrawn from Canada, while others has limits as to how much they can provide.
Following the U.S.'s Lead
Canadian market players are following the U.S.'s lead in finding alternative liquidity support for ABCP conduits.
In recent months, BMO Nesbitt Burns completed the first extendible commercial paper program to be done in Canada's corporate and asset-backed market. This structure, which was first introduced in the U.S. in August 1998, effectively transferred the market disruption risk - which Canadian rating agencies have a 100% liquidity requirement for - from the financial institutions to the investor, thus eliminating the need for third party liquidity support (see ASR 4/17/00).
Also following their U.S. counterparts, Canadian market participants "have turned, though in limited amounts to date, to co-purchase agreements," said CIBC's Scott. In these agreements, the assets in the deal are syndicated by selling them to different bank conduits.
Scott noted that it is also possible to fund a component of an existing multi-seller ABCP conduit with medium-term notes that are offered through an off-the-shelf prospectus. However, he said that given the disclosure issues around multi-seller conduits, "the better option for term-market access would be to take the sellers who have larger pools of assets and have them do single-seller deals in the term market where they could get name recognition and perhaps better execution."
He added although in the past the ABCP market had been able to economically accommodate just about any deal, now, in some circumstances, it makes more economic sense to go to the term market. "One of the reasons for this is this is the increasing scarcity of liquidity," Scott said.
Participants in the Canadian ABS market are also looking at accessing foreign sources of liquidity, particularly from the U.S. The difficulty with this option involves the Canadian taxation rules, which state that payments of interest made by a Canadian taxpayer to a non-resident will, subject to certain exceptions, be subject to withholding tax
"That doesn't really amount to a serious problem because if the facility is not drawn upon, there's no interest payable and therefore no withholding tax," said Martin Fingerhut, a partner at Blake, Cassels & Graydon LLP. "To the extent that it is drawn upon, one would expect that the length of time that the draw was outstanding would be relatively short that the amount of interest that would attract the withholding tax would be relatively small. Fees paid under the facility would be subject to withholding tax, but the amount of such tax is generally taken into account in the pricing discussions."
100% Liquidity Requirement Examined
"We've had some preliminary discussions with other people in terms of whether there's a need for 100% liquidity based on duration or in terms of credit enhancement," said DBRS's Nelson.
Duration would refer to the amount of time the market disruption would occur. There's an assumption that market disruptions, even in a triple-A scenario, would be fairly short. So, for instance, if you have paper that's outstanding for 180 days, the 100% liquidity requirement is not essential until the commercial gets within a 90-day or so window of maturing. This reduces the amount of third-party liquidity that's required.
In cases where the deal is credit-enhanced and there's a market disruption event, the credit enhancement built into the deal could possibly be used for liquidity purposes.
"There doesn't seem to be that much pressure on these types of alternative liquidity," said Nelson. "For the moment it seems like most people are looking at direct extension features on the notes that are being issued."
In a related development, the current version of the Bank of International Settlements proposal contains a provision that would allow a 20% capital charge for ABCP liquidity lines.
However, there's a provision that if these lines are unconditionally cancelable and are restricted in use for market disruption - as liquidity lines in Canada are - a 0% risk weighting may still apply.