The purpose of the research is to give understanding what is the company law background concerning the use of mezzanine financing, how mezzanine instruments are handled from accounting and taxation perspective and how they are used in the market today. On top of that is reviewed the size of mezzanine market in relevant countries. The main focus is in Finland and comparison is done to Sweden, Estonia, USA, UK and Germany. The differences of legal frameworks and markets in relation to the discussed financing form are analysed. The research objective has been to conclude what are some of the main differences of company regulation, accounting and taxation rules and local market conditions related to the topic in question. Additionally, it is reviewed how mezzanine could be used in bank lending going forward in order to support functioning capital markets. In the review of legal background, the focus has been on company law solely. Reference to other legislation is made only if it is necessary to understand better the specific company law regulation in question. The analysis of applicable accounting rules has concentrated on the local GAAP and IFRS regulation. In the review of taxation rules is focused on thin capitalisation rules and deductibility of interest from the borrower ́s view. When reviewing the local market conditions, the attention has been given to the size of the market in terms of amount of venture capital actors, volumes of venture capital investments, number of banks and volumes of bank loans. The research is based on academic and professional literature in company law and finance. The outcome of the research is that there are significant differences in the company law, accounting rules and taxation regulation between the observed countries. There are also significant differences in mezzanine markets between the observed countries due to variation of actors and their capacity to provide financing. This influences on the availability of the mezzanine financing in general. Additionally, it can be concluded that mezzanine is a potential bank lending form. Mezzanine financing could be used especially in situations where customer does not have collateral to offer and bank would be prepared to grant financing even with traditional debt instruments. Mezzanine instruments give also additional possibilities for a bank to price the lending to reflect better the risk of the financing transactions. However, mezzanine cannot be a tool which would allow banks to step to transactions or projects which would be riskier than those transactions or projects which are financed by banks today with traditional senior debt loan instruments. It is rather a tool which would provide to banks additional alternatives to price more accurately the risks they would take anyhow.

Mezzanine Financing : A Comparison between the Finnish and International Financial Market Regulation

Author(s): Milanesi, Diana | Advisor(s): Krishnamurthy, Prasad | Abstract: In the aftermaths of the global financial crisis of 2007-2009 (GFC), policymakers and regulators around the world embarked on far-reaching reforms of the over-the-counter (OTC) derivatives market. A key element in their agenda was the introduction of central clearing mandates for OTC derivatives, which was largely driven by the belief shared among policymakers and regulators that central counterparties clearing OTC derivatives (OTC CCPs) could reduce the counterparty risk and mitigate the systemic risk associated with their trading. During the past seven years, however, the scale and complexity of the process of implementation of central clearing mandates of OTC derivatives have gradually emerged. In particular, a dawning debate has arisen around the question of how OTC CCPs may themselves generate and/or exacerbate systemic risk within the financial system. The present work investigates this question in detail. After providing some background on OTC derivatives and related financial risks, the present work examines the operations and functions of OTC CCPs, covering aspects such as novation, margins, multilateral netting and the coordinated default management process. Following this preliminary analysis, the present work discusses multiple benefits and risks of OTC CCPs and, then, investigates relationships and dynamic interactions existing among them. This risk/benefit analysis of OTC CCPs, in turn, helps gain a realistic appreciation of OTC CCPs’ systemic-risk implications. Significantly, a number of procedures and mechanisms through which OTC CCPs can generate and/or exacerbate systemic risk are identified, which include the following:• OTC derivatives trading through OTC CCPs may create excessive concentration of multiple risks into one single focal point. This reduces the possibility for diversification and may increase the probability that the failure of an OTC CCP could have system-wide destabilizing effects. Furthermore, by concentrating the risk associated with the trades being cleared, OTC CCPs may themselves become systemically important entities and their failure may expose many market participants to severe losses. • By changing the topology of the network of connections in the OTC derivatives market, OTC CCPs essentially replace one set of interconnections with another, which could be as vulnerable to systemic failures as (or even more vulnerable than) the one existing prior to the implementation of central clearing mandates. The resulting interconnected structure is, then, made even more complex by the raise of “alternative forms” of clearing of OTC derivatives, which have emerged over the past few years driven by unprecedented developments in new technologies, including blockchain and hyperledger technologies.• Rigorous margin requirements enforced by OTC CCPs may have the effect of increasing operational complexity and rigidity within the OTC derivatives market, which, in turn, may lead to a more tightly coupled financial system. In addition, as shown in the aftermaths of the Brexit vote, OTC CCPs’ rigorous margining may create pro-cyclicality problems, and in the event of large price moves it may trigger “systemic margin calls.” In such a scenario, many OTC CCPs’ members (CMs) with losing positions would be required to make large variation margin payments in a very tight frame, and would be forced to raise funds simultaneously. This rush to liquidity may, then, create severe strains for CMs with destabilizing effect for OTC CCPs, as well. Moreover, the need to raise liquidity to meet large margin calls and the need to reduce (or close) positions because of the inability to meet such calls may create tight coupling and may lead to chaotic fire sales that further exacerbate price movements. The fire sales of assets may have spillover adverse effects that go far beyond derivatives transactions to impact any institution or firm holding the assets subject to fire sales, including those that don’t have any (direct or indirect) counterparty exposure to market participants trading cleared derivatives. Last, uncertainty about the solvency of market participants may induce chaotic information contagion and further assets liquidations, which may exacerbate price volatility and may result into severe declines in trading market liquidity.• Multilateral netting and setoff through OTC CCPs change creditor priority by increasing the priority of the OTC CCP and the derivatives counterparties over other claimants on a defaulted CM. In so doing, multilateral netting and setoff through OTC CCPs essentially redistribute value from one group of creditors to other creditors and re-allocate risks of losses from one set of claimants to another. This redistributive effect may be systemically damaging if the risk is transferred to parties that are as systemically important and as vulnerable as (or even more systemically important and more vulnerable than) OTC derivatives market participants. • OTC CCPs’ loss mutualization and risk sharing mechanisms may expose OTC CCPs to problems of adverse selection and moral hazard, and may increase the opacity of OTC derivatives trading, which, in turn, may create the risk of runs on OTC CCPs in the event of default of one or more of their CMs. In addition, margining and risk-sharing mechanisms of OTC CCPs make them particularly vulnerable to wrong-way risk (WWR), thus contributing further instability.• A typical OTC CCP’s default waterfall resembles the loss allocation structure of a collateralized debt obligation (CDO) as the various levels in an OTC CCP’s default waterfall are typically accessed in sequence, much like the tranches of a CDO. As a result, the risk characteristics of the two structures may be very similar. In particular, much like senior and super-senior tranches in a CDO, the risk exposure of CMs via an OTC CCP’s default fund is heavily concentrated in terms of systemic risk and WWR and it may increase significantly during periods of large market-wide shocks, high volatility and liquidity shortage. By building on the findings of the described risk/benefit analysis of OTC CCPs, the present works examines a new approach to systemic risk-related financial regulation, which has emerged in the aftermaths of the GFC and has been inspired by chaos theory, and applies this new approach onto the OTC derivatives clearing context through a two-step analysis. First, the present work focuses on the OTC CCP’s coordinated default management process and discusses how to improve it by considering behavior aspects in the pricing and structuring of an OTC CCP’s default waterfall. In particular, the present work examines innovative designs of OTC CCPs’ pre-funded mutualized default fund(s), which can create the necessary incentives for CMs to cooperate and help the OTC CCP during the coordinated default management process by participating actively in the hedging and auctioning of the defaulted CM's positions. Second, the present work identifies and discusses additional resources and stabilizing mechanisms that could be activated in the remote (but still possible) scenario in which an OTC CCP’s coordinated default management process backfires, including contingent capital, central bank’s liquidity resources, private systemic risk insurance fund(s), third-party systemic risk insurance, and systemic risk catastrophe bonds.

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A Risk/Benefit Analysis of Central Clearing of Over-the-Counter (OTC) Derivatives and a Chaos Theory-Based Perspective on Clearing Mandates

The financialisation literature is an invaluable resource to explore the expansion
of finance in modern capitalism. However, the debate focuses on the US and the UK
extensively, whilst being too general with regard to other contexts. This inattention
hinders a proper understanding of financialisation in its di↵erential nature across
societies. To rectify such limitation, this thesis advances a theoretically controlled
and historically informed study about a striking instance of financial excess outside
the Anglo-American scenario: derivatives in Italy.
The work argues that scholars are inattentive to the heterogeneous nature of
financialisation because they conceptualise the power of finance as entrenched in
socio-economic structures. As a result, they underplay the actors who adopt financialised
practices di↵erentially. Premised on this critique, the thesis advances an
agency-centred approach that analyses power from the perspective of agents. In so
doing, it examines the diverse traits of financialisation in relation to the specific
power struggles in which actors are involved.
Drawing on this method, the work shows that financialisation studies fail to appreciate
how key social forces deployed derivatives for political-strategic purposes in
the Italian context. During the 1990s, a neoliberal-reformist alliance of pro-market
technocrats and centre-left politicians got to power and pushed for Italy to join EMU.
This project functioned as an external limit on the domestic political-economic establishment
which relied on high public debt, the vast state-owned enterprise and the
opaque corporate-governance regime. In brief, citing a slogan widely used in those
days, the neoliberal-reformist coalition attempted to make Italy a ‘normal country’
in Europe. Derivatives were crucial in this regard because they helped the Italian
government comply with the EMU admission criteria. First, reformists encouraged
hedge funds to arbitrage the interest-rate convergence between Italian and German
bonds via OTC derivatives markets. Second, they arranged a currency swap that
window-dressed the 1997 deficit.
The thesis concludes by examining how other actors adopted derivatives to deal
with the neoliberal-driven modernisation of Italy. It studies how the Agnelli family
used equity swaps to secure ownership over FIAT and how municipalities manipulated
budget restrictions through interest rate swaps.

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Deriving a normal country: Italian capitalism and the political economy of financial derivatives

We study the effect of credit default swap (CDS) on the corporate bond market. We argue that CDS, by reducing the need of investors to liquidate the bonds in the face of credit deterioration of the issuer, reduces fire sale risk and provides bond liquidity. Given that bond investors are segmented by regulation – i.e., insurance companies, banks, and pension funds are subject to the risk-based capital requirements and in principle only hold high quality assets, – we expect the liquidity provision role of CDS to be concentrated among investment grade bonds. We test this hypothesis using a comprehensive sample of US corporate bonds with CDS contracts information over the 2001-2009 period. We show that the presence of CDS reduces yield spreads and increases liquidity for investment grade bonds. This effect is stronger during the financial crisis period. We provide a proper instrumental variable identification that pins down the need for CDS contracts by exploiting the level of loan concentration of the banks which the bond issuer borrows from. We also examine two events that have been shown to trigger forced sales by bond investors: bond rating downgrades from investment grade to high yield, and the selling pressure of property insurance companies following Hurricane Katrina. In both cases, the presence of CDS contracts lowers the impact of fire sales by reducing the drop in bond liquidity and the rise in yield spreads. Our results have important normative implications, as they suggest that – at least for the class of investment grade bonds – CDS may actually help to reduce risk contagion around financial crises.

/pdf/cds-and-the-liquidity-provision-in-the-bond-market-299hxx9y0w.pdf

CDS and the Liquidity Provision in the Bond Market

This paper extends Kremens and Martin (2019) and uncovers a novel component for exchange rate predictability based on the price difference between sovereign credit default swaps denominated in different currencies. This new forecasting variable - the credit-implied risk premium - captures the expected currency depreciation conditional on a severe but rare credit event. Using data for 16 Eurozone countries, we find that the credit-implied risk premium positively forecasts the dollar-euro exchange rate return at various horizons. Moreover, a currency strategy that exploits the informative content of our predictor generates substantial out-of-sample economic value against the naive random walk benchmark.

A Credit-Based Theory of the Currency Risk Premium

Foreword ( Professor Darrell Duffie, Stanford University). Preface. Acknowledgements. About the Author. Prologue: The 2007 2008 credit and liquidity crunch: Impact on structured credit markets. PART I: Credit risk and credit derivative instruments. CHAPTER 1: Credit risk. CHAPTER 2: Credit derivatives I: Unfunded instruments. CHAPTER 3: Credit derivatives II: Funded instruments. CHAPTER 4: Credit analysis and relative value measurement. CHAPTER 5: Credit derivatives III: Applications. CHAPTER 6: Credit derivatives pricing and valuation. CHAPTER 7: Credit default swap pricing. CHAPTER 8: The asset swap credit default swap basis I: The asset swap pricing of credit default swaps. CHAPTER 9: The credit default swap basis II: Analysing the relationship between cash and synthetic markets. CHAPTER 10: Trading the credit default swap basis: Illustrating positive and negative basis arbitrage trades. CHAPTER 11: Syndicated loans, loan-only credit default swaps and CDS legal documentation. PART II: Structured credit products and synthetic securitisation. CHAPTER 12: An introduction to securitisation. CHAPTER 13: Synthetic collateralised debt obligations. CHAPTER 14: CDO valuation and cash flow waterfall models. CHAPTER 15: Synthetic conduits and credit derivative funding structures. PART III: CD-R. CHAPTER 16: Files on the accompanying CD-R. Contributing authors. Afterword: Econometrics, finance and football ... Glossary. Index.

Structured Credit Products: Credit Derivatives and Synthetic Securitisation Second Edition

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Trading the Credit Default Swap Basis: Illustrating Positive and Negative Basis Arbitrage Trades

An Introduction to Securitisation

One of the most significant challenges facing banks participating in the securitization markets is the impact that more stringent capital and liquidity requirements proposed by the Basel Committee on Banking Supervision may have on the cost to these institutions and their customers of participating in these markets in the future. Additional requirements imposed by the so-called Basel 2.5 and Basel III proposals will substantially affect the incentives of banks to securitize their own assets and to invest in securitizations. In particular, the new liquidity coverage ratio that would be imposed by Basel III could require dollar-for-dollar liquid asset coverage of bank credit and liquidity commitments to securitization structures, including asset-backed commercial paper conduits, greatly increasing the cost of providing these facilities. Further complicating the issue for U.S. banks are the Collins Amendment to the Dodd–Frank Act, which imposes a capital floor on U.S. banks at the levels required when the Dodd–Frank Act was adopted, and Section 939A of the Dodd–Frank Act, which requires the removal of credit ratings from all federal regulations, including the capital regulations. This presentation, an explanation of regulatory capital and liquidity requirements for securitizations followed by a question and answer session on Basel III and structured finance, outlines the most significant aspects of these proposals that affect securitizations.

James Croke

Papers

Structured Credit Products: Credit Derivatives and Synthetic Securitisation Second Edition

Trading the Credit Default Swap Basis: Illustrating Positive and Negative Basis Arbitrage Trades

An Introduction to Securitisation

Basel III and Regulatory Capital and Liquidity Requirementsfor Securitizations

The Credit Default Swap Basis II: Analysing the Relationship Between Cash and Synthetic Markets