The delineation and quality of any new SME covered bond-style product – potentially featuring in European Commission announcements on Thursday – will be crucial to protecting the standing of traditional instruments, delegates were told at an ICMA CBIC/The CBR conference last week.

A key issue of covered bond harmonisation that the European Commission is expected to address in the mid-term review of its wider Capital Markets Union (CMU) project is the question of eligible collateral.

In response to questions of whether covered bonds could be used to finance the SME sector, the ECBC proposed a new SME-backed product dubbed the European Secured Note (ESN). While adopting covered bond techniques, the proposed product would be distinct from the covered bond, reflecting concerns over a possible dilution of the centuries-old product.

At an ICMA Covered Bond Investor Council (CBIC) and The Covered Bond Report conference in Frankfurt on Thursday, panellists discussed the potential impact of ESNs on the wider covered bond market.

Patrik Karlsson, director, market practice and regulatory policy, ICMA, and moderator of the panel, asked if this risked the creation of a “two tier” covered bond market, including issuance backed by alternative underlying assets.

Jens Tolckmitt (pictured speaking), chief executive of the Association of German Pfandbrief Banks (vdp), said that if the preferential treatment of the “core covered bond product” is to be maintained, these covered bonds must first be ringfenced.

“This doesn’t rule out that you can use the technique of covered bonds for other asset classes,” he said. “But you would do no good to the market if you mixed both these types of covered bonds.

“So the aim of this harmonisation exercise, in the way it seems to be designed, is the creation of a two tier market – it is not a risk, it is the aim.”

Luca Bertalot, secretary general of the EMF-ECBC, suggested that the covered bond market already has two tiers, the first comprising covered bonds eligible for CRR and the second comprising all covered bonds as defined in the UCITS Directive, and said the ESN would be “something completely different”.

“Where the Commission would put these two elements – whether it would be one single package or two packages for different things – I think this is a big question mark,” he said. “We have something that has existed for centuries and we have something that doesn’t exist in the market, so it is a big question.”

However, Bertalot said he “would not be surprised” if the Commission’s proposals accommodated these three distinct levels of covered bond, based on the Commission’s “careful” approach and on discussions in the European parliament.

Tolckmitt added that it would be important that a minimum quality is assured in this new “third tier” product.

“Why am I saying that? Because one of the issues that is only partly discussed is the question of whether we need a definition of asset classes not only in the core covered bond, and maybe in the UCITS covered bond, but also of asset classes that may qualify for such a third tier covered bond,” he said. “In Germany, we are strongly in favour of such a definition.

“My personal horror, I must say, is that we end up in a situation where the national legislator or whoever can decide to put, for example, credit card receivables into covered bonds, and thereby hamper the overall asset class. I think there is a real chance that this could happen at some point in the future, if you don’t make sure that you get it right in the very beginning.”

(This article was amended after publication to reflect that the CMU mid-term review will be published on Thursday, 8 June.)