The growth of loan issuance has been accompanied by a record increase in secondary market trading and the arrival of derivatives linked to these assets. Natasha de Terán explores how the market is developing.

Loan-linked derivatives – LCDSs or loan-only credit default swaps – insure investors and lenders against the probability of a borrower defaulting. Based closely on the popular credit default swap (CDS) instruments that have been credited with transforming bond market liquidity and transparency, the instruments have been widely hailed as the most exciting development to hit the loan market in years.

The excitement about the instruments is well-deserved because LCDSs should, theoretically, do much to drive the loan business forward. This is because they will help existing loan market participants to risk manage their loan exposures, and encourage a wealth of new investors into the loan market. Bank lenders will be able to use LCDSs to hedge out their loan risks accurately, instead of having to sell on loan assets, or keep them unhedged on their books. That should help lenders put on new loan business, diversify their risks and keep their borrower relationships in good shape.

In many cases, bank lenders that choose to use LCDSs as hedges will also qualify for capital relief under the new Basel II regime. Credit opportunity and hedge funds, institutional investors and structured credit specialists are meanwhile all expected to enter the loan market in greater numbers, thanks to the greater accessibility and manageability of the synthetic LCDS product. The greater involvement of these players should help to redistribute loan risks, foster secondary loan market liquidity, increase loan transparency and reduce loan pricing for borrowers.

Already there is evidence of some of this. According to Michael Gibbons, head of distressed debt at BNP Paribas, the spreads on LCDS contracts in Europe are dramatically lower than cash loan prices. He says: “This is partly because the CDSs are written on five-year tenors, while loans are typically seven or eight years in duration, but it also shows the dramatic impact these new investors are having on the loan market.”

New market, new problem

For all the instruments’ benefits, the path for LCDSs has not been clear – development of the market has been rife with controversy. This has particularly been the case in Europe, where disagreement over the finer points of the trade documentation has hindered growth.

As with all over-the-counter derivatives, the development of a robust, standardised form of documentation is pivotal to the success of LCDSs. But even today – almost 18 months after the first European loan derivatives transaction was struck – discussions continue over what European LCDS documentation should look like.

The way the documentation works today is as follows. In Europe, once a loan has been refinanced, any LCDS contracts referencing that asset are cancelled. New contracts are then negotiated, agreed and drawn up to cover any new loans. In contrast, under the International Swaps & Derivatives Association (ISDA)-sponsored US documentation, LCDS contracts remain open after a refinancing – the contracts are cancellable only if a dealer poll fails to agree on a suitable replacement obligation.

Both document types have their supporters but the split between the two camps is such that trading interest in European LCDS is one-sided: protection buyers dominate the market. This is because the protection buyers – typically bank lenders – like the documentation, while the protection sellers – hedge funds, synthetic structures and other investors – do not. The lenders quite legitimately prefer to have an exact match between the loans they have on their books and the LCDS protection they have bought; the sellers of CDS protection, meanwhile, like the simpler non-cancellable contract, and the arbitrage possibilities it provides.

Although billions of euros worth of European LCDS transactions have already been traded, the controversy and doubt over the existing documentation has discouraged many players from entering the market. Leander Christofides, head of European loan trading at JPMorgan, says: “The European document works very well insofar as it matches lenders’ assets and liabilities, but it has failed to attract speculative accounts and synthetic players due to its callability.”

Learning to compromise

In a bid to resolve this issue, key players in the European market have formed the European Loan CDS Working Group. Meeting twice weekly, the group has reached a consensus – almost all European leveraged loan market bankers had agreed that the documentation has to be changed to follow the US model more closely. But they found there would be difficulties in implementing the necessary changes.

The group’s goal was to produce a non-cancellable, reference entity-based loan CDS on the lines of ISDA’s US contract. But, as David Geen, European general counsel at the ISDA, wrote in a note sent out to the working group, this was not possible: “As a result of the relatively lower levels of public disclosure that presently exist in Europe in relation to borrowers and credit agreements, as compared with the position in the US, dealers have agreed that standardising a reference entity-based contract, that assumes knowledge by the parties of information that may not be available to parties on the ‘public’ side, will not currently be practicable.”

Instead, the dealer sub-group agreed to refine the existing European cancellable, reference obligation-based template and to discuss the potential inclusion of an option for non-cancellability following a refinancing to satisfy lenders’ interests.

Awaiting documentation

The immediate hope is that the new documentation will be in place by the middle of the second quarter and for volumes in single name LCDSs to rise strongly on the back of it. According to the head of loan trading at a European bank, a good deal of interest has already built up ahead of the new document’s roll-out: “We have spoken to 75-100 European and Asian banks, and another 200 or so investors, all of whom are ready to enter the market as soon as the new contract has been developed. In all, that means there is a phenomenal potential for the product.”

Bankers have no plans to sit on their laurels once a liquid market in single-name LCDSs has been established. Instead, they are hoping that portfolio loan credit derivatives – traded indices and synthetic collateralised loan obligations (CLOs) – will take off. Lisa Watkinson, global head of structured credit business development at Lehman Brothers, says: “The new document is important not only for encouraging more single name trading activity but also for the development of the structured business.”

Rapid response

The development of the LCDS market should affect the CLO market positively – spurring issuance of single-tranche bespoke synthetic CLOs utilising only LCDSs, as well as cash flow CLOs with buckets for synthetic assets. Once the LCDS market is fully developed, CLO managers should be able to source leveraged assets more easily, which should shorten warehousing periods and allow them to respond quickly to market opportunities.

“The development of a liquid LCDS market should make the CLO structuring process much easier, faster and more efficient. As a result, we expect to see CLO volumes increase quite sizeably,” says Ilan Hershkovitz, senior loan trader at Dresdner Kleinwort.

There are already signs that the nascent LCDS business is having a positive impact on CLO issuance. Lehman has recently pioneered a synthetic CLO programme, Aviv, in the US and, although there have not been any pure synthetic CLOS in Europe yet, several recent European CLOs have included synthetic buckets.

The other area that is slated for take-off is the index market. Last November, the European LCDS index – the 35-name, so-called LevX index – was launched by Morgan Stanley, Dresdner Kleinwort, Barclays Capital, Credit Suisse and Lehman Brothers. Interest in the index since has been robust but several key market players, including JPMorgan and Citigroup, have not been trading on it, owing to the ongoing disagreements over the underlying LCDS contracts.

Tradeable tranche market

Many expect that the LevX index will gather momentum as soon as the documentation issue is resolved later this quarter, and that, in time, the index will be expanded to include 50-100 reference names – an expansion that will in turn allow for the development of a tradeable tranche market. In the meantime, the focus is firmly planted on the US market where the 100-name LCDX index is set to launch next month.

Tom Price, managing director and head of loans at Markit, the calculation agent for both the US and European indices, says: “Trading volume in the LevX index has been higher than expected, but many potential players are still on the sidelines waiting for the non-cancellable contract. We expect liquidity to be very significant in the LCDX as soon as the index launches.”

Banking regulators and others who are worried about the abundance of liquidity, the recent surge in leveraged buyout activity and leveraged loan issuance may not see all this as a wholly positive development. But for the LCDS market and its supporters, the signs have never been more auspicious.

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