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.
