While the current market turmoil has slowed lending volumes, the industry is still going ahead with tackling the processing inefficiencies of the secondary loan market. Writer Frances Maguire.

the requirement for custodians to process increased volumes of a relatively new asset class, secondary loans, during the past two years with no real systems in place has meant that most of the work is undertaken by telephone and fax with settlement times as high as T+30 (trade date plus 30 days).

The emergence of this new asset class of corporate loans originated by commercial banks and similar private debt began when banks started offloading some of their loans from their balance sheets as collateral to repurchase agreement (repo) transactions. The market in secondary loans has seen rapid growth in the past three years.

According to Thomson Reuters, global syndicated loans total topped $4500bn in 2007, up 13% from 2006 and 32% from 2005. Last year, the US accounted for the largest portion of activity, $2100bn, followed by the UK, with $376.3bn of deals conducted.

Concern about the slowness of the settlement of loans has been so acute, on both sides of Atlantic, that both Euroclear and the Depository Trust & Clearing Corporation (DTCC) have developed and launched services for the syndicated loan market, to enable banks to better automate processes and improve settlement times.

New asset class

Paul Bodart, executive vice-president and general manager at the Bank of New York Mellon, says that bank loans have become a new asset class for collateralisation in the expanding repo market. As a result of the financial crisis, unsecured lending is increasingly being replaced by repo, a technique of collateralised lending.

Mr Bodart says: “As a result of this development, which emerged last year, the custodians saw more worlds connected with the new asset classes and needed to deal with it. Some of our clients are either investing or trading in loans, rather than in bonds or equities. Loans are not yet a security and trading loans is not as straightforward. There is less standardisation.”

Depositories Euroclear and DTCC are trying to support this newly emerged market by first finding a way to identify the loans and the parameters defining the loan, Mr Bodart adds. “We are not yet at the stage of creating a new international securities identifying number [ISIN] for specific loans as this would lead to an explosion of the number of ISINs – just some way of identifying the loans in terms of the characteristics, such as the duration and the maturity.

“If this instrument becomes more widely traded, there will be greater standardisation to make it easier to buy and sell them.”

Euroclear and DTCC’s new services offer a central loan database where market players can manage and monitor their loan portfolio; it is also a dynamic reporting tool. It will enable loan transactions to be matched by enabling the buyer and seller to agree on the loan characteristics, quantity and price electronically by applying the principles used for bonds and equities to this new investment segment. The collateral management tools that both depositories offer will be extended to cover bank loans.

Mr Bodart says that both the custody and issuer services divisions within BNY Mellon, as a custodian, are closely involved with the development of the new services. The bank must be able to adjust its systems to receive loan instructions and match the trades, as well as from an issuer perspective.

Safer lending

To date, the process has been manual and paper based, involving a lot of documentation and telephone calls for every transaction or transfer. It is an immature market that will develop – but clearly the current financial crisis will push institutions to more safer lending and a growing use of ­collateral.

Mr Bodart says: “Players can now allocate a single code for each loan with the new system. With this, as the number of transactions increase, these transactions can be processed in a much more automated way.”

The Loan Syndication Trading Association (LSTA) in the US was instrumental in developing electronic standards to communicate between its users. In January, a working group at the Loan Market Association, made up of 20 major banks active in the loan markets, began working with a group of financial institutions to address the lack of appropriate standardisation used in the loan operations and settlement in the European market. It has launched a project seeking co-operation from system vendors. This resulted in the launch of a three-phased service provision plan by Euroclear in June.

Improving efficiencies

  Jurgen De Weghe, director of LoanReach product management at Euroclear, says that due to lower volumes in primary market loans, Euroclear clients can spend more time improving efficiencies in loan processing in their back offices.

LoanReach will be rolled out in three phases to offer greater standardisation for the end-to-end processing of loans in the primary and secondary markets. The first phase, launched in June, offered agents managing the loans a centralised database in which to input loan data that will be made visible to the syndicate. Euroclear’s service also supplies free unique identification numbers for loans, which were non-existent, as well as providing a reporting tool for agents and lenders to view operational information and improve transparency.

Last month, phase two of LoanReach offered automated reconciliation of loan-related data between the agents and the lenders. Mr De Weghe says: “This was a big issue. Interest payments are now being calculated based on what is reflected on the agents’ books; automating reconciliations are enabling mismatches between agents and lenders to be eliminated.”

He adds: “There were a lot of incorrect interest payments being made due to mis-matches, which created a lot of extra work.”

Automated trade confirmation matching for secondary market trades will also be developed by the end of the year, in a bid to remove the amount of confirmation documentation needed.

“As this is all paper-based today, it is taking 20 to 30 days to settle the trades after they had been confirmed. A market of T+30 is extremely inefficient and risky. We will replace the paperwork to the extent possible by electronic means,” says Mr De Weghe.

Euroclear will offer reconciliation both at facility and contract level from day one, and both depositories will develop agent notices. Next year, in phase three, Euroclear intends to further develop automated matching for the primary loan market and enable full delivery-versus-payment (DvP) settlement for secondary market loan ­transactions.

While the product called Loaner is being positioned globally, Euroclear’s initial focus is Europe, and it is expected that banks will use it ­primarily for US dollar loans.

Mr De Weghe says: “While the primary syndicated loan market is very well established, the secondary market has only existed for about five years, and is still small compared to the primary market. However, it is a growing market. Volumes during the past few weeks have slowed much more in the primary market than in the secondary ­market.”

Lack of automation

The immaturity of the secondary market has also been justified due to the lack of automation in trade matching, reconciliation and the inability to do DvP settlement. “Our intention is to bring the settlement cycle down to T+10,” says Mr De Weghe.

Prior to developing its service, the DTCC concluded that increasing costs and processing inefficiencies would impede the sector’s growth, and elimination of paper-based communications for reconciling loan commitments was needed to reduce the spiralling processing costs and time lags.

Christopher Childs, vice-­president of global loans product management at DTCC, says that Loaner was developed as a direct result of approaches from large agents seeking an industry-wide solution. He says: “This is a growth market that grew dramatically during a relatively short period of time, and the operational processes were starting to creak at the seams. The credit crunch has obviously had an impact in terms of volumes but the period leading up to the credit crunch was a period of absolute growth for the syndicated loan market.”

The first two services that DTCC is launching this year are for reconciliation, which is now live, and enables loan agents to compare their records of positions with those of the lenders, and a messaging service to enable electronic communication for the market. Until recently, there was no mechanism for differences to be ironed out until the point where cash was being moved and much of the communication was via fax.

DvP settlement

The DTCC aims to develop these services to enable a DvP settlement mechanism for syndicated loans in the near future. “This is not years away and could be developed as early as next year,” says Mr Childs.

According to the second-quarter statistics published by the LSTA, the average loan settlement period in the US was T+19. Mr Childs says: “There are many different reasons for delayed settlement but all of the applications we have built, and will build in the future, will have an impact on bringing this down.”

Phase one of the DTCC’s reconciliation service reconciles loans at the facility or tranche level. On some deals, which according to Mr Childs cover about 5% of US assets and about 15% of European assets, there is a need to reconcile at a level below that called the contract level, to allow matching of ­different currencies and different borrowers within the facility. DTCC will deliver contract level reconcilement in phase two.

Leading agent bank Citi has begun sending its loan data to DTCC, and the ­International Central Securities Depository (ICSD) is working with the bank to bring the lender community on board. The ICSD is also working with an advisory committee of Citi and four other leading global banks – Bank of New York Mellon, Barclays Capital, Deutsche Bank and Royal Bank of Scotland to develop Loan/SERV.

Global solution

Regarding the launch of Euroclear’s offering for loans processing, Mr Childs says the DTCC solution is intended to be global and the institutions that DTCC will deal with can use the system in the US and European ­markets. “There are regional differences but this is very much a global market, and our strategy has always been to provide global solutions,” he says.

Despite volumes diminishing due to unwinds and secondary loan prices falling due to current market conditions, custodians have now got two services to enable faster processing. In addition, some banks are taking matters into their own hands. BNP Paribas, which is testing Euroclear’s LoanReach, has just integrated a business process management system, developed by ­Pegasystems, to improve corporate loan origination and processing, which will go live in early 2009.

But while some banks have reported using the recent slowdown to improve processes, there are still several custodians that have not yet signed up for either service – perhaps waiting to see if volumes will grow again.

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Institutional loan issuance ($bn)

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