Loan market dealers seem confident that the settlement issues that have dogged the US loan credit default swap (LCDS) market have been sufficiently addressed to allow the launch of the long-awaited LCDX index in the US this month. Europe launched its LCDS index – LevX – in November 2006 but so far unresolved issues surrounding documentation have meant that there has been relatively little liquidity.
The LCDS market has developed differently in the two regions, largely because of differences in what the markets wanted from the product. In the US, where there are large numbers of hedge funds and institutional buyers in the loan market, there was demand for a trading product and contracts were, therefore, non-cancellable. In Europe, where the market is still dominated by the banks, the desire was for a hedging product, and therefore one that was cancellable. In the US credit events are limited to bankruptcy and failure to pay and the CDS contract is linked to the reference entity, therefore any loan written by the entity is deliverable into the CDS. In Europe, LCDS is a reference obligation – not entity – product.
But in both markets concerns about how contracts are actually settled have been the overriding factor. Delays to physical settlement of LCDS contracts are common, partly because if the protection buyer owns the asset they can be incentivized to delay payment. In the US, the development of the physical settlement rider has solved the problem. "We came up with a compromise to force the protection buyer to close the loan," explains Dan Kamensky, senior vice-president at Lehman Brothers, at the recent LTSA conference in London. "This involves delayed compensation whereby the protection buyer has 30 days [after a notice of physical settlement (NOPS)] to find the loan. If it does not, the protection buyers has to pay interest to the protection seller to make [the protection buyer] move to settlement as quickly as possible." After 90 days the compensation increases by 10%. "This has not been tested yet but a lot of thought has gone into it and it will force the market to settle quickly," says Kamensky.
|
Leveraged loan vs LCDS growth comparison |
 |
|
Source: S&P/LTSA Levered Loan index, Lehman Brothers |
Because so many more loans in the US are publicly rated the determination of where tranches trade (whether they are first, second or third lien) is a trading standard, not a legal standard. This is done via a poll. A similar dealer poll mechanism has been put in place for the LCDX index, whereby only reference entities that are included in a syndicated secured list will be eligible to be included in the index. This list is drawn up by dealers, which designate the reference entity as first, second or third lien. If the loan is refinanced, a second poll will be undertaken to redesignate it.
Anecdotal evidence from some US banks indicates that LCDS volumes are approaching 70% of loan volumes, so when LCDX gets off the ground it should become very liquid very quickly. Once Isda documents are finalized in Europe, it is hoped that liquidity will increase in LevX as well. "LevX has brought people to the table to negotiate a single contract and will massively benefit liquidity upon introduction of the Isda confirmation," reckons Simon Richards, chief investment officer, fixed income, at RAB Capital in London.
The investor bases in the index products and the underlyings will remain discrete – with banks and CLOs buying loans and hedge funds buying LCDS – but liquidity, and volatility, in both will increase. Even more so if the indices converge. "Will the products converge? At some point – yes," noted Ian Sandler, executive director, senior bank debt sales and trading at Morgan Stanley during the LSTA conference. "Will it happen in the next year or two? Without a doubt – no."