When leveraged loan credit default swaps (LCDS) were unveiled almost two years ago they were greeted with optimism. The instruments were hailed as a boon for loan book hedgers as well as a way of giving more investors a way to trade in the loan market. Although these early promises have come to fruition in the US version of the product, the European market has lagged behind.
Despite dealers’ best efforts, two years after launch the European market for single-name LCDS lacks the liquidity and volumes seen in the US. The US market has topped $52 billion in volumes but in Europe volumes are languishing at the €15 billion to €20 billion mark. Some dealers admit that even that number might be a bit optimistic.
The European leveraged loan index, the LevX, is also underperforming. The US loan index, the LCDX, which only appeared in June, is already having more success than the LevX, which launched late last year. Trading on LevX has been described as moribund, posting about €10 billion in trades.
"In the European contract there is only a small handful of dealers who have been making a market in it and for the most part they have slowed down their markets," says Leander Christofides, head of loan trading at JPMorgan in London.
Surprisingly unsuccessful
Considering hedge funds’ ever-growing interest in the loan markets it’s somewhat surprising that the contract hasn’t been more successful. "Hedge funds want loans and bank arrangers want to sell loans to hedge funds," says Michael Gibbons, head of loan CDS trading at BNP Paribas in London. "The neatest way of doing it is through the LCDS."
Undeterred by the lack of immediate success, dealers have been marketing LCDS heavily. Their efforts have not had a huge impact and the European LCDS contract continues to be met with scepticism. At Markit’s LCDS conference in May, an informal poll taken at one of the sessions showed that only a very few on the buy side were using the contract. Dealers will reluctantly admit that the state of the market is still very much trade-by-appointment and so far the LevX has been a bit of a disappointment. Publicly, however, they are still beating the LCDS drum loudly.
Dealers’ dedication to the European product could soon pay off. Volatility in the leveraged loan market, on the back of contagion from the US sub-prime mortgage market and signs of softness in the primary market, has prompted interest in single-name LCDS and the LevX, say dealers. Hedge funds, which had largely avoided the synthetic loan market, are now coming in to short LevX.
Single-name pick-up
"The single-name trades have picked up in the last two to three weeks," says Gibbons. "The single names are being pushed by cash loan holders as a way of mitigating their risk. It’s a cheap way to hedge, but not until the prices actually widened did the other side of the equation come in where there were buyers seeing LCDS as an attractive opportunity."
What’s more, the European market is long overdue a new LCDS contract, which dealers hope will attract more players into the market. In late July, the International Swaps and Derivatives Association was putting the final touches to the new LCDS contract, which aims to resolve some of the issues the dealer community feels were a hindrance to market development. Specifically, dealers blame the cancellable nature of the original European LCDS contract for its failure.
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Levx stagnates and then drops off a cliff |
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European leveraged loan index |
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Source: Markit |
"Because it’s a cancellable contract, you don’t quite get the duration," says JPMorgan’s Christofides. "But the new contract that has been agreed by all the dealers does for the first time see through a refinancing and will provide better duration yet."
As the old European contract stands, because it references a specific reference obligation instead of the reference entity, in the event of a refinancing the contract cancels. This aspect of the contract has made it unpopular with dealers and their clients because of its effect on duration. The new version of the European contract will be non-cancellable and transfer to the new loan upon refinancing. Once this new European LCDS contract starts to trade, most dealers expect volumes to begin to catch up with those in the US.
Although the new contract deals with the cancellability issues, there are some concerns surrounding how the contract will perform. There are fears that in the case of refinancing, to determine whether the new loan is eligible to replace the old one public-side traders might have to take on private information. Public-side traders would then run foul of market abuse rules.
"I have to prove that the new loan is senior secured and has similar leveraged loan characteristics," says a London-based loan trader. "The only way I can prove that is by looking at the loan agreement. If I did a trade with a hedge fund that wants to stay public on a loan because they want to trade the bonds and the unsecured CDS they have to accept private information for me and that might put him into conflict."
The private nature of the European loan market was a sticking point in the original LCDS contract – an issue that might continue to dog the new one.
"We’ve spent quite a lot of time thinking about issues of confidentiality – how information can be passed on," says David Geen, Isda’s European general counsel. "You don’t want to be doing activities that can be viewed as market abuse. And then there’s more restrictive confidentiality issues, in that the underlying loan may have terms that if you receive information in relation to it if you’re a lender, you can’t pass that on or only on to a limited range of counterparties."
The new contract provides for these confidentiality issues. It says that parties will take all reasonable steps to be able to receive information concerning the reference obligation. Some ideas for getting around the private information problem include putting in place Chinese walls or nominating people to receive the information. Geen believes these steps should take care of some problems. Even so, it might be that some counterparties still can’t, not in good faith.