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CAPITAL MARKETS

Credit default swaps: Loan market waits for a transformational index

The launch of LCDX and release of Isda documentation in Europe could revolutionize risk transfer.

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.

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