Leveraged Finance: LCDS comes to Europe
The US Loan-only Credit Default Swap (LCDS) market grew from around US$2.5bn in outstanding contracts in 2005 to US$18bn last year, according to data from S&P and the Loan Syndication & Trading Association. Europe lags the US market but is set for similar growth. Donal O'Donovan reports.
In fact, Europe seems poised for a major breakthrough in LCDS.
However, there significant obstacles stand in the way of the market's development.
"Loans are much more esoteric and less standardised than bonds and that has an impact on the LCDS product," said Shane O’Gorman, a loan CDS trader at Credit Suisse in London, explaining that LCDS is a more difficult product to get right than regular CDS. "LCDS in Europe (and initially in the US) is cancellable and references a particular lien of a particular loan."
The effect is that a refinancing immediately sees CDS contracts torn up.
In 2006 the US derivatives industry manoeuvred around this obstacle by creating standard documentation containing key provisions including a limiting of credit events for the LCDS contracts to bankruptcy and failure to pay. The new contract excludes refinancing as a credit event where a substitute reference obligation is put in place with 30 days of repayment. US LCDS therefore became referenced to any equivalent loan held by the borrower entity, rather than to a specific tranche. That refinement met the desire among investors to hold a contract which is relatively free of the constant ‘orphaning’ concerns that arise because loans can be, and are, repaid at any time.
O’Gorman sees Europe moving fairly swiftly in the same direction, albeit without moving entirely to the US model. "Right now it looks like the plan is push on with a compromise whereby cancellable contracts will continue to trade alongside newer contracts with a non-cancellable clause included which has been agreed and approved by the ISDA and all the major players. The new agreed contract should give an immediate lift to liquidity and confidence in the product," he said.
As well as impacting liquidity the twin track approach would mean existing LCDS contracts could continue in place unaffected by the change, with market participants able to invest in the contract which best suits their purpose.
O’Gorman expects the increase in liquidity to bring new entrants into the market without driving out existing buyers of LCDS. "Bank loan books will continue to buy protection, particularly with Basel II creating a regulatory need to hedge risk, hedge funds and the structured community, notably synthetic CLOs will allocate into the product not least because the loan market's ratio of return to volatility is unrivalled right now," he said.
Myles Llewellyn Jones, head of secondary loan trading at ING, agreed that the current situation limited tradability: “Right now, with more sellers than buyers, the yield is from selling. There is a desire to create a more liquid/tradable product."
The development of less cancellable contracts will meet some of the concerns of potential investors but the European loan market’s own characteristic privacy is also an issue.
While the bond CDS market has grown up referencing publicly traded securities in Europe, there is no obligation on borrowers or lenders to file publicly information on loan contracts, including details of repayments or refinancing. This means information supply is limited to those on the ‘inside’ of any deal.
“The problems boil down to the difficulty of referencing a private instrument," said ING's Llewellyn Jones. "In Europe, loan agreement details are not made public in the way they are in the US. If the referenced entity is not quotable and tradable then it becomes extremely difficult to price against volatility.”
He points back to the US solution, suggesting it could be possible to trade LCDS without greater disclosure by sponsors and borrowers: “That’s a key reason US-style LCDS is preferable – if the referenced entity is broadened out then there is no need to look as closely at the loan agreement, which gets around the private information issue.”
Such a compromise would likely deter some investors, however, who would still face difficulties tracking the various credit facilities of the referenced entities.
One potential solution is use the continued development of the LCDS market to push for a culture of greater disclosure. “If transparency helps to bring pricing down through the secondary market, it creates an incentive for sponsors,” said Llewellyn Jones.
Without greater openness, the LCDS product has relatively limited appeal. Its chief usefulness will be as a hedging product for investors already in a loan. Other investors would not be in a position to play in a market where they could too easily be caught out. An LCDS market
characterised by hold only investors rather traders will not see the huge expansion witnessed in the CDS or US LCDS markets. But that potential for expansion means seller banks will continue to pursue innovations to overcome what hurdles remain.