From PLI’s Course Handbook
Advanced Swaps & Other Derivatives in 2007
#11333
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introduction to U.S. LCDS and LCDX
Jennifer Grady
Richards Kibbe & Orbe
INTRODUCTION TO U.S. LCDS AND LCDX
Jennifer Grady, Richards Kibbe & Orbe
Overview of LCDS Development
•The LCDS product (Loan Credit Default Swap) is CDS (Credit Default Swap, typically used to reference unsecured bonds) tailored to the loan market
•Allows isolation and active trading of credit risk at the levered/secured level of the capital structure, without burdens of ownership of the underlying loan (e.g., no assignment or legal fees, no eligible assignee issues, electronic settlement platform)
•Two principal documents govern U.S. LCDS transactions:
–LCDS Standard Terms Supplement: published by ISDA on June 8, 2006; amended version published May 22, 2007
–Physical Settlement Rider (Rider to LCDS Standard Terms): published by LSTA on June 19, 2006; amended version published on June 18, 2007
What Is a Credit Default Swap?
•If a “Credit Event” occurs during the term of the contract in respect of a specified “Reference Entity”, Protection Buyer will have the right to deliver certain “Deliverable Obligations” of the Reference Entity to the Protection Seller in exchange for a par payment
What is a Syndicated Secured Loan?
•LCDS Standard Terms Supplement adds a new characteristic which an Obligation must satisfy in order to be deliverable.
•Definition:
–Syndicated Secured means “any obligation, including any contingent obligation to pay or repay borrowed money resulting from the funding of an unfunded commitment, (i) that arises under a syndicated loan agreement and (ii) that, on the relevant day, trades as a loan of the Designated Priority under the then-current trading practices in the primary or secondary loan market, as the case may be…”
•A trading rather than a legal standard
•“Designated Priority” is specified on a trade-by-trade basis as either “First Lien”, “Second Lien” or “Third Lien”
Determination of Syndicated Secured: Dealer Poll
•Markit Group will run periodic indicative polls of a group of specified dealers as to the universe of obligations that are Syndicated Secured in respect of widely traded Reference Entities
•Markit will list all Reference Entities and corresponding Syndicated Secured Loans on its website (called “Syndicated Secured List”) and will identify a Reference Obligation for each Reference Entity
•The Markit polling procedure will also be used to identify Substitute Reference Obligations
Optional Early Termination
•If all secured loans are paid off (e.g., unsecured refinancing after issuer upgrade) and Markit removes its list, or if a corporate event occurs resulting in the migration of the contract to a new Reference Entity that has no secured loans, the LCDS is cancelable at either party’s option after 30 Business Days (unlike standard CDS, which remains outstanding)
•Effect of cancellation:
–Protection buyer pays premium through the end of the search period
–Parties “tear-up” transaction and no further payments are due from either party
Credit Protection: Credit Events
•Bankruptcy of Reference Entity
•Failure to Pay with respect to “Borrowed Money” “Obligations”
–Obligations can be (i) direct obligations of Reference Entity, (ii) obligations guaranteed by the Reference Entity on behalf of downstream affiliates, (iii) the Reference Obligation
–Obligations are not limited to loans, includes bonds
–Failure to Pay $1mm or more
–Information issues (generally need public verification)
(Note: Restructuring is not a Credit Event in standard U.S. LCDS, but is in European LCDS)
Auction-Generated Price for Cash Settlement
•If certain conditions are satisfied, then the “cash settlement default” provides that LCDS trades will cash settle at the Final Price determined in a relevant auction run by ISDA and Markit Group. The auction procedures are based squarely on ISDA’s auction protocol that has evolved over the past few years through its use to settle high yield CDS contracts upon the Credit Events of Collins & Aikman, Delta Airlines, Northwest Airlines, Delphi, Calpine, Dana and Dura
•The auction is a hybrid of cash and physical settlement. Parties who wish to transfer ownership of the underlying loan can submit physical settlement requests and standard contracts cash settle at the Final Price
Understanding the LCDS Auction Protocol
•Dealers vote to determine whether to hold an auction on a particular Reference Entity following a Credit Event (any of the 100 Reference Entities included in the LCDX index is likely to generate an auction)
•ISDA will then publish relevant LCDS Auction Settlement Terms, which identify the terms governing the upcoming auction
•On the Auction Date, Markit Group will run an auction in accordance with the relevant LCDS Auction Settlement Terms, which involves two stages:
–Setting an initial price through submissions of bid/offer pairs and simultaneously calculating the open interest generated by participants wishing to physically settle
–Using limit orders to match the open interest and determine the Final Price
What Happens if No Auction is Held or an Auction Fails?
•If an auction is not held on the related Reference Entity or if an auction fails to generate a Final Price, the relevant LCDS Trade will physically settle pursuant to the Physical Settlement Rider
•Protection Buyer will deliver a NOPS and the parties will move to settle the trade by delivery vs. par payment
Physical Settlement: Harmonization of Two Markets
•Current state of U.S. secondary loan market:
–The documentation governing each distressed transaction is individually negotiated
–Chain of title is important and upstream review is a key component of the settlement process
–Distressed settlement timeframes are long, and T+20 remains an aspiration
•CDS Market Expectations:
–Prompt and efficient settlement is demanded by participants and regulators
–No negotiation of settlement documents
Physical Settlement Rider: Modified LSTA Settlement
•The Physical Settlement Rider was developed as an attempt to harmonize the settlement conventions in the US secondary loan market and the CDS market to allow for fast and efficient physical settlement of LCDS trades
•The key achievement of the Physical Settlement Rider is non-negotiable settlement documents
•Because there is no negotiation of documents, settlement timelines are mandated and have been significantly shortened from the current LSTA market expectations
Physical Settlement Rider: The Market Standard Indemnity
•Market Standard Indemnity: Amendment to be made to any LCDS settlement document which makes the document non-negotiable
–A new protection will be included in any Assignment, Participation, Subparticipation or Assignment of Participation document. The protection provides that Protection Buyer will hold Protection Seller harmless for any loss to Protection Seller arising from the Agreement or upstreams (documentation evidencing chain of title of the transferred loan) being inconsistent with standard market practice.
–“Standard market practice” is determined as of the Settlement Date of the Agreement and of each upstream
–This indemnity is designed to “read in” any credit-specific non-LSTA provisions
LCDX: Continuing Development in the LCDS Market
•LCDX: An LCDS index product enabling parties to exchange the credit risk underlying a portfolio of 100 equally weighted Reference Entities
• No Substitute Reference Obligations: If all secured loans of a Reference Entity are paid off, or if a corporate event occurs resulting in the migration of the contract to a new Reference Entity that has no secured loans, that Reference Entity drops out of the index after 30 Business Days and is not replaced until the next roll date
• Index rolls every six months
• Index of names is determined by a vote of the participating dealers
• Cash Settlement through the ISDA Auction Protocol in same manner as LCDS trades
•LCDX product was launched on May 22, 2007
• Trading volumes:
• $11 billion notional traded on the launch date
• $150 billion notional traded in the month of July
• $255 billion aggregate notional traded since launch
• New Developments: LCDX Tranche Product expected to be launched in the fall of 2007
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