Loan derivatives poised for explosive growth

By Paul J. Davies
Financial Times, London
Thursday, May 3, 2007

http://www.ft.com/cms/s/bd5ce25a-f9a4-11db-9b6b-000b5df10621.html

The market for derivatives of the risky corporate loans that are generally used to fund private equity buy-out deals is beginning to enjoy improving trading volumes and many are predicting that the next 12 months will see explosive growth.

The US market for default swaps on junk-rated loans -- which provide a kind of insurance against non-payment of the debt -- has seen outstanding notional volumes jump to $52.1 billion in the first four months of 2007 from $31.6 billion at the end of last year, according to estimates from Lehman Brothers.

In Europe, meanwhile, outstanding notional volumes in the same sector have only reached about €15bn-€20bn ($20.4 billion-$27.1 billion), according to Tom Johannessen of Dresdner Kleinwort.

However, Europe also has an index of loan derivatives, launched about six months ago, which on its own has generated almost €10bn worth of trades, according to Mr Johannessen.

Many evangelists for the instruments, known as loan credit default swaps, say the market is poised to witness the kind of explosive growth that has characterised other credit derivatives markets.

In Europe, however, lingering problems with documentation are still holding the market back, although many hope these issues will be put to rest soon with the release of a standardised contract from the leading derivatives trade body, ISDA.

Robert Lepone of Morgan Stanley, who has been a driving force behind the development of these derivatives in Europe, told Markit Group’s second annual LCDS conference in London this week that the new ISDA document should be ready by the end of this month.

The new contract would be non-cancellable, which means it would remain outstanding after the original individual loan it was based on had been repaid if there was another loan that could be referenced in its place, Mr Lepone said.

This would make the European market similar to the US and draw in a much broader range of players. Panellists at the conference were predicting growth over the next 12 months for the European market of between five and 10 times once the new contract was in place.

But some say other problems remain to be resolved.

"The market standard documentation supposedly coming in at the end of this month will bring other players into the market, but there are other issues," said Dagmar Kent Kershaw, head of structured credit products at Prudential M&G.

There was still uncertainty over exactly how restructurings, refinancings and credit events would be dealt with under the contracts, she said, as well as ongoing concerns about the imbalance between participants who have access to non-public company information and those who don’t.

"The market is definitely moving in the right direction on LCDS, there has been progress and there should be more soon, but we're not 100 percent of the way there yet," Ms Kershaw said.

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