The Loan Only Credit Default Swaps (LCDS) market has been an increasingly hot topic, especially as the market gears up for the launch of the LCDS Index - expected at the end of the month - marking the product's U.S. expansion.
Tim Milton, a trader in the bank loan trading group at Goldman Sachs, took time to speak with ASR sister publication Bank Loan Report last week, focusing on settlements, liquidity and the general direction of the LCDS market.
A point of discussion has been the difference between cash settlements and physical settlements in the U.S. LCDS market and which direction the market is moving. Do you see the LCDS market moving towards cash settlements in the U.S.?
The LCDS market has moved towards auction settlements, which collapses numerous bilateral settlement negotiations between dealers and customers into a single market wide auction process. Participants can choose between cash or physical settlement through the auction.
What is the current settlement structure in the U.S.?
Currently, the standard LCDS document calls for physical settlement, which intends for an underlying deliverable obligation to be exchanged. While the counterparts can agree to a cash settlement - transfer the associated net cash position instead of delivering the asset - or alternative settlement mechanisms, the current document is set up so that the fall back mechanism is physical and if not that, then cash.
Is there a time frame for when you expect auction settlements to become integrated into the market?
The auction settlement for the index will be immediate since it will be built into the contract. However, for single name credits, it is still undecided. I would estimate within the next couple of months, but that is less certain.
Where do you see liquidity trending in the LCDS market, and what types of obligations are being referenced the most?
The most liquid names are the large benchmark cash loan credits, particularly those recently issued. Also driving LCDS liquidity are credits that trade actively in the unsecured CDS market. I expect that after the index launches, the 100 credits that compose the index will become more liquid as dealers and clients replicate the index by trading the underlying single names.
The leveraged loan market seems to have endless deal volume and cash flow. But how do you see the LCDS market working out in the event of a liquidity crunch?
One of the best things that could happen in the LCDS space, something very beneficial to the growth in the unsecured market, would be a turn in the credit cycle. We have had a very positive cycle for the past three years, and a turn in that cycle would better motivate buyers of protection.
Credit events would also benefit the LCDS market, giving industry players the chance to actually walk through and test the documentation, with regards to settlement, the auction mechanism, counterpart risk and loan settlement.
Any thoughts on when a credit turn might happen?
If you look at credit curves in the unsecured space, as well as the LCDS space, the market is pricing in a deteriorating credit environment over the next two to four years.
Tim Milton will be speaking at the Loan Syndications and Trading Association's LCDS conference on May 16, 2007 in New York. He has been in the bank loan trading group at Goldman Sachs for the past year and was previously in their credit derivatives sales group. To learn more about current trends and developments in the LCDS market or to attend the conference, visit the LSTA website at www.lsta.org.
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