Prolonged trade settlement times are a thorn in the side of the leveraged loan market, and the problem has only worsened over the past several years as volume of both new issuance and secondary trading has taken off - in large part due to demand from collateralized loan obligations.
There are some recent signs of improvement, though settlement times still vary widely by agent bank.
It can take three weeks or more after a sale agreement is reached for loans to be allocated to the buyer; that compares with an average of just three days for high yield bonds. There are numerous reasons for the delay, ranging from know your customer rules for bank agents to the requirement to obtain the issuer’s consent.
The gap widened from an average of 18.3 days in 2009 to an all-time high of 23 days in 2013, according to financial data services firm Markit. This can heighten counterparty risks in funding (remember Lehman Bros.?) and reduces liquidity. Some say it has also deterred some potential investors from putting money to work in the $850 billion institutional loan market.
But data compiled by Markit show that 2014 saw the first improvement in average settlement times in six years, with the banks, mutual funds and other traders on its widely used loan settlement platform shaving the average settlement time to 21.1 days in spite of a marked increase in the number of allocated deals to 475,187 from 353,768 in 2013.According to Markit managing director Scott Kostyra, much of the improvement was attributable to the 10 firms with the fastest settlement times through Markit’s loan settlement platform. Those traders who were able to shave their average settlement times to 15.5 days, most surprisingly through more-efficient desk operations and other in-house improvements rather than through major changes to counterparty dealings. The vast majority of loan trades are settled through Markit’s platform.
“The good news is for the top 10 and the top 20 firms, what was interesting to see is that there really is the ability for these firms to be able to have impact on the settlement times on their own,” said Kostyra. Settlement times are considered most crucial to loan mutual funds that are more sensitive to liquidity risk from delayed settlements.
According to the LSTA, there were 254 funds at year’s end 2014 that controlled $141 billion in assets under management.
Although data detailing individual firm performance is considered proprietary, Markit did share that five of the top 30 firms were able to reduce times by three days or more, and 10 of the top 30 achieved double-digit percentage reduction. Three firms saw a 20% improvement in times, with the best improvement shortening settlement times by 30%.
Markit credits the firms’ focus on eliminating redundant tasks, monitoring trade performance metrics and finding ways of identifying potential delays, both within a firm and with counterparties and agents.
Still, despite the improvements, loan trade settlements at T+20 days remain far outside the norm for settlement times in other capital market trades. The median of T+13 days, as the Loan Syndications and Trading Association prefers to measure settlement times, also far lags such comparable instruments as the average T+3 settlement times for high-yield bonds.
The notional value of unsettled loan trades stood at $52.5 billion on Dec. 31, according to Markit.
The LSTA has established T+7 as the target settlement period it would like to see become the standard through the industry, as that is the time at which delayed compensation fees are enacted. Those fees provide incentives for buyers to delay settlement, of course (often deemed as “renting the balance sheet,” or gaining compensation without an outlay of new money), but there are other major factors that bring about delays.
Each firm involved in a trade must follow through with “know-your-customer” (KYC) regulations play a huge factor, in that each underwriter involved in a trade must perform due diligence on verifying client data necessary to comply with various anti-money laundering, anti-terrorist funding and other legal compliance reviews. By most accounts this is the biggest cog in the pipeline, with up to 40 different documents that must be provided per trade.
Delays are also commonly introduced before a deal settles when bank agents freeze trades in order to deal with prepayments and repayments, interest rate resets, new borrowings, or loan amendments, according to the LSTA.
Frequently borrower consent must be obtained for funds to participate in a syndication, a process that can take anywhere from 5 to 10 days, according to sources familiar with the process. Banks are often unwilling to speed up this process by applying deemed consent rights, which go into effect if a borrower fails to issue a denial or approval within a set number of days.
There is also the sheer size of the market and the increased number of players in the field. As trades grow more complex and involve more counterparties, consents and agreements must be reached across the board before funds are exchanged. “Oftentimes, what happens is that one trade is allocated to 10 funds. Maybe nine of those funds are ready to settle, but the 10th isn’t for one reason or another,” said Kostyra. “So that entire block trade, or master trade, often doesn’t settle until the last allocation is done.”
In a January newsletter, the LSTA stated that most delays could be excised with simply better workflow procedures. The trade group stated that 80% of par trades “do not settle within a T+7 time frame for no reason other than they represent traffic on a highway.’”
In 2014 the LSTA’s operations and settlement committee worked to recommend improvements in the trading trenches, and last month delivered a list of “best practices” recommendations to members to remove some of the delays and speed bumps.While those recommendations remain behind closed doors, the LSTA did note among the recommendations was to submitting KYC documentation earlier to agents and counterparties, perhaps even prior to entering into or sub-allocating a trade. “By receiving the information earlier, agents and counterparties should aim to perform the KYC, AML, credit and tax analysis, as soon as possible and in any event by no later than [seven] business days after the effectiveness of the credit agreement for primary trades and T+7 for secondary trades,” the newsletter stated.
The LSTA also floated some ideas to create for “workable unique” identifiers in trades, namely publishing the standard CUSIP numbers for loan issues in a public file by the allocation date when the credit facility is distributed by an arranger, making them more identifiable and “easily available to be used for both trading and pricing the facilities prior to when the deal actually closes.”
Given these voluntary best practices, as well as the internal improvements being noted among the most efficient trades, Markit’s Kostyra sees an opportunity to continue shortening the settlement lag time and significantly reduce counterparty risk for investors. It could also increase liquidity, with fewer funds tied up in limbo and also new types of investors entering the space.
Kostyra notes, for instance, that several clients have pitched the attractive interest rates and low default environment in loans to sovereign wealth funds, but the discussions usually end when the subject of settlement times are broached.
Fund managers might ask, “if I put half a billion in and I want to get $200 million out how long would it take?’” said Kostyra. “When the answer is two weeks to two months, it doesn’t go very far.”