Loan Market

Gone are the days of chalkies, jobbers and blue buttons pacing around a trading floor to get quotes.

Financial markets today are more automated, computerised and run on ever increasingly sophisticated application software using high level encryption and firewalls to ensure that trading platforms and networks are secure from hackers. Additionally, the back end settlement side of trading has eliminated paper and is digitised. So it would seem completely surreal to imagine a one trillion-dollar financial market operating today on merely a phone and a piece of antiquated 80s technology, the faxmachine.

Believe it or not this market does actually exist , it is known as the unregulated market for leveraged corporate loans. The issuing and trading of loans is being conducted in relatively archaic conditions and that seems odd for a market with such a massive annual turnover.

Trading on the unregulated market for leveraged corporate loans has ballooned from a turnover of a 35 billion USD in 1997 to a massive one trillion-dollar (1,000 billion) USD in just 17 years.

So let's delve into the unregulated market for leveraged corporate loans. Despite this market's spectacular growth and massive turnover, the mainstream doesn't really talk much about it and many investors are to some extent being kept in the dark about it’s workings.

The unregulated corporate loan market has been slow to adopt to new technologies and continues to operate on labour-intensive methods, manual processes and human inefficiencies with lengthy settlement times. This is partly due to the relative complexity of the asset class, according to analysts. “There are two things that make this such a unique asset class,” said Scott Kostyra, managing director and head of loan settlement at Markit. “One is the syndicated model, so the fact that you have got one bank managing all these loans across the syndicated lenders for one borrower has created a complex communication cycle. The other is that the loans are unique in a technical sense—they are floating, don’t have a fixed payment schedule and have a variable nature for repaying interest. That complexity makes it a burden to track or manage the assets from an accounting and communications standpoint.”

Trading on the loan market is laborious, time consuming and long winded. The unregulated loans market mainly involves private deals and that makes securing details challenging. Legal counsel from both sides have to sign off the trade terms. Additionally, standards are non-enforceable so each deal requires its own conditions to be thrashed-out and it needs to be agreed by each side of the legal counsel. There are unscheduled events, unscheduled pay-downs, and payments on the principal of the loan.

Since there is no clearing platform, transactions rely on the exchange of detailed documentation. While par loan documents are now largely standardised, distressed loan documents are customised and jam-packed with legalities. The outcome can be a chain of documentation issues. This means that a party eager to settle may have to wait for three others down the line.

“We are all aware of the inherent inefficiencies which exist in the loan market, especially in terms of trade settlement and the length of time it takes to settle the loans in the market,” says Alan Kennedy, head of operations for Mitsubishi UFJ Fund Services in the US.

What about moving to the manual processing system as a short term fix to the problem. Many industry experts don't believe that this would fix the problem, even if parties and counterparties agree and sign quickly, a position is not going to move on the register until the documents have all been sent to an agent and countersigned. Agent notifications mostly come in via fax and are non-

standardised, meaning a human being must trawl through the data, understandeach notification or request, and then add it to the system.

Despite the antiquated structure of the loan market, funds continue to keep pouring in from mainstream investors. Particularly, from Kansas and New York pension plans. In an era of near-zero interest rates even conservative investors are being attracted to riskier asset classes with the aim of getting decent returns on their funds. Moreover, high yield seeking investors are heavily tied up in the corporate loan market. Perhaps this explains why the trillion dollar corporate loan market has grown exponentially in less than two decades.

Last year Markit conducted a survey based on automating the loan market. Participants were asked to grade the operational efficiency around the loan trade settlements.

Votes for Excellent scored 0 percent, 9 percent for Satisfactory, 21 percent voted Needs Improving, 37 percent voted Dis-satisfactory and 33 percent believed that the system needs improving. In other words, the vast majority of traders (91 percent) are unhappy with the way business is conducted on the corporate loan market.

But what would happen to the corporate loan market in, for example, a fast market, in a rapid downturn, when everyone is rushing for the exit door at the same time, would investors (including the pension funds) get their money back at the click of a button?

“It’s a critical issue,” said Beth MacLean, a money manager at Newport Beach, California-based Pacific Investment Management Co., which oversees 1.97 trillion USD, including the world’s biggest bond mutual fund. “Any single retail fund not being able to meet their redemptions would have a ripple effect on the whole market.”

Perhaps that is no surprise, markets are so globally interconnected today, they are like one giant machine. When one critical part fails, for whatever reason, the machine just grinds to a halt.

To date, no regulators have taken responsibility for fixing the deficiency.