Loan-only Credit Default Swaps

Loan credit default swaps (LCDS) permit both the parties to exchange the credit risk with respect to a specified loan without transferring the ownership of such loan.  The existence of such instrument in European markets, where the regulatory environment may make in certain circumstances transfer of ownership of loans a relatively cumbersome exercise, should be a welcome innovation.  However, despite strong leveraged lending activity in Europe, growth in European LCDS volumes has not kept up with the growth that we have seen in the United States.

An Loan only Credit Default System is a credit default swap (CDS) where the underlying is a syndicated secured loan rather than any other asset class (e.g. bonds (corporate or sovereign), unsecured loans, asset-backed securities, etc).  Even in the fast-growing derivatives market, this is a product which is set to have a significant impact on the financial market. An LCDS is a contractual arrangement pursuant to which one party-protection seller promises the other party to take on the risk of default– usually Failure to Pay, Bankruptcy and sometimes Restructuring - of a specified entity in respect of its obligations under an underlying asset or a portfolio of assets. Following the occurrence of a Credit Event and the satisfaction of certain pre-determined conditions, the protection seller is required to make a payment to the protection buyer in accordance with a pre-determined formula.

If the LCDS stipulates Physical Settlement - the protection seller pays an amount equal to the notional amount multiplied by the reference price which is usually 100%, against delivery by the protection buyer of an obligation with pre-determined characteristics.  If Cash Settlement is stipulated - the protection seller pays the protection buyer an amount equal to the Reference Price minus the recovery rate on the Reference Obligation following the Credit Event multiplied by the Notional Amount.  In return for the protection offered, the protection buyer promises to pay the protection seller a fixed premium at re-determined intervals up to the termination date of the LCDS (Termination Date).  It may all sound like insurance but it is not – the contract is based on a formulaic pay out on the occurrence of certain pre-determined events and does not require the protection buyer to own the assets for which protection is provided, nor to have suffered a loss.

Derivative contracts are generally concluded on the standard 1992 or increasingly the 2002 Master Agreement as amended and supplemented by a Schedule (together, ISDA Master) each as published by the International Swaps and Derivatives Association, Inc. (ISDA).  Pursuant to the terms of such ISDA Master, the parties can enter into any number of transactions each of which will be documented by a confirmation which incorporates the 2003 ISDA Credit Derivatives Definitions as amended and/or supplemented from time to time.  This sets out the specific terms of each such transaction and any amendment and/or supplements to the ISDA Master.  Template forms of LCDS documentation have been prepared for the US LCDS market and were published by ISDA on 8 June 2006.  Template forms of LCDS documentation in draft form have been prepared for the European market and were last circulated by ISDA on 2 May 2006.