Seven days, or no pay.
That's the idea behind a new compensation policy (read "threat of penalty") meant to solve an age-old problem: slow settlements of leveraged-loan trades.
Changes will be made sometime during the second quarter in how buyers of syndicated corporate loans that are below investment grade earn interest on loans they have agreed to purchase but not yet taken possession of — also known as delayed compensation.
Perhaps the strictest change is that, if trades do not settle within seven business days, buyers will not receive any such compensation at all.
Settlement times in the $600 billion market are notoriously long, some three weeks, on average. This creates counterparty risk, and it ties up already scarce dealer liquidity.
The Loans Syndications and Trading Association has been wrestling with the problem for years. Its latest effort is designed to discourage buyers from dragging their feet. Rules that take effect shortly will require collateralized loan obligations and other buyers to show they are prepared, with cash in hand, to settle a trade within seven business days. Otherwise they risk forfeiting the accrued interest and fees they normally earn during a delay.
"The idea of this is to unleash liquidity by aligning the interests of everybody in the market, so the dealers are ready willing and able" to acquire the loans from sellers and settle with the buyers in seven business days, the LSTA's executive director, Bram Smith, said in an interview with Asset Securitization Report, a sister publication of American Banker.
As it stands, buyers of loans that are not classified as distressed benefit from a "no fault" system that pays them the interest they would have earned on the loan had it closed on time within seven business days (known as "T+7"), no questions asked. For distressed trades, delayed compensation kicks in if settlement exceeds 20 days.
Nor are buyers required under the current system to commit funds until the settlement takes place.
The onus is not entirely on buyers; the new rules will also push dealers to take possession of loans more quickly, reducing the counterparty risk to sellers waiting to remove the loans from their books.
The LSTA has been developing the new rules for more than a year. It held a final round of meetings with members in March to explain them.
Buyers may feel that the new rules will penalize them for delays that are outside of their control, such as regulatory hurdles and the lack of automated processing of trade documentation and data. Sellers and dealers, for instance, are often slowed by having to conduct "know your customer" compliance procedures, and with processing exceptions that crop up when a trader has to ensure a buyer is permitted to purchase a loan under a borrower's consent clause in the original credit agreement.
While there are still manual and paper-based processes like emails and faxes needed to complete trades, most major trading platforms already have automated systems in place to deal with many exceptions quickly, said Ellen Hefferan, senior vice president of operations and accounting at the LSTA.
One example is agent freezes, or when a trading desk halts a trade because of new issues such as increases in loan rates.
"Realistically, most of [these trades] do settle out of system," Heffernan said. "There's no reason to settle a trade on paper anymore. And the systems provide for the 'confirms' and the assignments to be executed."
Should those delays take place, the new rules provide for buyers to receive their delayed compensation, so long as they have met the qualification they are ready to settle within seven business days.
The new rules will "shield" buyers for issues "out of their control," Smith said.
He noted that settlement delays allow buyers to temporarily avoid capital charges on their purchases, boosting their liquidity.
Smith pointed to a recent study by Fitch Ratings showing that CLO managers have on average $103 invested for every $100 in assets under management, meaning, "they can always, in a sense, be overinvested."
"You won't see that anymore" under the new rules, Smith said.