Blockchain shows clubby leveraged loans a path forward

C redit

markets were given a reminder this week of how quickly liquidity can evaporate as even the most highly traded securities proved difficult to shift in the turmoil sparked by Italy’s political crisis.

Nowhere are investors more aware of that than in the leveraged loan market, where transactions can take weeks to settle. Pressure is now building for the market to adopt technology developed to run cryptocurrencies like Bitcoin as a potential way to unlock one of the most arcane corners of finance.

The leveraged loan market has grown to around US$1.2 trillion, according to LCD, S&P Global Market Intelligence. Even so, it takes 33 days on average to settle transactions in Europe, the Loan Market Association says, versus two days for most stock and bond trades. That’s restricting growth and blockchain is being touted by some participants as a potential solution.

“Slow settlement is a major deterrent to many of the investors looking at the loan market,” said Charles Bennett, managing director in European credit sales at Credit Suisse Group AG. “Technology is the answer to improving this process and blockchain looks to be in a really strong position.”

Loan market lobby groups are studying the technology’s potential impact on an industry that still depends on phone and even fax messages. The LMA recently ran a seminar that discussed how blockchain could shake up the market and the Association for Financial Markets in Europe has set up a working group looking into its possibilities. The New York-based Loan Syndications & Trading Association told members recently to “prepare for disruptive innovation”.

The market for leveraged loans, used by the riskiest companies to raise cash, is traditionally controlled by banks acting as agents between borrowers and investors. Advances in blockchain since it was adopted by cryptocurrency providers to keep a digital tally of transactions could limit the role of the so-called “golden ledger”, in which banks record the identities of loan buyers, how much they hold and deal terms. That may address the current imbalance of data and high risk of error.

MANUAL RECORDS

Lenders have to keep manual records on their holdings and the interest they’re due because they don’t have access to the agents’ data. Phone calls and emails from investors checking their records match the ledger account for about 25% of agents’ operational costs, according to consulting firm Keystone Strategy. Blockchain could enable each investor to easily keep track of where they stand.

“A lot of the delay in settling trades comes from checking that all parties agree on the same terms,” said Joseph Salerno, chief executive at fintech company Synaps Loans. “With blockchain, they know the position recorded on the ledger is the authoritative version.”

Synaps is developing a blockchain-based product that uses an algorithm to distribute loan information across a digital network of nodes or hubs, with each one hosted by a participant in the market, said Mr Salerno. The company is a joint venture between tech firm Ipreo and blockchain startup Symbiont and was tested last year with 19 firms, including Barclays Plc, State Street Corp and Wells Fargo & Co.

MORE TRANSPARENT

Rival Finastra started offering a system in late April that it developed with software firm R3 and organisations including BNP Paribas SA, HSBC Holdings Plc and State Street.

“With more transparency we can expect to see an increase in investors and more liquidity,” said Jacqueline Morcombe, who is responsible for lending sales and strategy at Finastra.

But removing kinks from an old-fashioned system may not be straightforward. Agents who earn a fee from investors for every loan trade in Europe could oppose increased automation if it reduces their profits, said David Milward, London-based head of loans at Janus Henderson Investors.

“Some banks may see the agency function as a profit centre, given the fees they’re generating, so they may resist more efficient trading,” he said.

COMPLEX TASKS

Agent banks also carry out some functions new technology can’t replace, such as know-your-customer procedures and handling borrower requests to veto certain lenders, said Beth MacLean, a money manager at Pacific Investment Management Co, which oversees $1.8 trillion, including the world’s biggest bond mutual fund.

“Until the technology can carry out those tasks, as well as more complex jobs like distributing interest and processing pre-payments, I can’t see it speeding up settlement,” she said.

Slow settlement “can be a liquidity issue” during bouts of stress, though most managers have facilities in place to compensate, said Ms MacLean.

Instead of using blockchain to distribute loan information, financial data firm IHS Markit is exploring its use to speed up cash transfers.