What Is a Loan Credit Default Swap (LCDS)?
A loan credit default swap (LCDS) is a sort of credit derivative in which two parties trade the credit risk of an underlying loan. The form of a loan credit default swap is similar to that of a standard CDS, except that the underlying reference obligation is restricted to syndicated secured loans rather than any sort of corporate debt.
Loan credit default swaps are sometimes known as loan-only credit default swaps.
- A loan credit default swap (LCDS) enables one counterparty to trade the credit risk on a reference loan for premium payments to another.
- The overall framework of a loan credit default swap is the same as that of a standard credit default swap.
- The distinction is that the reference obligation underpinning the contract in the LCDSD can only be syndicated secured loans.
Understanding a Loan Credit Default Swap (LCDS)
In 2006, the LCDS was launched to the financial sector. The strong market for credit default swaps at the time demonstrated that there was still a need for additional credit derivatives, and the LCDS was primarily seen as a CDS with the reference obligation changing to syndicated debt rather than corporate debt. The International Swaps and Derivatives Association (ISDA) helped to standardize the contracts being used at the same time as the creation of syndicated secured loans for the purpose of leveraged buyouts was also increasing.
There are two kinds of LCDS. A cancelable LCDS, also known as a US LCDS, is often meant to be a trade product. The cancelable LCDS, as the name implies, may be canceled at an agreed-upon date or dates in the future with no penalty expenses. A non-cancelable LCDS, or European LCDS, is a hedging product that incorporates prepayment risk into its makeup. The non-cancelable LCDS continues in existence until the underlying syndicated loans are repaid in full (unless a credit event triggers it) (or a credit event triggers it).Because a US LCDS has the ability to cancel, these swaps are more expensive than equivalent non-cancelable swaps.
LCDS have a substantially greater recovery rate than CDS on bonds since the underlying assets are syndicated secured loans. 1
Loan Credit Default Swaps vs. Credit Default Swaps
These derivative contracts, like ordinary credit default swaps, may be used to hedge against the buyer’s credit risk or to acquire credit exposure for the seller. A LCDS may also be used to wager on the credit quality of an underlying firm to which the parties have no prior exposure.
The recovery rate is the most significant distinction between an LCDS and a CDS. The debt underlying an LCDS is secured to assets and takes precedence over secured loans in any liquidation proceedings, but the debt underlying a CDS, although senior to shares, takes precedence over secured loans. As a result, the better the quality of the reference obligation for an LCDS, the higher the recovery value if the loan fails. As a consequence, an LCDS often trades with narrower spreads than a standard CDS.
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