Liberty Street Economics: Active trading could drive loan standardisation

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By Flora McFarlane.

A Liberty Street Economics report analysing the US secondary loan market has found that increased trading and liquidity will potentially standardise loans.

João Santos, Federal Reserve Bank of New York & Pei Shao, University of Lethbridge

The authors, João Santos and Pei Shao, looked at the US secondary loan market, which is no longer characterised just by banks and insurance companies but a diversified set of institutional investors including loan mutual funds, hedge funds, pension funds, private equity firms, and brokers.

The diversification of types of investor has seen the average term loan attracting five different types of investors in 2013, up from just two in 1991.

“The arrival of these new investors likely boosted secondary loan market activity”, said the authors, pointing to the diversification of business models as a contributing factor to the increase in trade by investors in order to meet targets.

The trading volume in the secondary loan market swelled from US$8 billion in 1991 to US$517 billion in 2013, seeing a compound annual growth of around 20 percent.

“The new investors trade more actively, for a variety of reasons” noted the report, which include meeting liquidity needs, pursuing minimum return targets or boosting equity return through leverage.

This increase in diversity of investors was found to give rise to divergent opinions about the value of the loans, leading to “trigger trading”.

Measuring liquidity and investor diversity, the study investigated whether costs are driven down as the liquidity or security of the loan increases.

With data from 4964 term-loan-year observations between 1998 and 2012, based on figures from the LSTA/Thomson Reuters Loan Pricing Corporation, the analysis revealed that bid-ask spreads fell, consistent with the expectations of increased liquidity alongside the increase in types of loan investors.

“While our evidence points to a strong relationship between investor diversity and loan liquidity, not all investors increase liquidity”, Santos and Shao concluded.

However closer analysis revealed that the new investor types, mainly private equity firms and funds, have had a positive effect on loan liquidity, in contrast to banks and insurance companies that generally follow a buy-and-hold strategy.

“The need to cater to active trading investors will likely incentivise loan originators to standardised loans”, the authors concluded, which would lead to easier trading and resulting in more liquid market.

©TheDESK 2017
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