Saving the Leveraged Loan Market from Itself
The leveraged loan market has grown at an explosive rate in recent years, but the anachronistic technology it relies on for the settlement process puts sustained growth at risk. Long settlement times make the leveraged loan market illiquid and the largely manual process creates an unnecessary opportunity for massive errors and outright fraud. If the market for leveraged loans does not self-regulate, government regulation will eventually intervene and curtail recent growth.
Leveraged loans are used to finance corporate acquisitions, buyouts, and other high-risk ventures. They are typically offered by lenders to corporate borrowers who can not get traditional financing due to subpar creditworthiness. These loans are then sold to institutional investors such as hedge funds, insurance companies, and pension funds. While the leveraged loan market has grown from about $1 trillion in 2007 to more than $4 trillion, loan settlement technology has not kept pace with growth. It can take weeks or even months to settle a single trade — far too slow to properly serve this fast-growing market. This lack of liquidity makes it difficult for firms to price deals accurately and effectively hedge risk. Furthermore, the manual nature of the settlement process makes it opportune for errors and fraud to occur. Among the most notable is the Revlon incident in August 2020 where Citigroup, acting as Revlon’s loan agent, mistakenly paid off their entire $894 million loan not due until 2023 instead of making the routine $7.8 million interest payment. The end result was years of litigation and an increased awareness of the risk that wiring an average of $5.4 trillion daily poses to the banking industry. This was not an isolated incident, however. In 2016 a suspected fat-finger trade was deemed the likely culprit of a sharp and sudden decline in the value of the British Pound, while in 2015 a confirmed fat-finger trade resulted in Deutsche Bank accidentally sending $6 billion to a hedge fund client.
These problems could be solved with the adoption of a real-time electronic settlement system that utilizes distributed ledger technology to lessen the occurrence of mistakes and fraud. Unfortunately, the leveraged loan market is held hostage by loan settlement technology last updated when Friends was a television mainstay. The result is a lagging average settlement time of T+21.3 days reliant on an overly manual process involving mountains of paperwork and even fax machines. Many see these inefficiencies as a mere prelude to a repeat of the 2008 Financial Crisis that resulted in the Dodd-Frank regulations.
While some find the prospect of another financial crisis far-fetched, the recent failures of Silicon Valley Bank (SVB), Signature Bank, and Silvergate exemplify the fragility of the global economy. In fact, for many Americans, the most recent retail bank failure in memory was George Bailey’s in Bedford Falls last Christmas Eve. Bank runs are not the sort of thing that happens nowadays — or so we thought. Therefore it is much more plausible that a catalyst event for adverse regulation will befall the leveraged loan market which has attracted past headlines such as: “A Big Risk Hanging Over European Banks: Leveraged Loans”, “Wall Street Loves These Risky Loans. The Rest of Us Should Be Wary.”, and “Do leveraged loans pose a threat to the US economy?” among others.
In fact, lawmakers are not even waiting for a major macroeconomic event to trigger further regulation, in 2021 the Stop Wall Street Looting Act was introduced which, among other measures, would redefine managers of CDOs (which includes CLOs) as a specific category of “securitizers’’. This would also effectively re-impose risk retention on CLO managers, requiring them to purchase and hold 5% fair value of CLOs under their management. Fortunately, there are not enough votes for this detrimental legislation to pass. However, the same could be said in 2005 when reform of Fannie Mae was proposed in the Senate via the Federal Housing Enterprise Regulatory Reform Act of 2005 (S.190). Although this oversight regulation never became law, after the Financial Crisis of 2008 Charles W. Calomiris and Peter J. Wallison opined in the Wall Street Journal that “In light of the current financial crisis, this bill was probably the most important piece of financial regulation before Congress in 2005 and 2006”.
It was only after the housing market crashed, in part due to CDOs, that there was enough Congressional support to pass legislation limiting the activities of the banking sector and financial markets in the form of Dodd-Frank. Technology could be the preventative measure needed to waylay the next Dodd-Frank or Sarbanes-Oxley (SOX). More importantly, it could allow for the exponential growth of the industry to increase unhindered.
Forest Park’s loan settlement platform Parlake is the self-regulating solution Leveraged Finance needs to avert market-crushing regulation. Parlake utilizes the innovation of Blockchain consensus to root out mistakes and fraud while bringing loan settlement time down to T+3 days as opposed to the average of T+21.3 days. Parlake mitigates problems that have long plagued the syndicated loan industry: human error, loss of reference data, and an excess of physical documentation. All of these manual submissions within the environment can easily be manipulated by malactors creating very, very expensive problems. In addition to solving these problems, Parlake has innovative features designed to streamline efficiency including improved search functionality, seamless file sharing, automated allocation checks, the ability to add closing notes, and even a designated Portfolio Manager signing section.
These past few weeks have displayed how markets once presumed to be sound can come crashing down almost instantaneously due to improper management. Although the leveraged loan market has grown in recent years it risks succumbing to a similar fate unless it adopts cutting-edge software with the safeguards distributed ledger technology provides. Parlake is an all-encompassing solution that will allow, and even aid, the leveraged loan market to grow uninhibited by keeping public appetite for burdensome regulation low and settlement times even lower.
