The Loan Syndications and Trading Association held a small meeting last Wednesday to discuss what role it should play with regard to the total return swaps market. Recently described as the "wild west of the loan market," there are no formal guidelines across the market, but rather each bank sets its own rules by contract.
"We are trying to figure out exactly what the market wants us to do," Elliot Ganz, executive v.p. and general counsel, said. He explained the association is still trying to get its hands around the issue and it is too early to say what the next step may be. While there are a variety of issues under discussion, voting rights are front and center.
In a typical TRS, one party agrees to pay the total return of an asset to a counterparty which assumes the credit risk -- in exchange for a floating interest rate and a guaranteed spread. But the question of who controls the voting rights the initial party or the counterparty is not easily answered.
There are generally two ways voting rights are dealt with. The first is that the party offloading the risk agrees to consult with the buyer, most often a hedge fund. The second is that the hedge fund has the contractual right to direct the vote. Both options can have a lot of implications relating to accounting, taxes and in the case of a bankruptcy. It is unclear if a TRS contract has been tested by a bankruptcy.
A large belief in the TRS community is that the total return receiver, the hedge fund, should be able to control the vote because they are responsible for the performance of the underlying asset. The first party, a bank, owns the asset but the risk sits with the hedge fund. The only major risk the bank has is counterparty risk, that's why it may be less sensitive to the vote.
"We know voting rights are all over the place. It's not clear whether that is a negative thing or not," Ganz said. He stressed the association never wants to do something the market doesn't want it to do, but rather it reacts to the calls, complaints and or concerns individuals might have.
Some market participants are not sure it needs a best practices guide, but admitted that if one is being put together they want to be involved. "There is room for improvement [with TRS], but there is also room to make it worse," one dealer said. His large concern focuses on voting rights. "If they came out and said [hedge funds] couldn't have voting rights, we wouldn't do it," the dealer said. However, he said that if the LSTA was looking to make it clearer how loans are supposed to settle off of a TRS, that could be helpful. A second trader said that each bank has its own program and its own way of doing a TRS that separates it from its competitors and it should be the bank, not the LSTA, that governs that program.
The first dealer said he doesn't think a lot of people are focused on the issue right now. "None of our clients know about this. If something good comes out of it, we'll adopt it. If not, we don't. We'll do whatever the customer wants us to do," he said.
The association previously held a TRS call Sept. 6, which featured 225 people on the phone and 75 in person (CIN, 10/20).
