Loan Market Automation: The Route to Operational Excellence

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1 Loan Market Automation: The Route to Operational Excellence Continued growth in the loan market spurs the need for innovation and integration across systems A MARKIT WHITEPAPER FEBRUARY 2014

2 Introduction With loan issuance reaching a record high of $565 billion to top the $535 billion record previously set in 2007 (Source: S&P Capital IQ/LCD) and total leveraged loan outstanding at $1.3 trillion as of December 2013 (Source: Markit, Figure 1), market activity signals that growth in the loan market will continue. In addition to creating new opportunities, this growth will also pose new challenges and increased operational risk for market participants as they will need to manage rising data volumes and trading activity. Figure 1: Total leveraged loan outstanding 1,600bn 1,400bn 1,200bn 1,000bn 800bn At the 2013 Markit Loan User Conference, representatives from across the industry took part in a series of polling questions (Figure 2). Based on their responses, this paper assesses their perception of current market trends and how those trends are impacting market participants. Figure 2: Poll respondents (82 total) 24% Banks 9% Fund administrators 16% Hedge fund 10% Insurance company 4% Other 38% Money management and investment firms \ 2

3 Among poll respondents, an overwhelming 84% agreed that the loan market will continue to see growth over the coming year and a half, though they were split on whether the current pace of growth will persist (Figure 3). Despite the recent and potential upcoming growth in the market, manual processes are still pervasive, resulting in inefficiencies that could become even more inefficient as growth continues. Technology and new innovations can help participants keep up with the size of the market, and this paper will explore solutions that can deliver greater efficiency, in terms of speed, flexibility and costs, to participants across the loans market. Figure 3: Outlook on leveraged loan market growth over the next months 36% Pedal to the metal, more of the same 48% Pace slows, but growth continues 12% Slight decrease, too difficult to sustain growth 4% Major macro shift or regulation results in a large decline Growth in the loans market Growth appears to be driven primarily by the hunt for yield as well as by uncertainty around interest rates (Figure 4). While decreasing interest rates in recent years have been rewarding bondholders, investors are now expecting a reversal of this trend and are bracing for a rise in interest rates. Figure 4: Factors driving the loan market 13% 40% 17% 4% 11% 14% 1% Monetary policy Chasing yield Interest rate risk Diversification New investors entering the market Senior secured and high recovery rate Leveraged buyouts \ 3

4 This potential interest rate volatility is leading traditional fixed income buyers to hedge their risk by turning to floating rate loans, which have historically yielded positive returns when rates rise and have a low correlation to investment grade bonds. The growing demand is evidenced by the billions of dollars of inflows from June to August 2013 into the funds that invest in leveraged loans as fixed rate products see outflows (Source: Markit Loan User Conference panel, State of the Loan Market ). A resurgence by corporate America is also contributing to the loan market s growth. An increase in mergers and acquisitions is helping to drive new loan issuances, while the robust performance of borrowers bolsters the loan market. CFOs and CIOs at the corporate level are also concerned about interest rate risk and are seeking out the floating rate exposure of loans. Furthermore, as opposed to bonds, loans provides the ability to refinance and the flexibility to pay down cash balances. Adding to the appeal of the asset class to traditional fixed income investors is the availability of covenant lite loans. These loans have looser structures and operate in a similar fashion to bonds, as opposed to loans with traditional maintenance covenants. In 2013, over 50% of new issues were covenant lite deals (Source: S&P Capital IQ/LCD). The flexibility of covenant lite loans makes them attractive to borrowers, though potential restrictions placed around covenant standards could result in borrowers turning to bonds instead of loans. The rise in new issues and investors is also resulting in a wider breadth of names and contracted bid/ offer spreads, boosting liquidity in the loan market. According to an LSTA Trade Study, trade volumes are up almost 32% to $521 billion as of Q3 2013, compared to $396 billion in 2012 (Source: LSTA). Additionally, in 2013, Markit s ClearPar platform is on pace to settle a total notional volume of $925 billion, a 68% increase over Inefficiencies in the loan market Despite the growth of the asset class as it pushes more into the mainstream, adoption of technology has thus far been lagging in the industry, resulting in continued inefficiencies. This is particularly notable in trade settlement processes in the loan market, where a vast majority would assign a dissatisfactory or failing grade to current trade settlement processes (Figure 5). Figure 5: Grading operational efficiency around loan trade settlement 0% 9% 21% 37% 33% A (Excellent) B (Satisfactory) C (Needs improvement) D (Dissatisfactory) F (Failing) \ 4

5 While the market has grown in size and trade volumes have increased, settlement times are also rising. In Q3 2013, average par settlement times hit a new record of T (Source: LSTA, Figure 6). Unsettled trade volumes are also showing an upward trend, with $43.9 billion in unsettled trades at the beginning of 2013 increasing to $49.4 billion in Q3, representing a 12% increase over the course of the year (Source: LSTA). Figure 6: Average par settlement times Number of business days to settle Q Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 Even among the top buyside firms in the loan market, there is no measurable progress towards the LSTA guideline of a T+7 settlement period for par loans. Among the top 30 buyside firms, representing 50% of total volume, the shortest settlement time is T+12.5 and the longest is T+27.8 (Source: LSTA). Manual, bilateral processes are still pervasive around loan trade settlement, resulting in settlement mechanisms that have become even more backlogged as the market increased in size and liquidity. According to an LSTA survey, the top causes for increased settlement times for US primary loan trades include the lack of delayed compensation, which provides agents no incentive to settle in a timely manner, delays in suballocating trades, the KYC process as well as staff cutbacks and manual processes (Source: LSTA). The increasing settlement times means that counterparty risk continues to be an issue. If volatility increases and a significant movement in prices occurs while a trade is outstanding, the risk becomes greater the longer a loan trade remains unsettled. As in other markets, loan participants are diversifying rather than specialising only in loans. According to a Markit poll, a majority of respondents invest across multiple asset classes (Figure 7). Settlement periods for bonds and equities, the top two asset classes that loan market participants are also active in, are usually T+3. There is industry demand to bring the loans market closer in line to the efficiency of other asset classes, not only to streamline how the loan market itself operates, but also to improve participants overall ability to manage diversified portfolios. \ 5

6 Figure 7: Firm investments 7% 29% 19% 34% 14% 68% Asset based lending Bonds Equity Loans Total return swaps All of the above Beyond trade settlement, inefficiencies around data management and reporting as well as a lack of standardisation and integration are also commonplace in the loan market. Many processes, such as reconciliation and reporting, remain highly manual and labor intensive, requiring sufficient staff to dedicate significant hours in order to complete tasks. Although straight-through processing is available, there have been many delays in adoption. The persistent segregation of systems and operations continues to result in inefficient processes, particularly around interactions between the front, middle and back office (Figure 8). Improved integration and automation would significantly help participants streamline collaboration and improve operational efficiency. Figure 8: Biggest pain point around front, middle and back office interactions 28% 10% 36% Timeliness of providing reports Accuracy and adjustments to delivered reports Continuous reporting design and content updates and additions While the industry is seeing growth, operations teams are finding their resources remaining flat or even reduced. To ensure their firm can keep up with the growing size of the market while keeping costs low, their focus needs to be on finding ways to improve efficiency, rather than on adding more and more costly resources. 26% Intraday ad hoc requests \ 6

7 Solutions Loan market participants recognise the need for greater adoption of technology to support processes across the loan trade lifecycle (Figure 9). An integrated approach would significantly enhance efficiency. Products that are integrated, rather than used in isolation, enable systems to communicate with each other seamlessly. Figure 9: How to increase efficiency across the industry 40% Adoption of better tools and systems and greater transparency 35% Regulatory mandate 22% More discipline in the industry 3% More people 0% Good as it is Innovation around integration is a key part of the movement from batch calculations that are run once a day to a more realtime approach, supported by the ability to move information between systems faster (Figure 10). Industry participants broadly recognise the shift towards more realtime updates to enable them to more accurately assess current positions and respond more quickly to market activity. Figure 10: Largest value add of a front office portfolio management solution 54% 3% 2% 27% Self-service web and mobile widgets for insight, discovery, idea generation, etc. Relative value analytics and portfolio optimisation Continuous alerting based on custom user criteria 14% Simplicity of pre trade hypotheticals and what if scenarios Realtime access to data changes and updates, including performance \ 7

8 Research and investment analysis Trading Settlement Asset servicing and reconciliation Portfolio management, reporting and accounting Loan indices Markit Counterparty Manager Markit Notice Manager Markit Pricing Data Markit Reference Data Markit WSO Software: Compliance, Interfaces Markit Counterparty Manager Markit WSO Software: Administrator, Agent, Interfaces, Reporting Markit Loan Settlement Markit WSO Software: Administrator, Agent, Interfaces, Reporting Markit Counterparty Manager Markit Notice Manager Markit Pricing Data Markit Reference Data Markit WSO Software: Administrator, Agent, Interfaces, Reporting Markit Notice Manager Markit Pricing Data Markit Reference Data Loan indices Markit WSO Software: Accounting, Administrator, Agent, Compliance, Interfaces, Reporting The loan market is an ecosystem with a variety of participants coexisting and interacting with each other. The systems that participants use should reflect this dynamic. Markit delivers an integrated and scalable suite of solutions that support the front, middle and back office. Customers have the flexibility to manage the solutions in-house or to outsource their portfolio management functions partially or entirely to Markit. Markit s integrated solutions enable customers to reduce processing effort by minimising manual data entry and interactions as well as to improve accuracy and identify discrepancies in trade data early. For example, the current custodian flow entails the manual download of documents that are then delivered via unsecure channels such as fax, followed by authentication via phone calls. Markit s custodian services makes documents and trade messages directly available from a central platform, offering secure delivery via electronic messages, which are automatically imported into the system. This frees up both customer and buyside resources. Having integrated systems that communicate with each other also helps provide more insight into issues that may be causing delays or bottlenecks. Rather than simply adding more resources blindly and potentially adding unnecessary costs, participants can be more strategic about deploying resources. The loan market is also taking steps towards standardisation. The use of FpML, which facilitates electronic communications between loan market participants, is among the most significant initiatives underway in the loan market. Although greater adoption of FpML is anticipated in 2014, participants will still require time to develop trust in FpML transmissions. \ 8

9 Markit Notice Manager, an online document management service that processes, categorises, stores and digitises agent notices, supports FpML, faxes and to provide customers the flexibility to centralise notices regardless of format. Customers gain online access to realtime information, with the ability to consume data directly into back office systems, including a seamless integration into Markit WSO software and services. Even when there are high loan processing volumes, Markit Notice Manager keeps loan information up to date on close to 4,000 facilities, including every cash flow and transaction, so that customers stay current, organised and able to meet deadlines. Tackling settlement times by adopting processes that are simple, scalable and flexible would help streamline operations. In particular, if participants could STP plain vanilla trades, resources would be made available to focus on the more complex issues, such as KYC, that are not as systems-focused. Markit Loan Settlement, an electronic trade processing platform for settling syndicated loans trades, facilitates STP by automating loan trade affirmation, confirmation and matching. The goal is to couple inventory and settlement, while supporting realtime integration with Markit WSO platforms and agent bank systems for settling trades, replicating a centralised book for the market. By leveraging inventory data, it provides exception-based trade management. Loan ecosystem delivering seamless data integration Markit Notice Manager & Reference Data Vendors Markit WSO Software Markit Loan Settlement is used by major buyside and sellside institutions who are committed to improving settlement efficiency across the industry by driving adoption of the platform. Markit Loan Settlement Customer systems Markit Pricing Data With settlement streamlined, the industry would have the time and resources to focus on other initiatives, including KYC, which is perhaps the largest, most duplicative and costly process that loan market participants are confronting. Markit, in partnership with Genpact, is developing a centralised client onboarding solution aimed at creating standards around documentation and data, to establish a common process to be adopted across the industry to help participants meet KYC requirements. Markit WSO Services \ 9

10 The service, which builds upon the existing Markit Counterparty Manager hosted document management system, will centralise the non-proprietary processes for onboarding new clients, manage client reference data and remediate existing client accounts to new standards. It will result in significant cost savings through operational and technological efficiencies, reducing the need to manage duplicative documents and information and providing an improved experience to participants. Industry participants are also seeking improved front office systems (Figure 11). Loan market participants would benefit from a front office solution that offers portfolio risk management, enterprise wide collaboration and reporting, as well as investor portal solutions. A data hub that can integrate with Markit and customer data feeds and systems would round out the solution. Figure 11: Largest value add for firms 62% Front office portfolio management functionality and reporting 12% 15% 12% Senior management access to portfolio information and performance on the road Investor relations reporting and transparency Corporate compliance access to data and ability to set alerts Markit has recently launched the initial phase of a new reconciliation solution, built on the Markit Enterprise Data Management platform, to address industry demands (Figure 12). The points of reconciliation the solution supports include par/outstanding, cash and security master. The reconciliation solution builds upon Markit EDM s flexible configurations, exception management capabilities and intuitive user interface. Figure 12: Most important features of reconciliation providers 8% 27% 11% 2% 13% 41% Hosted solution Exception management service Exception management user interface and website Automated, ad hoc deliveries Reporting Flexibility \ 10

11 Conclusion In order for participants to keep up with the growing size and increasing activity in the loan market, enhanced operational efficiency through adoption of technology and interconnected systems is beneficial. Markit is an established and trusted solutions provider, known for its ability to deliver integrated solutions to fulfill customer requirements (Figure 13). By offering seamlessly connected solutions that address the entire loan trade lifecycle, Markit facilitates STP while enabling customers to reduce costs. Customers are able to focus resources on strategic initiatives rather than expending resources on manual and labor intensive administrative processes. Figure 13: Who do you expect to carry the load on integration solutions? 50% Markit plus my internal technology team 22% 11% My internal technology team 13% Markit Markit plus my non-markit vendors 3% 1% My non-markit vendors I don t believe in integration Markit delivers comprehensive data, processing and software solutions to support customers loan portfolio management needs, and also offers complete servicing of loan portfolios as a managed service. By offering customers the option to deploy solutions to support in-house management or to partially or fully outsource loan portfolio management functions, Markit delivers the flexibility and scalability to meet the specific needs of a broad range of customers. Through continued collaboration with industry participants across the board, Markit is dedicated to driving innovation forward to deliver solutions that enhance how participants operate. \ 11

12 Note to press About Markit To request further information or permission to reproduce content from this report, please contact: Alex Paidas \ Corporate Communications alex.paidas@markit.com Markit is a leading global diversified supplier of financial information services. We provide products that enhance transparency, reduce risk and improve operational efficiency. Our customers include banks, hedge funds, asset managers, central banks, regulators, auditors, fund administrators and insurance companies. Founded in 2003, we employ over 3,000 people in 11 countries. More information For more information on the products and services from Markit, please contact us at sales@markit.com or call one of our regional offices: London New York Amsterdam Boulder Dallas Frankfurt Hong Kong Tokyo Toronto Singapore Sydney markit.com \ 12