$4.7 Trillion was borrowed in 2014 as syndicated loans, half of it in the US according to Reuters. Unlike conventional bilateral loans, syndicated loans, are funded by multiple lenders and packaged as a single loan to the borrower. One of these lender is designed by the loan issuer (the borrower) as the arranger. The role of the arranger is to “build the book” structure the loan by pulling other lenders, define the lending facility terms, and pricing, typically a spread over a reference index such as LIBOR. The arranger may also take up the role of an agent, administrating the loan after origination.
The perils of the arranger
Although multiple banks may compete to be awarded the arranger mandate, An arranger, may have little interested in the loan itself as it might be used only as entry point to access more lucrative services from the issuer. Arranger must play a balancing act to provide a competitive price for the issuer while allowing enough spread to avoid under-subscription i.e insufficient lenders to cover the whole loan.
For pricing the loan, the arranger will rely on a subset of investors e.g other banks, institutional investors, etc to asses risk appetite. Divergence between this estimate and the final price as well as unfavorable market movements represents risks of under-subscription. The situation is worse if arranger is underwriting the loan since the arranging bank is pre-committed to ensure loan is funded. Although the deal can be structured to allow some flexibility to abort the syndication under adverse conditions, the arranging entity may still be motivated to proceed if the other existing or potential non-loan services to the issuer justify the risk of a manageable loss on the loan.
Taking a distributed ledger approach
The delay introduced by the pull nature of price discovery hints at the utility of some sort of shared ledger provided by Distributed Ledger Platforms (DLP). Candidates lenders could in real-time update bid prices and allocated loan tranches for different spreads which can then be tracked in the shared ledger. Given the non-static nature of the loan e.g covenant waivers, loan extension, etc. DLP could provide granularity to which portion of the loan a modification would apply. The shared ownership and cryptographic security inherent in DLPs, would allow also transfers of loan slices among lenders, blurring the primary and secondary market division for syndicated loans. In this scenario, participants benefit from transparency and the arranging bank from their competition, all benefit from improved liquidity. Concurrent participation in the pricing process can speed up the building of the book and improve pricing estimates accuracy
Flexible centralization
Although the loan syndication is centralized around the arranging bank, DLPs do not force a choice between decentralization and preserving centralization. The arranger can cherry pick what part of the process gets decentralized and to what degree. In this use case, most parts of the book building exercise are still centralized, only the allocation and pricing are moved towards the decentralized end of the spectrum. This notion of decentralization as a continuum rather than a dichotomy is well explained in Richard Brown’s piece on unbundling of trust
Another tool provided by DLPs not discussed here are smart contracts. On the next post we will explore the use of smart contract to automate the pricing process of syndicated loans.