A single-name Credit Default Swap contract is an insurance contract written designed to transfer the credit risk of fixed income securities between parties.

When a credit event arises, the protection buyer receives a payment from the protection seller to compensate for the credit losses. In return, the protection buyer pays a premium to the protection seller over the life of the contract.

There are two main reasons why CDS contracts are more liquid than most corporate bonds.

First, they are more standardised. For instance, the credit events that trigger payment to the protection buyer are now clearly defined in the ISDA credit derivatives definitions.

Second, a CDS contract allows market participants to undertake long credit risks without a cash payment, as well as undertake short credit risks with less difficulty and at lower cost than with corporate bonds.

In order to provide protection for a specific loan against a credit risk, a new derivative instrument of structured finance known as Loan Credit Default Swap (LCDS) has been introduced.

Leveraged loan Credit Default Swap (LCDS) is an extension of Credit default Swaps (CDS) derivative and allows investors to reference secured loans in standardized credit derivative contracts. LCDS basically covers the double and single-B high yield universe and it trades actively in 50-odd Reference Entities.

The protection sellers in LCDS are mainly hedge funds, who seek quick access to leveraged loan exposure. Bank loan portfolios sell protection to add exposure to issuers with underutilized credit lines. Similarly, buying LCDS protection provides a more accurate hedge for loan portfolios than senior unsecured CDS. Leveraged investors may buy LCDS protection to short credit risk, without the need for a REPO market.

The general structure of a LCDS contract is similar to that of the regular corporate CDS, but the fact that the reference assets are syndicated loans gives rise to unique characteristics for LCDS. The recovery percentage for loans is higher in comparison to other instruments like bonds. Credit Suisse, Deutsche Bank, Merrill Lynch, Lehman Brothers & Morgan Stanley are few names which have started trading in Loan CDS industry.

The investor (also known as the protection buyer) who wants to purchase "protection" has to pay a fee or a premium to the protection seller. In return, the protection seller agrees to pay the value of the loan in case of a default or if the loan is restructured.

The interaction between the Protection buyer and the Protection seller is schematically represented below:

• Bankruptcy
• Failure to make a principal or coupon payment
• Restructuring

• CDS provides protection against a credit risk for entire organization while a LCDS provides protection against the credit risk on a specific loan.
• In European markets, in the case of a CDS contract, if a company buys or calls or backs the loan, the contract can be terminated while LCDS contracts can be transferred to another loan of the same organization if the loan is called.
• An LCDS contract terminates in case the 'Syndicated Secured facility' is canceled and not replaced within an agreed number of days (usually 35 business days). After the expiry of the agreed number of days, either party may deliver a notice to terminate the trade. The protection buyer is required to pay accrued interest up to and including the termination date.

iTraxx LevX (European Leveraged Loan CDS Indices) which was introduced and regulated by the International Index Company (IIC) comprises of Senior & Subordinated loan indices.

The iTraxx LevX Senior Index comprises of the 35 most liquid 1st lien credit agreements traded in the European Leveraged Loan CDS market. The iTraxx LevX Subordinated Index comprises the 35 most liquid 2nd and 3rd lien credit agreements traded in the European LCDS market. The average maturity of indices is five years & the indices rolls on a six monthly basis.

To simplify the calculation, the 5-year mid spreads for the iTraxx LevX Senior and the iTraxx LevX Subordinate should be >= 75 bps (basis points) and >= 225 bps respectively.

The physical settlement of Loan CDS trades is also known as the physical settlement rider. Physical settlements are governed by LSTA (Loan Syndication & Trading Association). A settlement is necessary when there is a credit event, in which case, the protection seller pays the protection buyer the notional amount of the trade but at the same time the protection buyer delivers a loan or revolver which:

• Trades as a loan of the Designated Priority (first, second, or third lien)
• Is a Participation Loan i.e., the protection buyer can create a participatory note.
• Includes rights for the protection Seller.
• Arises under a syndicated loan agreement: