The envelope, please… Blockchain and shareholder voting

Who knew that shareholder voting could be so… suspenseful?

If you missed the news, Proctor & Gamble has been locked in a bitter battle with shareholder activist Nelson Peltz, who wants a seat on the board. This led to the biggest shareholder battle to date, with over 2.5 billion votes (for 2.5 billion issued shares) in play. Robocalls, social media ads and a flood of mailings… the tactics got fierce.

suspense

At stake is the structure of the consumer goods conglomerate. Peltz – CEO of asset management firm Trian Partners – wants a seat on the board, and to break P&G up into three distinct units, to streamline operations and add flexibility. P&G says that the recent restructuring is already showing positive results, and changing the composition of the board would bring unnecessary disruption.

At the annual general shareholders’ meeting, P&G announced that Peltz’ bid had been defeated. Shareholders had voted to not give him a seat on the board, by a margin of 6.15 million votes, which sounds like a lot but when taken in context of the overall number of outstanding shares, was only 0.2%. A statistician would argue that is well within the margin of error.

And she would be right. Yesterday the FT reported that a recount by an independent expert found that the margin was only 43,000, in favour of Mr. Peltz. Effectively, a dead heat. The final, definitive results are not yet in. But Mr. Peltz could well get his board seat.

Why the lack of clarity in the outcome?

As you have most likely seen with national elections, counting votes is cumbersome, and largely manual. Even today, there is no definitive way to ensure that votes are not double-counted or falsely filed. One of the main problems is collecting all the votes, which are still mainly submitted on paper, either at a company’s annual general meeting, or sent in via physical mail (although some firms allow online voting). Another is making sure that the count is not manipulated. This requires rigorous identity verification, and a decentralized process of tally.

A separate issue is identifying who has the right to vote – with shares held at central depositories and “ownership” represented by a type of cession of rights, this is often not as clear as it should be.

Could blockchain technology, with its security and automation, help? Several large proxy voting managers believe so.

Last year, Russia’s National Settlement Depository announced that it has tested a blockchain-based voting system. The Abu Dhabi Stock Exchange unveiled a blockchain-based voting service that allows shareholders to both participate in and observe the process. And Nasdaq ran an e-voting trial, which recorded stock ownership on a blockchain platform, and issued digital voting right assets and tokens.

Earlier this year, Broadridge – the world’s largest provider of proxy voting infrastructure – revealed that it is building a blockchain platform on ethereum to streamline the sharing of information between custodians. A pilot run was successfully executed (in parallel with voting using traditional software) with JP Morgan, Northern Trust and Banco Santander.

Around the same time, financial services company TMX group (operator of the Toronto and Montreal stock exchanges, among others) revealed that it had completed a proxy shareholder voting prototype built on Hyperledger

And just last week, a group of central securities depositories (CSDs) announced progress on a distributed ledger proxy voting platform. Swift is among the institutions participating, to assist in ensuring compliance with international financial messaging standards (which would open up the platform to uses other than voting).

Timelines on any of the above projects going into the production are at the moment vague. Will any of them even happen? With shareholder voting generally an in-network activity (with limited, if any, need for participation from outside organizations), why use blockchain at all? Why not just go for a robust, efficient database?

Because of the vulnerabilities of centralization, which in many cases doesn’t matter – but when it comes to voting, that’s a different story. First of all, even a distributed database can be hacked and manipulated. Second, shareholders need to be certain that the vote was fair, and that the company in question has not tried to influence the tally. If they are granted real-time transparency into the voting process are more likely to trust the system, and therefore more likely to vote.

Plus, as shareholder voting becomes even more important, propelled by improvements in the technology (reduction of friction) and increased activism, audits of processes by external parties are going to become even more of a regular feature. An access node would facilitate that, as well as reduce the costs.

And finally, proxy polls are not cheap. According to FactSet Research Systems Inc., a “typical” proxy battle costs about $1 million, mainly from printing, mailing and legal fees. For context, the P&G battle is expected to cost the company over $35 million (small change compared to its Q2 income of $2.2 billion, but still…).

And even with that expenditure, it might not win. Final results are yet to come, so the battle isn’t over yet.

But the drama and nail-biting suspense sheds light on the urgent need to reform shareholder voting technology. Current platforms are, in general, inefficient. And electronic voting systems run by any one organization, even audited ones, will always have a cloud of doubt over the controlling interests. The transparency and security of distributed ledger systems could offer a more robust, lasting and scalable solution. Widespread use is still a long way off, though, and they’re unlikely to be practical until the murky issue of stock registration is solved.

While perhaps not the decentralize-the-organizations disruption that blockchain technology originally promised, it would be a step towards a more democratic governance, enabling shareholders to participate in corporate decisions more frequently and with less upheaval. It could end up giving shareholder activists more firepower and motivation, even perhaps going as far as to change what we understand by “shareholder capitalism”. Or capitalism overall, for that matter.

And when it comes to letting the market decide, it must be galling for the P&G board to see the positive price reaction to the news that they might not get their way. If the close outcome of the voting doesn’t send the board a strong message (in other words, when almost half of your shareholders side with your most vocal critic, you’re doing something wrong), perhaps the voice of the market will.

FX trading fines and regulation catch-up

Photo by Ben Rosett on Unsplash
Photo by Ben Rosett on Unsplash

In my last post I mentioned some hefty fines incurred by foreign exchange dealers for trading infractions. The amount keeps climbing.

Yesterday the Financial Times reported that Credit Suisse has just been fined $135m by New York state’s financial regulator for “unsound” conduct between 2008 and 2015. Apparently the traders shared client information with other global banks to manipulate foreign exchange (FX) prices and maximize Credit Suisse profits.

What’s more, the bank was found guilty of front-running (putting your order in just ahead of clients’ orders to take advantage of resulting price movements) between 2010 and 2013.

And (this ties in to my previous post) between 2012 and 2015, traders took advantage of the “last look” feature of their electronic trading platform, which allows dealers to back out of a trade before execution, by applying it to all client trades. To make matters worse, it lied to clients about why trades were rejected.

It’s one thing to use the system to profit your own book over your clients’. It’s quite another to lie about it.

This is one of the reasons for the increasing volume of calls to reform the last look practice. Many traders think it should be banned. Others believe that it should be allowed, but that traders should be honest and upfront with the conditions in which a previously agreed trade would be rejected.

Going back to the Credit Suisse infringements, what blows my mind is that they openly talked about frontrunning and using proprietary information in electronic chat rooms. And get this: one of chat rooms was known as “The Cartel”. It’s not the stupidity that surprises me, it’s the arrogance. If everyone’s doing it, it’s fine, right? Why even try to hide it?

The sentences are coming thick and fast. In September, HSBC was fined $175m by the Federal Reserve for “unsafe and unsound” FX trading practices. In July, the Fed ordered BNP Paribas to pay $246m for charges relating to its FX conduct between 2007 and 2013. These fines follow others of more than $5.7bn levied on a handful of major banks in 2015 by the US Department of Justice, and over $3bn handed down by the US Commodity Futures Trading Commission and the UK’s Financial Conduct Authority in 2014.

While we may be blinded by the volume of fines, we need to put them in context of the overall size of the FX market. The largest market in the world, it trades over $5tn per day. Apart from the massive profits the rogue traders earned for their banks (no doubt largely reflected in handsome bonuses), the fines also reflect the gravity of the infringements. Damage to its reputation and a loss of trust would pose a risk to global commerce and trade.

The high profile of these cases could add momentum to the move towards trading platforms that offer greater transparency to clients and to the regulators.

The FX market, already of systemic importance, is likely to expand as world trade continues to grow. Until recently, large clients didn’t have much of a choice – to get big deals done, you went to the big dealers. Now, however, newcomers with shinier platforms are nibbling away at market share. Increasing compliance adds to costs, and the advantages of largely manual, opaque and relationship-based execution are becoming less apparent. Especially with increasing scrutiny.

The embarrassment for the regulators at the revelations that this was going on for as long as 10 years before anyone noticed will surely give them a good incentive to push for better reporting and greater access to trading records.

So, distributed ledger-based trading platforms in which the regulators have a node that allows them to see in real time what’s going on? Confidentiality issues aside (because they can be solved), it is likely to happen in some form.

Regulators monitoring electronic chat rooms? That’s a different story.

FX trading and last look doubts

photo by Veri Ivanova for Unsplash
photo by Veri Ivanova for Unsplash

The murky world of foreign exchange trading could be about to get a bit more transparent.

A few days ago, the sovereign fund of Norway (NBIM) – the largest in the world, with over $1tn under management – published a report calling for improvements in the foreign exchange (FX) market. It feels that the market’s friction and opacity tilts profits unfairly towards the dealers, and that the lack of transparency is weakening trust in the system.

It points to three particular aspects of FX trading, specifically: last look, algorithms, request for quote feeds and their relationship with interdealer prices.

While each is intriguing and worthy of further digging, I want to take a closer peek at “last look”, since it exemplifies how new technologies can both improve and complicate trading, and how evolving infrastructure requires a regular re-think of established processes.

Looking back

What is “last look”? It’s a “way out” for the dealer, who can renege on an agreed trade if certain conditions are not met. It could be that the client doesn’t pass the credit check. Or it could be that the price moves against the dealer.

This last aspect gives last look the whiff of unfair advantage. Critics claim that it can be used to “cherry pick” trades, only following through on the profitable ones, which would negatively impact market confidence and liquidity. It could also lead to “front running” of trades, whereby information from client orders is used for the dealer’s own profit.

Others argue that its use as a latency buffer – protecting against price moves between order agreement and order execution – is no longer necessary given technology improvements that make that time gap almost negligible. And the lack of information – often clients are not told why their trades fell through – weakens confidence, which could impact order size and even willingness to operate in the market.

Proponents claim that the practice allows dealers to quote better prices – with less risk in a trade, the spread can be narrower, which implies a better deal for the clients.

What’s more, the option of backing out of a trade enables dealers to post their price on several exchanges at once. Without that option, the dealers run a higher risk that the market will move against them. With posts on several exchanges, changing all of them takes time (seconds, but that’s a long time in FX). So, last look encourages a wider spread of trading venues, which in theory enhances liquidity.

Wait a second

Norway’s sovereign fund is not alone in its concerns about the practice, which has been coming under increasing scrutiny.

Vanguard (the world’s largest mutual fund manager), Citadel (one of the world’s largest alternative asset managers) and others have called for its elimination. Several exchanges have echoed that sentiment. XTX Markets Limited, one of the world’s biggest spot currency traders, officially stepped back from the practice in August. The Bank of England has been publicly questioning the practice since 2015.

Global regulators are also taking a closer look. In 2015, Barclays was fined $150m for what was deemed abuse of the practice – not only did the bank filter all trades in which the market moved against it (as opposed to using last look as a sporadic protective measure), but it denied doing so. (2015 was a ripe year for FX manipulation – Barclays was fined a further $2.3bn for other FX infractions, and penalties levied on Citigroup, JP Morgan, UBS, Bank of America and the Royal Bank of Scotland brought the total to almost $6bn.)

However, removing the practice will leave end users vulnerable to predatory manoeuvres, especially given the prevalence of high-speed trading. It could also constrict liquidity as dealers protect themselves against risk.

Rules, please

Why can’t the regulators step in and establish certain rules? Because the FX market is notoriously difficult to regulate, largely due to its cross-border nature. Which jurisdiction would apply?

In an enlightening example of self-regulation, the Global Foreign Exchange Committee (GFXC) was created in May 2017 as a forum for FX market participants (including central banks). Its first act was to issue an updated FX Global Code, a set of “best practices” for the foreign exchange community.

It does not rule out last look, but does ask practitioners to disclose the criteria, in order to allow end clients to make the appropriate adjustments. The GFXC simultaneously issued a request for feedback on the practice, demonstrating a willingness to contemplate adjustments.

So why are the Norwegian sovereign fund and others protesting now? Just two years ago, NBIM publicly came to the practice’s defense, citing its potential to improve available liquidity for investors.

It turns out that their positions are not inconsistent. Even now, it is not advocating the removal of last look. What it wants is more transparency.

Furthermore, it is no doubt aware of the deteriorating levels of trust in FX trading. The previously mentioned scandals and fines are probably the tip of the iceberg when it comes to abuse, especially since the rules have been vague and the FX market is opaque to begin with.

And, the protests could be influenced by fund managers’ need to increase revenue and lower costs through narrower spreads and more transparent pricing. Quoted in the Financial Times, the co-author of the report said:

“We want to be more explicit about the risk sharing between us and the dealer. The client is providing optionality for the dealer. We would like to be rewarded for this option.”

Large market participants no doubt understand that the system is changing, and so are expectations. Calls for market reform are both timely and self-serving, contributing to a cleaner image and hopefully a more robust system.

Looking forward

So, what would a solution look like?

While blockchain technology is by no means the solution to all things financial, it could offer a useful tool for a platform that allows transparency, immutability and decentralized (but permissioned) participation. A major drawback would be the latency – it’s not the fastest way to share data, and the FX market is used to split-second speed.

It is clear that enhanced disclosure is a stop-gap remedy. Once the goal posts start moving, it’s impossible to see where they will stop. What’s more, temporary solutions are not conducive to a lasting realignment of trust. And with self-interest up against community fairness, and a huge economic sector in play, a more durable solution is urgent.

Will blockchain technology end up playing a part? It’s possible, perhaps even probable, especially as new features emerge and work-arounds gain strength. It’s unlikely to be the only solution, though, as database technology and communications infrastructure also continue to evolve. And as long as speed remains a competitive advantage, decentralized resilience and transparency are unlikely to be the main priority.

What’s more, the FX sector is unlikely to see a sweeping change in the near future – it’s just too big and important for that. However, the processes that keep the system running need revision and updating, to continuously improve efficiency and trust.

And eventually, the patchwork of solutions to specific problems will point to a deeper evolution, one that favours interoperability over universality, reliability over speed and trust over profit.

Blockchain and capital markets: interest rate swaps

by Alex Jodoin on Unsplash
by Alex Jodoin on Unsplash

And now on to the next riveting stage of our exploration of the impact of blockchain technology in capital markets. Welcome to interest rate swaps (IRSs), one of the most powerful risk-management tools in the market.

They’re not as complicated as they sound. There are several different types of swaps, but the basic “vanilla” variety works like this: if I am paying a fixed interest rate on my debt and I’d rather pay a variable rate, and if you have the opposite situation, then we swap. Not the actual debt, because that would be either complicated or downright impossible (cross-border regulations, collateral requirements, etc.). What we swap is the payment – I’ll send you the equivalent of your variable interest payments, and you send me your fixed payments. I’ll then use what you send me to keep my lender happy (he wants fixed payments – I pay him with your money), but my actual payout is to you at a variable rate. With that, I have converted a fixed obligation into a variable one.

Why would I want a different interest structure than the one I contracted with my lender? Well, maybe I have a fixed rate, but I think rates are going to come down so I want to switch (and, of course, you think they’re going to go up and so would rather lock in a fixed rate). Or maybe I want a fixed rate but my bank will only offer me a floating structure, and you have the opposite problem.

While mainly used by banks and other financial institutions to hedge their interest rate exposure, IRSs can also be used as a tool for portfolio management, taking positions on interest rates at various points in time. (It’s also possible to do this by going long or short Treasury bills, but interest rate swaps require much less capital outlay.)

Big stuff

The market is huge, trading almost $1.9bn a day, which makes interest rate swaps one of the most actively traded instruments in the over-the-counter (OTC) market.

Interest rate swaps have traditionally traded OTC (directly between two parties) rather than via a regulated exchange – most contracts are drawn up to satisfy particular conditions, and are not standardised enough to list on exchanges. As with credit default swaps, the Dodd-Frank Act of 2010 radically transformed the market in the US, mandating that a wide range of IRS contracts (but not all) be traded on “swap execution facilities” (SEFs), rather than by phone. These newly-created trading venues aggregate order books (increasing market transparency), and allow participants to ask for quotes from several dealers simultaneously – they are similar to exchanges in function, but have a more limited scope and fewer listing requirements.

Also, all swaps traded on SEFs have to be cleared via a central counterparty (CCP). Once a trade is confirmed, the CCP acts as buyer and seller, taking on the settlement risk. This lowers the collateral required of the parties to the trade, but increases the trading costs.

And, all swaps trades have to be reported to swap data repositories (SDRs), providing volume and pricing information to the market. SDRs also enable regulators to gauge participants’ risk exposures.

In Europe, the changes are similar to those in the US. The European Market Infrastructure Regulation (EMIR) – passed in 2012 – mandates that certain classes of interest rate swaps clear through CCPs. Those that are not required to do so still have to comply with tighter risk compliance rules. EMIR also tightened the reporting requirements.

In the US, interest rate swaps fall under the jurisdiction of the Commodity Futures Trading Commission (CFTC), and in Europe under the European Securities and Markets Authority (ESMA).

Connected data

The Chairman of the CFTC, J. Christopher Giancarlo, has often said in public that blockchain technology could have a big impact on how swaps are handled, helping to smooth the complexities brought about by Dodd-Frank (not that the market was straightforward before). However, the blockchain activity going on in this sector is relatively modest, compared to other types of derivatives, which is strange given its size and the potential impact on execution efficiencies.

While the pooling of risk aspect of central clearing would be a complicated area to automate (given the necessary level of flexibility), the redundant processes and documentation requirements could be streamlined via a distributed ledger. And the chaos of data reporting, especially given its systemic importance, points to this area as one likely to attract the attention of blockchain executives and developers.

Also, the actual agreements recorded on a blockchain could be largely automated using smart contracts. For instance, they could pull the interest rates for floating swaps from an established oracle and automatically calculate the relevant payment.

And, the current lack of transparency in the market due to the legacy of OTC trading could be alleviated by putting all swaps on a blockchain platform, and giving the relevant parties (as well as the regulators) access via their own node.

Step forward

UK bank Barclays – together with blockchain consortium R3 and the International Swaps and Derivatives Association (ISDA), a trade standards body that has played a significant role in the standardisation of swaps – have trialled a similar solution. They developed a distributed ledger prototype based on Corda (which is not technically a blockchain, but that’s a different story) with the aim of recreating derivatives agreements using smart contracts.

The scheme envisions ISDA acting as a central repository for smart contract-enabled documents. Swaps dealers could use these to create new agreements, with all counterparties collaborating. The hash (compressed representation) would be uploaded to the distributed ledger, eliminating the need for all parties to store their own set of documents.

While the platform could ostensibly be used for a range of financial instruments, the first example tested was an interest rate swap.

Media giant Thomson Reuters also had interest rate swaps in mind when it designed a data stream (called BlockOne IQ) specifically to interact with smart contracts. The streams of both variable and fixed interest payments could be made much simpler with automatic calculations and adjustments linked to uploaded agreements.

While the firm’s more traditional APIs are available to market participants, a dedicated oracle would open up access to a growing range of decentralized applications. It is expected to reach a decision by the end of the year on whether or not to monetize the experiment.

It’s not just the incumbents that are taking a look at this segment. Synswap, set up by two ex-traders, hopes to challenge current post-trade processes by disintermediating central counterparties from the clearing process. Its initial focus is ostensibly on interest rate and credit default swaps, and a prototype currently in development will perform key post-trade functions such as matching, confirmation, collateral management and settlement.

In plain sight

I am surprised that there isn’t more IRS-focused blockchain activity going on, given its characteristics and needs:

  • They are easily automated
  • The market has a relatively limited number of participants
  • The data collection is complicated (and can be simplified)
  • The accounting is complicated (and can be simplified)
  • There is little overlap with other instruments (which means that dedicated solutions – which are easier to implement – could work)
  • The market is still relatively opaque, in spite of a push for greater transparency
  • Data collection is complicated (and can be simplified), and slow – the latest figures given by the Bank of International Settlements are from April 2016
  • The instrument is systemically important (which implies increased attention from the regulators)

Of course there are complexities that would be hard to integrate into a blockchain, such as the mutualisation of losses and the management of margin levels.

But the potential is significant, and worthy of investigation. It will be fascinating to see what other projects emerge in this space, especially given its importance to capital markets, and the lessons it could impart to the rest of the sector.

A slippery slope

by Matthew Henry via Stocksnap
by Matthew Henry via Stocksnap

I never expected to get riled up over accounting.

Alexandra Scaggs in the FT this morning expertly dissects a paper in the CFA Institute’s Financial Analysts Journal, in which the authors claim that profits are no longer important in company valuations.

As an ex-investment analyst, this is befuddling. I used to be pretty damn good at financial models, all of which were based on earnings projections. And as an entrepreneur, I cared a lot about cash flow.

However, times have changed. The stock prices of Amazon and Tesla do not reflect earnings forecasts (which no-one really has a clue about, anyway) – their price/earnings ratios are crazy. And yet, that does not mean that they are bad investments (this is not professional advice!).

This disconnect could well be why so few tech companies are going public – that, and the relative ease with which they can come by funding through other methods.

I have been getting increasingly concerned about the accounting standards for initial coin offerings (ICOs), and will wail about them more in another post.

But for now, let’s focus on asset value.

Research and development (R&D) costs are considered “expenses”, and hit the bottom line. Capital outlays and acquisition costs are considered “investment” and can be capitalized and amortized over time. So, it makes more sense (from an accounting point of view) to buy a research company than to do it yourself.

But then, assuming you consolidate the figures, and assuming your new R&D team keeps at it, you’re back to having high costs relative to the growth in assets.

Again, this could partially explain why tech companies are increasingly realising that IPOs are not for them.

ICOs, on the other hand… No-one seems to care about fundamentals such as future earnings there.

And in a free market, that is the investors’ choice. But it does represent a fundamental shift from the value-creating roots of corporate participation, which we should be aware of.

We also need to contemplate the long-term impact that this shift could have. When we focus on speculative gain (as with most of the ICO market today), we don’t really care what the company does, or how. We care about how “cool” it is, how “hot” the topic. We veer towards an alarmingly short-term bias which will, if it persists and spreads, affect the investment decisions of the companies themselves.

An economy focused on short-term deliverables and market appeal will become more volatile. This will give speculation a veneer of common sense. And, let’s go big here, possibly undermine the very essence of capitalism.

We need to think about that.

Blockchain and credit default swaps, Part 2 – the application

by Snufkin via StockSnap
by Snufkin via StockSnap

As we saw in the previous entry in this series, credit default swaps are ideal for blockchain testing because:

  • they’re complex yet with a “programmable” structure;
  • they’re increasingly standardised following recent changes in regulation; and
  • they operate in a self-contained market – although they reference other securities, they don’t actually link to them, and can operate solely on straightforward data inputs.

The largest project currently underway – not only in credit derivatives but also in the financial industry as a whole – is that of the Depositary Trust and Clearing Corporation (DTCC) in the US, which is working on rebuilding its credit default swaps processing platform with blockchain technology.

To appreciate how huge the launch could be, let’s take a closer look at the structure of the DTCC and what it does.

Too big to fail

Set up in 1999 to combine the Depository Trust Company (established in 1973 to hold security titles) and the National Securities Clearing Corporation (founded in 1976 to handle clearing and netted settlement), the DTCC is currently the largest securities processor in the world. It settles transactions of almost $1.7qn a year (that’s quadrillion, with 15 zeroes). There’s no point in trying to get your head around that large a number.

Since then it has acquired or created further subsidiaries to extend its services to include pan-European equities clearing, fixed income transaction processing, information management for trading institutions among other functions.

In 2006, the DTCC launched the Trade Information Warehouse (TIW) service, to centralize the storage of information regarding trades of over-the-counter (OTC) derivatives. One of its main functions is to maintain the “golden copy” − the unique, reliable and actionable record of transactions. It also manages post-trade processing such as payments and adjustments over the life of each contract (which, in the case of OTC derivatives, can be as long as 10 years). It currently handles the event processing services for 98% of the world’s outstanding CDSs.

Time for an upgrade

This is the platform that the DTCC wants to replace with blockchain technology. One of the main attractions is the possibility of making the “golden copy” accessible to all participants. Another is being able to automate the processing of lifecycle events via smart contracts (currently a largely manual process). Also, on the current infrastructure, settlement can take as long as a week to close, whereas on the new platform it could be almost instantaneous.

To this end, the DTCC started work on the redesign of TIW at the beginning of 2017, following a successful proof-of-concept executed in 2016. IBM is acting as project lead, blockchain startup Axoni will provide the technology, and R3 is acting as advisor. The platform is expected to go live in early 2018, at which time the underlying protocol will be submitted to opn-source blockchain consortium Hyperledger (of which the DTCC is a founding member) for others to also work on.

Given the systemic importance of efficient derivatives settlement, initially the new platform will launch in “shadow” mode and run alongside the current system. Participation will be optional, and participants will adapt their internal processes gradually, with large firms implementing their own nodes on the ledger while smaller ones hook in via the DTCC’s node.

To start with, the platform would only handle information and reconciliation. Payments would continue to move on traditional rails.

Thinking ahead

An interesting question is why the DTCC would do this. Are they not potentially writing themselves out of the picture?

What they are in effect doing is “disrupting” their own processes. As the largest CDS post-trade processor, they do have a choke-hold on the market. But the DTCC is a not-for-profit organization, owned by the industry. As such, its obligation is to the market participants, and includes future-proofing its service. What’s more, a reduction in reconciliation costs could boost transactions and liquidity, possibly helping to offset the post-crash decline in trading volumes.

Furthermore, its systemically important role gives it a clear view of how fast financial services can shift. By upgrading the principal post-trade platform and making it easier for derivates to be centrally cleared, the DTCC could be getting ahead of regulatory changes. With a node on the distributed ledger, regulators would have a complete and real-time view of the state of the market.

Big impact

When the platform goes live (expected to be early next year), it will be the largest project to date to enter production. Its effects will not be visible to the mainstream market, but the financial sector will be watching this closely, not only to see if the technology works, but also to gauge the impact of the cautious implementation strategy.

Blockchain technology is not the answer to all of the problems, structural and otherwise, that currently plague financial markets. But its potential is intriguing, especially the opportunity to affect how information is handled. That in itself could fundamentally change how the markets work.

With many more projects in the pipeline – from the DTCC as well as other significant players in the field – the launch of the CDS blockchain platform could well be the tipping point that triggers a host of implementations. With that, we will finally be able to say that the next era of financial infrastructure has begun.

Tiptoe through the tulips

by Aaron Burden via StockSnap
by Aaron Burden via StockSnap

While cringing through reviews of “Tulip Fever”, released in the US last weekend, I couldn’t help but wonder why the story still captures our imagination.

The bitcoin bubble has often been likened to the tulip bulb mania of the Amsterdam markets in the 17th century. That is wrong.

While the speculative fervour may have the same underlying root (cough, sorry), namely the me-too desire to get rich quick, there the similarities end. Historical analogies make for good copy, but unless you believe history does repeat itself (and I don’t), the usefulness ends there.

First of all, in the tulip frenzy, the actual price of tulips was volatile, but not nearly as much as the futures price. People were entering into contracts to buy tulip bulbs at a certain price a few months hence. In early 1637, the Dutch authorities decided that the futures contracts would become options – the purchase contract could be “cancelled” upon payment of a small percentage. In other words, speculators were buying the right (but not the obligation) to buy tulip bulbs at certain prices – these are the ones that went through the roof, not the actual prices at which the bulbs changed hands.

Second, bitcoins are obviously not tulips (not nearly as pretty), but even the nature of the investment (or speculation) is totally different. Bitcoin actually has a practical use. It can be used to transfer value without third party control or interference. It satisfies all of the characteristics of money, except for the (dubious) requirement that it be authorised by a central authority.

Tulip bulbs, on the other hand, have the potential to make people happy, but beyond that, they’re not useful, not even as a means of exchange. They are 1) not a store of value (they perish), 2) they are not fungible (no way is a lily-flowered the same as a viridiflora), and 3) they are not limited in supply. They shot up in price because people expected them to shoot up in price. The same can be said of bitcoin, true, but the difference is in the residual value – what is the underlying use worth? With bitcoin, it is potentially worth a lot. Tulip bulbs, not so much.

(Although as a caveat I would like to stress that I do believe that the enjoyment of beautiful things, even ephemeral ones, is worth paying for – although nature so often gives them to us for free. An interesting anecdote is that the most coveted bulb during the tulip mania was the Semper Augustus – it turns out that the flower’s beautiful striations were due to a virus that eventually killed the breed off. Even nature’s accidents can have aesthetic value.)

It remains to be seen what impact the growth of the bitcoin derivatives market will have. In the case of tulips, the emergence of a liquid options market lend the market some stability – the strike prices were volatile, the actual traded prices much less so. Could bitcoin’s development follow the same path? Or will derivatives undermine the financial incentives of proof-of-work consensus? As soon as I have the time, I’ll be looking into this some more.

Blockchain and credit default swaps – Part 1, an overview

by Matthew Henry via Stocksnap
by Matthew Henry via Stocksnap

Next up in our look at the potential impact of blockchain technology on the derivatives market are credit default swaps. There is much to unpack here, so this section will be divided in several parts: the first entry will give an overview of what the instrument is and why its market is so important. The second will talk about blockchain work already going on in the space. Later posts will discuss recent scandals and new legislation in more detail, and how regulatory changes point to blockchain roadblocks and opportunities.

The credit default swap (CDS) emerged in the 1990s, rose to notoriety in the 2008 crash, and was one of the protagonists of the hit 2015 movie “The Big Short”. Few financial instruments get to star in a film, but the CDS has a talent for superficial deception: it masquerades as a humdrum insurance play, but in reality, it can be a volatile risk investment.

Although the CDS market is nowhere near as large as other derivatives such as foreign exchange and interest rate swaps, it has attracted more than its proportional share of scrutiny and criticism. To understand why, let’s take a look at how they work.

What is a CDS?

Stripping it down to the basics, a credit default swap allows a holder of a bond (corporate or sovereign) to hedge the exposure by promising a payout (usually a pre-established percentage of the face value of the bond) if the issuer defaults on its debt. So, if you hold a debt instrument issued by a corporation which then goes bankrupt, your bond is almost worthless but you offset that with the payout from the CDS.

This hedge can be especially useful if the bond is relatively illiquid, which would make it difficult to sell if the market starts to get nervous. The possibility of hedging can also lower borrowing costs by reducing the risk of a security.

It’s important to note that a CDS is not actually tied to a certain bond – it just references it.

And you don’t have to hold the referenced obligation to buy a CDS. You could just do so for speculation if you believe that things will go badly for an obligation issuer. Or, if you’re convinced that a company is solid with no risk of default, you could write a CDS – someone will pay you a purchase price and periodic interest, and you will only have to make a payout if you’re wrong.

Given current volumes (greater than the those of the underlying obligations), it seems that speculation is the main motive these days for purchasing CDSs. However, limits are starting to be imposed. For instance, the systemic risk inherent in betting on government defaults (and possibly doing what you can to nudge them along) led the European Union to ban the purchase of “naked” CDSs (held without the underlying security) for sovereign bonds.

It’s not just debt default that could trigger a payout. Any “credit event” could suffice, depending on the contract, such as a debt rating downgrade, a restructuring or a currency redenomination (although new standards exempt the debt of members of the EU switching to a new sovereign currency, unless the creditworthiness declines).

And, CDSs don’t always have to be based on a specific debt security. They can also reference several bonds at once.

As if all that wasn’t complicated enough, you can also buy and sell a “credit default swaps index”, which allows you to hedge your entire bond portfolio. These derivatives are standardised financial instruments, with relatively high liquidity.

Apparently trading volumes on credit derivative indices has shot up recently, indicating unease about the US debt and interest rates. In fact, the CDS market is becoming so sophisticated that it is increasingly read as a barometer for market outlook.

Where do they trade?

Originally, all CDSs traded on over-the-counter (OTC) markets. However, the lack of control over the accumulation of heavily leveraged positions did serious damage in 2008 when unexpected payouts came due.

The 2008 financial crisis triggered a re-examining of regulation and oversight, which culminated in the Dodd-Frank Act of 2010, the most sweeping reform since the Glass-Steagall act almost 80 years earlier. One aspect, the Volcker Rule, mandated the separation of proprietary trading and commercial banking (to ensure that customers’ deposits were not used for trading for the bank’s own profit). This meant that many large CDS traders exited the market, further reducing liquidity.

Title VII of the Dodd-Frank Act, which came into effect in 2013, ruled that all CDS index derivatives (not single-entity CDS, or those that reference a narrow range of borrowers, since they generally have low trading volumes) had to be centrally cleared – that is, settlement had to be carried out via a central clearing house, which stands between the buyer and seller and ensures liquidity and delivery. It also mandated more reporting and increased collateral requirements.

The clause also requires all cleared credit derivatives to be traded on a regulated exchange, or a swap execution facility (a registered trading platform with more oversight than the OTC market).

Europe has followed a similar path. The European Market Infrastructure Regulation (EMIR), introduced in 2015, mandates the reporting of derivative contracts to a trade repository, and requires the central clearing of CDS indices and certain euro-based corporate credit default swaps. This is to be gradually implemented over 2017-18.

The global net volume has shrunk considerably since 2008 (when it reached a whopping $60tn), but is still a considerable $10tn a year.

According to the Bank of International Settlements, the majority of CDSs are still OTC-traded. This is likely to see a substantial shift in the short term. In 2015, a group of large asset managers, including Citadel, BlackRock and Anchorage, pledged that they would centrally clear their own single name CDS trades, with a view to increasing volume and lowering costs (in addition to having lower liquidity, non-cleared single-name CDSs carry heavy capital charges).

A significant change for the market is that the Act requires all swaps – even uncleared and OTC-traded ones – to be registered with a swap data repository (SDR).

The US and Europe account for about 90% of the global CDS market, with Latin America following behind with about 5%. China recently started trading CDSs – given the relatively fragile state of its bond market, this source could become significant in the near future.

Who regulates them?

This is a complicated area, with overlap, gaps and quite a bit of confusion, even within jurisdictions.

In the US, the two main regulatory bodies when it comes to financial instruments are the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC).

The SEC has regulatory authority of “security-based swaps”, including CDSs that reference a particular bond or a narrow range. The CFTC regulates credit swaps based on indices. Both organizations jointly cover credit swaps that have a commodity component (such as foreign exchange). Also, both organizations jointly make decisions regarding jurisdiction, data recording and intermediaries. (I’ll be writing about this more soon, as it’s a fascinating mess.)

In Europe, the framework appears to be simpler: the CDS market is regulated by the European Commission (EC). The European Markets Securities Authority (ESMA) makes regulatory proposals for the EC’s consideration, and can set fines in certain circumstances.

The International Swaps and Derivatives Association (ISDA) sets global standards.

Overview

So, here we have a systemically important yet relatively opaque financial market, with complicated regulation and siloed data. The complexity alone, with a relative lack of standards and an increasingly international impact, makes the need for streamlining clear – even though the consequences are not.

More investigation of the regulation of the CDS market is warranted, as is a detailed understanding of recent rulings and fines in the sector, but this post is long enough as it is. However, the recent surge in interest in CDS trading makes clarity on the lessons learned and the way forward especially important.

In the next post in the series, we’ll look at some of the ongoing work on blockchain implementations in this market. As we’ll see, the progress is slow, but – given the complexity – that is both understandable and desirable.

Blockchain and capital markets: foreign exchange trading

FX market

For something so little talked about, the foreign exchange (FX) market is a big deal.

The world’s largest and most liquid financial market, over $5tn a day changes hands in FX cash and derivative transactions. That’s more than the entire annual GDP of some countries.

The bulk of transactions are for FX derivatives, and few appreciate how integral these are to the functioning of the world economy. In terms of value, FX swaps are the most traded instrument in the world, exchanging an average of $2.4tn per day. When a central bank, commercial bank, corporation or fund manager needs a foreign currency for a purchase, an investment or a hedge, they generally resort to FX swaps – basically, they lend their domestic currency to foreign institutions, and simultaneously borrow from them the currency they need. This works out to be much cheaper and faster than directly borrowing the money in another country. In principle, the collateral for each side is the payment (or series of payments) they commit to making to the other.

As with most derivative markets, the system is clunky and relatively expensive, operating on dispersed, decentralized exchanges with duplicate processes, a lack of standardisation, an emphasis on direct relationships and increasing capital requirements. Although the infrastructure has radically improved over the past few years with the introduction of new trading venues, greater liquidity, algorithmic execution and improved data aggregation, the industry still regards settlement risk as one of its greatest threats.

New technologies and processes are making a difference, and are becoming even more essential in light changing regulation and increasing costs. Clearing houses are becoming even more important, for example, and traditionally opaque over-the-counter markets are being given a welcome (but expensive) wash of sunlight as post-crisis financial regulation demands greater transparency and less risk.

Given the decreasing profitability of swap market making (due to greater capital requirements and a recent slump in volume due to macroeconomic conditions), many prime brokers are either pulling out of the sector or closing out smaller clients, leading to lower liquidity and increased risk. This encourages even more prime brokers to pull out. Non-bank dealers and infrastructure innovations are picking up some of the slack.

Several capital markets businesses – both startups and incumbents – are looking at how blockchain technology can help reduce operating costs.

One of the most prominent is Cobalt, a startup working on a blockchain platform for FX post-trade settlement which it claims can reduce risk and cut costs by 80% (according to the FT, banks currently spend about $500m a year on technology for currency trading). In May, it announced that two of the world’s largest FX traders – Citadel Securities and XTX Markets – will use its service. They join 22 other banks and traders, including Deutsche Bank, UBS, BNP Paribas and Bank of America Merrill Lynch, in testing the platform ahead of a launch expected later this year.

While Cobalt is currently building on a blockchain platform designed by UK-based startup SETL, it aims to be ledger agnostic. The startup cites Tradepoint (a foreign exchange trading technology provider), First Derivatives (a database technology developer, which will apparently feed the data) and Kx (focused on high-speed data processing) as tech partners, and counts CitiGroup (which has the lion’s share of the global FX market) and DCG among its investors.

From startup to industry incumbent… NEX Group (formerly ICAP) has been working on a distributed ledger for FX trades – called Nex Infinity – built with technology from New York-based startup Axoni. The company recently began allowing clients to test the platform.

This makeover is a key part of the company’s strategy as it moves away from its history as one of the market’s leading interdealer brokers and into trading infrastructure. Its subsidiary Traiana will most likely end up playing an important role in the rollout of NEX Infinity, as it is one of the market’s leading post-trade and risk specialists. (As an aside, the founder and CEO of Cobalt – Andy Coyne – used to be CEO of Traiana.)

And, moving up the ladder, CLS Group – the world’s largest FX settlement service (handling over 50% of global FX transactions) – is working on CLS Netting, a blockchain-based settlement system for trades in currencies outside the standard service. The platform won’t be used in the core settlement system, but rather to improve liquidity in other currencies with more challenging legal frameworks that are currently settled on a bilateral basis, such as the renminbi and the rouble.

CLS is a founding member of blockchain consortium Hyperledger, and the platform is being built on Hyperledger Fabric. Several banks – including Bank of America, Goldman Sachs, Citi, JPMorgan Chase, Morgan Stanley, HSBC, Bank of China (Hong Kong), Bank of Tokyo-Mitsubishi UFJ, FirstRand and Intesa Sanpaolo – have expressed an interest in participating. Not bad for a fledgling project. Development is expected to near completion in early 2018.

The FX market is not an easy one to disrupt, even though the opportunity is obvious. First, scale matters – small startups, unless they have influential backers, are at a disadvantage in a sector in which most participants know each other, and trust is an important factor. What’s more, the incumbents increasingly seem to be aware of the potential of blockchain technology, as well as the need to innovate.

Second, the spectre of tightening regulation and the impact of macroeconomic trends add risk to the outlook for any foreign exchange project, for both startups and incumbents. FX volumes have been declining for a couple of years, although the slump has been concentrated in the spot market – derivatives are growing nicely, for now.

The next 12 months should see some key announcements in the nexus between blockchain technology and FX trading, as projects mature and more proofs-of-concept emerge. As regulations change, economic trends realign and even newer technologies develop, the market will continue to evolve towards a more efficient, transparent and trustworthy financial service. We are witnessing what will be looked back on as a fundamental shift in capital markets.

Blockchain and capital markets: equity swaps

by Jan Vasek, via StockSnap
by Jan Vasek, via StockSnap

The world of capital markets is littered with terms that sound simple on the surface, but thoroughly confusing once you start poking at them.

Take, for instance, “equity swaps”. Easy, you swap equities with someone else, right?

It turns out that you don’t swap equities. You swap the returns that the other party’s equities give. That way you can diversify your portfolio without having to actually sell underlying holdings. Selling large holdings incurs costs and can move the market, which you probably want to avoid. Or, maybe your fund’s bylaws prohibit you from doing so. Or, maybe you would rather avoid capital gains tax. Other possible advantages include retention of voting rights (you want to retain your holding in a company but would rather have a fixed dividend than a variable one), access to illiquid markets, or being able to legally go around holding restrictions (eg. limitations on foreign funds).

So, let’s imagine you have a holding that pays you a fixed rate, the same payment every year. But you would rather a variable one. Rather than sell your fixed rate security, you enter into a swap with another party that has a holding that pays (for example) the return on the S&P 500 stock index. They are tired of so much volatility and want something more stable (or maybe they have fixed payments coming up and need to lock in those receipts).

So the two of you enter into a swap – you get the other party’s payments from their security, they get yours.

Now, just imagine the complicated and duplicated paperwork that backs up this operation.

Digitisation helps, obviously. Traiana, founded in 2000 to provide pre-trade risk assessment and post-trade solutions, is the market leader in electronic processing of over-the-counter (OTC) swap trades. It connects derivatives exchanges, institutional investors, interdealer brokers and swap execution platforms, channelling trades to clearing houses and providing analytics.

It is owned mainly by the Nex Group (formerly ICAP Ltd.), which at one stage was the world’s largest interdealer broker for OTC trading with daily transaction volume of over $2.3tn. After a tumultuous few years (which included whopping fines from the Commodities Futures Trading Commission in the US and the UK’s Financial Conduct Authority), that division was sold at the end of 2016, and Nex now focuses on market infrastructure.

Traiana counts among its investors such blue-chip firms as Bank of America Merrill Lynch, Barclays, Citigroup, Deutsche Bank, JP Morgan, Nomura, and the Royal Bank of Scotland.

Yet in spite of the presence of a clear market leader, the sector does not have a common infrastructure, leading to costly data reconciliation.

Could equity swaps benefit from blockchain technology? That’s what New York-based startup Axoni is hoping to determine.

Last year it completed a trial involving nine market firms, including Barclays, Credit Suisse, IHS Markit and Capco (a capital markets consultancy owned by FIS), as well as shareholders Citigroup and Thomson Reuters. The project established a blockchain processing network for equity swap trades using Axoni’s proprietary distributed ledger software.

One interesting aspect is the involvement of Traiana competitor IHS Markit in the trial. One of Axoni’s investors is Euclid Opportunities, the investment arm of Traiana’s parent Nex, and the two firms also both have Citigroup and JP Morgan as investors.

Although it worked with IHS Markit in this trial, Axoni has collaborated with Traiana on other projects in the past, such as a securities post-trade prototype in early 2016 and a foreign exchange one currently under development.

Could there perhaps be industry consolidation further down the line?

While equity swaps are a small part of the global OTC derivatives market, they could be considered the “low hanging fruit” of the sector for capital markets blockchain integration. The processes are complex, and the market is distributed and fragmented. What’s more, changing regulation calls for increased transparency and reporting. Coherence and coordination will benefit all participants, adding liquidity while reducing costs.

A blockchain-based platform would have the additional advantage of scalability, perhaps also including other types of swaps and offering even further efficiencies to market participants.

While blockchain exploration is ongoing in other areas of capital markets, Axoni’s equity swaps test is an interesting snapshot of a concrete use case. Furthermore, it points to how the sector will be restructured: carefully, one application at a time.

(This is the first in a series on the potential impact of blockchain technology on capital markets. Up next: FX.)