Stock exchanges, cryptocurrency trading and trying harder

Until a few years ago, Avis – the second-largest car rental firm in the US for much of the last half century – ran an iconic advertising slogan: “We’re No. 2. We Try Harder.” Given my soft spot for underdogs, I thought it was brilliant. Embrace reality, turn a negative into a positive and move the goal posts.


I was reminded of that this week when Germany’s no. 2 stock exchange revealed a planned launch this autumn of a cryptocurrency trading app. Börse Stuttgart’s subsidiary Sowa Labs has developed a mobile platform that enables clients to trade bitcoin, ethereum, litecoin and ripple. Onboarding will supposedly take minutes, and although initially only available in German, apparently an English language version is in the works (the company also runs the second-largest stock exchange in Sweden). Perhaps even more interesting, the app will use “artificial intelligence” to sift through crypto Twitter and select those tweets that best indicate price trends (can’t wait to see that).

While a distant second to Deutsche Börse in terms of turnover, Börse Stuttgart is – according to its website – the market leader for exchange trading in corporate bonds (as opposed to over-the-counter trades, which dominate volume). What’s more, and this is especially interesting given its cryptocurrency strategy, Börse Stuttgart is Germany’s leading exchange for retail investors. Its website claims:

“Ground-breaking ideas for the benefit of retail investors are a tradition at Boerse Stuttgart.”

Although founded as far back as 1861, it seems to have been eager to embrace new technologies, offering “best size” and “best price” practices for the retail market, long before most of its peers. And now, cryptocurrency trading.

As well as the empowering idea of the second largest having to try harder, another underlying force is at work here, one that we’ve seen replicated across the finance sector: the incumbents are the best positioned to take new technologies mainstream.

The economist Joseph Schumpeter posited, almost 100 years ago, that large firms are more enablers than barriers when it comes to technological development. Their reach and economic power gives them a huge advantage when it comes to “appropriating” technology, further consolidating their position and further centralizing the sectors in which they operate.

True, the landscape has changed. The growth of computing and open source technologies has distributed access to new ideas among a much broader range of actors. Startups are gaining significant clout, and are likely to become the new incumbents as market structures shift.

Yet, the current incumbents seem to be aware that embracing new technologies is not only good for the bottom line, it could also become a matter of survival. And, in the process, the technologies reach a wider audience.

We’re seeing this in the cryptocurrency sector. Most commercial banks, central banks and stock exchanges are running blockchain trials and designing proofs-of-concept. And in cryptocurrencies, while many institutions are still keeping a cautious distance, a few brave innovators are incorporating new services to improve access to a market that is obviously not going away.

Is this just another case of a financial institution using “cryptocurrency” as window dressing to enhance its profile, or is there significant demand amongst Börse Stuttgart’s retail client pool for cryptocurrency trading? According to an internal survey, there is – and the company’s record on innovation and retail focus points to a genuine interest in improving the customer experience when it comes to a new asset.

Beyond the easier access to cryptocurrencies, a more subtle change could result: the increased perception that bitcoin, litecoin and peers are neither a threat to the established system, nor a clandestine investment opportunity. The backing of a large and reputable financial institution brings what was once a niche activity into the hubbub of mainstream markets – and, it perhaps further entrenches these assets’ role as trading vehicles rather than decentralized enablers or financial disruptors.

Lessons learned: Taurus and the ASX blockchain integration

image by Tamarcus Brown via StockSnap
image by Tamarcus Brown via StockSnap

London, 1993. A big decision was about to be made, that would send ripple effects across Europe and forward through time, acting as a warning against ambition and consensus.

For the past 10 years, the London Stock Exchange had been working on a significant upgrade of its securities settlement system. With paper-based systems groaning under the 1980s boom in share ownership, pressure was building not only from nimbler competitors but also from the regulators across the Channel. If London wanted to maintain its role as the continent’s money centre, it needed to upgrade.

The new system was called Taurus, and its goal was to remove as much physical documentation from the system as possible. It also planned a move to rolling settlement, reducing the payment period for equities from three weeks to three days.

Yet things were not going well. The first sign was the rhythm of missed deadlines.

From the outset, the project was complicated. It aimed to include as many sector stakeholders as possible, in spite of conflicting interests. Institutional investors wanted a fast, reliable service, while private investors wanted lower costs. Also, the existing registrars (dominated by large banks) were given a say in the development of a centralized registry, even though it would undermine their business model. Well into the development cycle, they torpedoed the idea.

What went wrong?

In the haste to get development off the ground, the project allegedly started without a clear roadmap. And delays gave more time for the various stakeholders to add requirements.

Even with clear and stable stewardship, that scale of development would have been tough. Yet the project management structure was not clearly defined, and the lack of centralized control meant that interlocking pieces were being developed out of sync, with sections of the process at different testing stages, while other functions had not yet been designed.

Also, given the long lead time (which ended up being more than double the initial estimate), the system – if launched – would already have been behind the competition from day one.

The final straw came when an investigation in 1993 revealed that completion would take another two to three years, at double the cost-to-date.

The decision was taken to scrap the whole project. The exchange’s investment of over £70 million (over £140 million in today’s money) was lost. The London Stock Exchange handed over responsibility for the development of a new stock trading system to the Bank of England, and its CEO resigned.

It wasn’t just the colossal waste of money and the damage to its reputation that made many fear for the exchange’s future. Hundreds of brokers had based their systems development on the assumption that Taurus would be the main platform, and thousands of employees had been trained. The total cost to London’s financial centre was estimated to be in the hundreds of millions of pounds.

Of course, it’s easy to see in hindsight where things went wrong. And it’s easy to believe that today, big systemic projects would be managed with different principles.

While that may be the case, the fate of Taurus serves to highlight the colossal complexity of introducing a new systemic platform. Throw in a technology that has yet to be tested “in the field”, and you have a potential powder keg of risk.

All change

I’m talking about the decision of Australia’s primary securities exchange, ASX, to upgrade its clearing and settlement platform to one based on distributed ledger technology.

Announced late last year, the news sent waves of excitement through the blockchain sector – it would be one of the first major public-facing applications of the technology, which many have touted as having the potential to decentralize finance.

Introduced with bitcoin, the blockchain offers a way of sharing data that removes the need for validation from a central authority. The elimination of redundancies and the speed with which information can be transmitted and acted on present significant cost reductions, especially intriguing in an era of diminishing margins and increasing competition in the financial sector.

It’s not yet clear whether the technology that ASX will use (developed with blockchain startup Digital Asset) will technically be a blockchain, in which information is stored in blocks that are irrevocably linked to previous blocks, ensuring data integrity. The official press release referred to “digital ledgers”, and while the two terms are often used interchangeably, some distributed ledgers don’t rely on linked blocks to share and verify inputs and outputs. However, since the boundaries of the new technology are being blurred as the concept evolves, the announcement was treated as a triumph by blockchain sector participants – official, public validation of the potential benefits.

Be careful

And yet, it is by no means the windfall that the headlines proclaimed.

First, it isn’t happening anytime soon. At the end of March, the ASX will reveal a potential live date for the new platform – it will most likely be years away. We won’t get a clear indication of the expected timing until the end of June.

And, as we saw with Taurus, in complex undertakings, deadlines are often extended. Hopefully the new system will be revealed within a much shorter timeframe than the failed British attempt’s estimated 13 years…

If it gets revealed at all. The ASX platform does need to be replaced – known as CHESS, it is 25 years old and is struggling to keep up with newer and nimbler competitors. But the decision to build on top of a relatively untested technology with uncertain scaling and bottlenecks is a brave one. And few development projects progress without setbacks.

It’s fair to assume that the planning will be meticulous and thorough. But will it manage to avoid the pitfalls of overwhelming systemic change?

Learning from the mistakes of Taurus will help. But the leap forward in technology with this development adds a new layer of complexity.

A large part of the problem will be managing expectations. While “blockchain” has been hailed as “the next industrial revolution”, we are not going to see a new decentralized stock exchange emerge before our eyes. As far as the public is concerned, things will continue pretty much the way they are.

For the financial and technology sectors, though, it is a big deal. If all goes well, back office costs will be reduced, new efficiencies will be explored and distributed ledger technologists will learn much from the real-world rollout.

The true change, however, will come years down the road, as other exchanges around the world take a look at their own clearing and settlement processes, as regulators encourage compatibility and connectivity, and as frictionless cross-border trading finally begins to look like a possibility.

But first, the ASX system needs to be successfully launched. And, as we’ve seen, it’s nowhere near as easy as it sounds. While the decision to migrate a country’s main securities settlement and clearing platform to a distributed ledger is good news for the blockchain sector, it is too soon to celebrate.

Bitcoin futures and the meaning of finance – how did we get here?

Photo by Brandon Morgan on Unsplash
Photo by Brandon Morgan on Unsplash

One outstanding note in the cacophony of the bitcoin futures debate is an intriguing claim that I confess I didn’t understand at first: that bitcoin has no “natural sellers”. What’s unnatural, I thought, about people wanting to sell to realize profits? It turns out that’s not what the phrase means.

It means that nobody needs bitcoin. So why hedge it?

To go deeper, let’s look at why capital markets exist. They were developed to enable firms to raise money outside of bank loans. Bonds and equities pair those that need funds with investors who want a return.

Derivative markets emerged to protect cash flows. This both gives producers more security, and helps to raise funds – investors are more likely to “lend” to a company with protected income than to one subject to the vagaries of nature.

In essence, capital markets exist to help businesses flourish. Old-school capitalism.

Here’s where the “natural seller” part becomes important.

Farmers need to sell wheat. It’s what they do. Oil producers need to sell oil. Steel manufacturers need to sell steel. Gold miners need to sell gold. So, they all should protect those sales in the derivative markets.

No-one needs to sell bitcoin.

So what income flows are the derivatives protecting? Mutual fund redemptions, maybe. Pension plan payouts. But do we really think that mutual funds and pension plans should have significant exposure to bitcoin?

This question is important for whatever side of the bitcoin debate you’re on. If you’re a sceptic and think that it’s all a ponzi scheme, surely you don’t want institutional funds heavily invested in an asset that will no doubt crash. If you’re a bitcoin believer, do you really want the “money of the future” stuck in funds? Where’s the decentralizing potential in that?

So, it could be that the constructive purpose of bitcoin derivatives is to protect flows for funds that are either taking irrational risks or hijacking the finance of tomorrow. This is a far cry from ensuring that farmers can make a living and oil producers don’t go bust.

We could argue that all this started to go awry back in the ‘80s with the creation of synthetic derivatives that had as their sole aim to make a profit at the expense of others (trading being a zero-sum game). We could also argue that back then we got ahead of ourselves by letting markets run far ahead of the infrastructure. We know what happened next. (Ok, I’m simplifying, but the point still holds.)

And we could ask ourselves what good bitcoin futures will do the economy as a whole. To what productive use will their markets contribute? Are they adding stability, as per the original intent of derivatives? Or could they be adding yet another layer of complexity that masks a deepening fragility?

Of course, playing the long game, this could be what true bitcoin believers have known would happen all along. That the world will see (again) how unstable the current financial system is. And to what will people turn when widening cracks send central banks scrambling?

True, the bitcoin price would also likely tumble. But the technology would still work. People would still be able to independently transfer funds. And the advantage to having an alternative to an interconnected and unstable system would become more apparent than ever.

The threat of bitcoin futures

photo by Jesse Bowser on Unsplash
photo by Jesse Bowser on Unsplash

The financial press has been in a flutter of excitement over the launch of bitcoin futures trading on not one but two reputable, regulated and liquid exchanges: CME and Cboe.

CME Group (Chicago Mercantile Exchange) is the largest derivatives exchange in the world, as well as one of the oldest, with roots going back to the 19th century. It will launch bitcoin futures trading on December 18th.

Cboe Global Markets owns the Chicago Board Options Exchange (the largest US options exchange) and BATS Global Markets (the platform on which the Gemini-backed bitcoin ETF would have been listed had it been approved). It plans to beat CME to the punch by launching bitcoin futures trading on December 10th.

In theory this opens the doors to institutional and retail investors who want exposure to bitcoin but for some reason (such as internal rules, or an aversion to risky and complicated bitcoin exchanges and wallets) can’t trade actual bitcoin.

And that expected flood of interest is, from what I hear, part of the reason that bitcoin’s price recently shot past $11,000 (which, considering it started the year at $1,000, is phenomenal).

I’m missing something. I don’t understand why the market thinks there will be a huge demand for bitcoin itself as a result of futures trading.

First, a brief primer on how futures work: let’s say that I think that the price of xyz, which is currently trading at $50, will go up to $100 in two months. Someone offers me the chance to commit to paying $80 for xyz in two months’ time. I accept, which means that I’ve just “bought” a futures contract. If I’m right, I’ll be paying $80 for something that’s worth $100. If I’m wrong, and the price is lower, then I’ll be paying more than it’s worth in the market, and I will not be happy.

Alternatively, if I think that xyz is going to go down in price, I can “sell” a futures contract: I commit to delivering an xyz in two months’ time for a set price, say $80. When the contract is up, I buy an xyz at the market price, and deliver it to the contract holder in return for the promised amount. If I’m right and the market price is lower than $80, I’ve made a profit.

Beyond this basic premise there are all sorts of hybrid strategies that involve holding the underlying asset and hedging: for instance, I hold xyz and sell a futures contract (I commit to selling) at a higher price. If the price goes up, I make money on the underlying asset but lose on the futures contract, and if it goes down the situation is reversed. Another common strategy involves simultaneously buying and selling futures contracts to “lock in” a price.

Futures contracts currently exist for a vast range of commodities and financial instruments, with different terms and conditions. It’s a complex field that moves a lot of money. The futures market for gold is almost 10x the size (measuring the underlying asset of the contracts) of the physical gold market.

How can this be? How can you have more futures contracts for gold than actual gold? Because you don’t have to deliver an actual bar of gold when the contract matures. Many futures contracts settle on a “cash” basis – instead of physical delivery for the sale, the buyer receives the difference between the futures price (= the agreed-upon price) and the spot (= market) price. If the aforementioned xyz contract were on a cash settlement basis and the market price was $100 at the end of two months (as I had predicted), instead of an xyz, I would receive $20 (the difference between the $100 market price and the $80 that I committed to pay).

Both the CME and the Cboe futures settle in cash, not in actual bitcoin. Just imagine the legal and logistical hassle if two reputable and regulated exchanges had to set up custodial wallets, with all the security that would entail.

So, it’s likely that the bitcoin futures market will end up being even larger than the actual bitcoin market. That’s important.

Why? Because institutional investors will like that. Size and liquidity make fund managers feel less stressed than usual.

The bitcoin market seems to be excited at all the institutional money that will come pouring into bitcoin as a result of futures trading. That’s the part I don’t understand.

It’s true that the possibility of getting exposure to this mysterious asset that is producing outstanding returns on a regulated and liquid exchange will no doubt entice serious money to take a bitcoin punt. Many funds that are by charter prohibited from dealing in “alternative assets” on unregulated exchanges will now be able to participate. And the opportunity to leverage positions (get even more exposure than the money you’re putting in would normally warrant) to magnify the already outrageous returns will almost certainly attract funds that need the extra edge.

But here’s the thing: the money will not be pouring into the bitcoin market. It will be buying synthetic derivatives, that don’t directly impact bitcoin at all. For every $100 million (or whatever) that supermegahedgefundX puts into bitcoin futures, no extra money goes into bitcoin itself. These futures do not require ownership of actual bitcoins, not even on contract maturity.

Sure, many will argue that more funds will be interested in holding actual bitcoins now that they can hedge those positions. If supermegahedgefundX can offset any potential losses with futures trading, then maybe it will be more willing to buy bitcoin – although why it would allow its potential gains to be reduced with the same futures trade is beyond me. And, why hold the bitcoin when you can get similar profits with less initial outlay just by trading the synthetic derivatives?

That’s the part that most worries me. Why buy bitcoin when you can go long a futures contract? Or a combination of futures contracts that either exaggerates your potential gains or limits your potential loss? In other words, I’m concerned that institutional investors that would have purchased bitcoin for its potential gains will now just head to the futures market. Cleaner, cheaper, safer and more regulated.

So, if the market is discounting an inflow of institutional funds into actual bitcoins, it’s likely to be disappointed.

What worries me even more is the possibility that the institutional funds that have already bought bitcoin (and pushed the price up to current levels) will decide that the official futures market is safer. And they will sell.

Now, it’s possible that the demand for bitcoin futures and the general optimism that seems prevalent in the sector will push up futures prices (in other words, there will be more demand for contracts that commit to buying bitcoin at $20,000 in a year’s time than those that commit to buying at $12,000 – I know, but the market is strange). This will most likely influence the actual market price (“hey, the futures market knows something we don’t, right?”).

And the launch of liquid futures exchanges increases the likelihood of a bitcoin ETF being approved by the SEC in the near future. That would bring a lot of money into an already crowded space.

Buuuut… it’s also possible that the institutional investors that are negative on bitcoin’s prospects (and there’s no shortage of those) may use the futures markets to put money behind their conviction. It’s much easier to sell a futures contract with a lower-than-market price than it is to actually short bitcoin. These investors may well send signals to the actual bitcoin market that sends prices tumbling.

And the leverage inherent in futures contracts, especially those that settle for cash, could increase the volatility in a downturn.

That’s pretty scary.

Let’s not even go into the paradigm shift that this development implies. The growth of a bitcoin futures market positions it even more as a commodity than a currency (in the US, the Commodity Futures Trading Commission regulates futures markets). And even more as an investment asset than a technology that has the potential to change the plumbing of finance.

So, while the market appears to be greeting the launch of not one but two bitcoin futures exchanges in the next two weeks (with two more potentially important ones on the near horizon) with ebullience, we really should be regarding this development as the end of the beginning.

And the beginning of a new path.

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: 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.)

Could Brexit encourage blockchain development?

by Rob Bye via Stocksnap
by Rob Bye via Stocksnap

The FT reported yesterday on the intensifying staring match between the EU and the UK over financial services.

London has for some time been in danger of losing its position as the world’s clearing center for euro-denominated derivatives. The city’s clearing houses handle up to three-quarters of the global euro-denominated derivatives market.

The European Central Bank (ECB) has long argued that oversight of euro clearing services would be easier if they were relocated to within the Eurozone, and in 2011 issued a policy reflecting this. The UK took the case to the European Court, which eventually sided with the UK. The reason given was not because geographical restrictions would discriminate against some member states (the UK’s main argument), but because the ECB’s role is to supervise payment systems, not securities settlement. The ECB still alleges that settlement oversight is essential for payment system stability.

Now that Britain will soon no longer be an EU member, the battle lines are shifting. The European Commission (EC) is preparing legislation for June that will impose geographical restrictions on euro-based clearing. An interesting twist is that the EC is not waiting until Brexit becomes a reality.

The policy, due for publication tomorrow, moves to extend the ECB’s role to include supervision of clearing houses if they provide “critical capital market functions” (such as derivatives swaps). If this goes ahead, it will mean that either the activity needs to relocate, or the UK has to allow ECB supervision on British territory (which it’s unlikely to be happy with).

If the activity has to relocate, the fallout will be considerable, and the impact could be felt around the world. Euro-denominated derivatives clearing accounts for about one third of the global interest rate swaps market.

It’s probable that some clearing houses will prefer to wind down than move (CME Group recently decided to pull out of London due to lack of profitability). The larger ones may find that they lose clients. Either would be enough to contract medium-term liquidity in the market.

Short-term, the potential problem is more serious. Clearing houses reduce liquidity risk in financial markets by standing between two traders in a transaction. They also increase transparency by being in a position to publish the price at which a trade executed.

Disrupt those functions, or even temporarily interrupt them, and you increase systemic risk. You also increase the cost of clearing, as economies of scale are reduced.

Some clearing houses are looking into blockchain applications as a way to reduce costs and enhance liquidity. In 2015 a group including settlement giants CME Group, Euroclear and LCH.Clearnet formed a working body to discuss how the technology might be used to settle transactions. The Depository Trust & Clearing Corporation (DTCC) in the US is specifically looking at credit derivatives settlement.

And notable blockchain startups such as Setl, Digital Asset, Clearmatics, Symbiont and others are also working on protocols to either help or replace traditional clearing houses.

So, there is movement to seek greater efficiencies in settlement, reduce dependence on clearing houses and reinforce transparency. But it’s happening slowly.

Understandably so. Blockchain technology is still new and relatively untested in financial applications. And systemic market infrastructure is not something you play around with.

However, the clock is ticking. And heavy investment in new systems that perpetuate current inefficiencies and are not future-proof will end up adding even more pressure to financial services firms’ already squeezed margins.

I’ve written before how financial shifts due to pending regulation end up spurring research on new uses.

Now we can add political pressure to the list motivating factors.

Could a bitcoin ETF happen in the near future?

Now that the market excitement over the possibility of a bitcoin ETF seems to have been put to bed with the SEC rejecting both the Winklevoss and the SolidX proposals, it’s worth thinking about what needs to change for an official bitcoin investment vehicle to happen.

Forbes published today an interesting article by Moe Adham that unpacks the SEC decision. He pins the causes on two things:

    1) The lack of “surveillance-sharing agreements with significant markets”, in this case between the listing exchange (BATS) and a commodity exchange operator (Gemini, which does not have a significant market position). The concern is that the market insignificance of the exchange on which the underlying asset will be traded could leave it vulnerable to manipulation.
    2) The Gemini Exchange is not regulated enough (it is, though, one of only two regulated bitcoin exchanges in New York – but apparently that’s not enough).

Moe then goes on to hypothesize on what would need to happen before a US-listed bitcoin ETF is approved:

    1) The majority of bitcoin trading needs to happen on US-based exchanges.
    2) US-based bitcoin exchanges need to be regulated.

I agree with Moe that both of the above are unlikely to happen in the near future, but I don’t believe that those are the necessary conditions.

In its ruling, the SEC specified that the main reason for the rejection was:

“because the Commission believes that the significant markets for bitcoin are unregulated.”

While this may be true today, it’s unlikely to remain the case for long. As we have seen, several other major markets have made moves to regulate their cryptocurrency exchanges, and we will most likely see this trend pick up steam.

Even if the SEC were to insist on most exchanges being US-based (which I think even they would agree is an unreasonable condition), it’s not totally out of the question. Almost 40% bitcoin trading now happens in US$, making it the largest market, according to Cryptocompare.

via Cryptocompare - Bitcoin ETF
via Cryptocompare

Although only two of the top five US$-BTC exchanges are based in the US (Poloniex and Coinbase), one of them (Coinbase) already has a New York BitLicense. Poloniex, on the other hand, pulled out of New York rather than have to apply for a BitLicense. But that might change, either because Poloniex shifts priorities or because the requirements become less costly and cumbersome.

In the bitcoin sector, regulation is a trend that can only move forward.

With increasing exchange oversight and greater liquidity in the major trading markets, bitcoin prices will become more reliable and transparent, solving another of the SEC’s concerns.

So, I’m more optimistic than Moe that we will see a listed bitcoin ETF in the near future.

I don’t, however, think it will happen in the US first. Another country is far ahead in terms of regulation and acceptance by the financial system, and its regulators are more likely to approve a liquid, listed bitcoin investment vehicle in the short term.