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 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.
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.
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.
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.
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.)
The market is huge, trading almost $1.9bna 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).
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.
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.
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.)