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.)