What’s behind the growth of equities swaps?

Key Takeaways

• Swaps can limit buy-sides’ regulatory exposure.

• Sell-side firms’ shrinking commissions makes swaps attractive.

• Robust solutions are needed to manage the complex workflows.

Equity swaps trading has grown in popularity due to various factors, making it an attractive strategy for buy-side firms. Swaps offer a range of benefits, from reducing regulatory risks to providing easier market access and potential tax benefits. With global markets becoming more interconnected and the regulatory environment becoming more complex, the demand for innovative trading solutions like swaps continues to rise.

This blog post explores the key drivers behind the growing popularity of equities swaps trading and the technological and operational challenges that come with it.

The lure of equities swaps for buy-siders

There are a number of factors that drive the demand for swaps trading from the buy-side.

Trading via swaps can lessen regulatory exposure. For firms that operate across many different jurisdictions, managing restriction and disclosure requirements in different markets is a major challenge. Such rules are also often subject to change. Swaps allow buy-side firms to gain short exposure to these markets while having the sell-side firms handle the regulatory complexities and risks.

For example, the execution of short sell orders is subject to uptick rules in various markets. This prevents traders from executing orders at intended price levels in a timely manner. Moreover, some stocks are short sell restricted. These rules have led to the demand for synthetic short via long sell, which allows a buy-side firm to get short exposure via long sell orders.

In EMEA, UCITS registered hedge funds have become popular with investors due to their transparency, lower leverage, and enhanced investor protection. However, regulations prohibit UCITS funds from physical short sell strategies. They are only permitted to short using derivatives. This has increased demand for synthetic trading strategies.

In many markets, foreign investors are required to obtain Investor IDs from the authorities before trading on certain markets. Each legal entity and possibly each fund at a buy-side firm must have its own unique investor ID, adding significant overheads for risk management and middle/back-office processing. Swaps allow buy-side firms simpler access to start trading in ID markets, removing the operational burden of becoming a local registered entity.

Each order entered on the exchange must be attached to a registered investor ID. Above a certain level of stock ownership, the position of the fund must be declared to the regulators. Failure to declare the position can trigger heavy penalties. By using equity-linked products, buy-side firms can build their positions without leaking the information to the broader market.

A buy-side firm looking to get investment exposure to a particular equity market may prefer to avoid exposure to a local currency that may have conversion restrictions or is difficult to hedge.

Equity-linked products can provide tax advantages for foreign investors by leveraging tax treaties between the country where the product is issued and where the underlying equities are traded. For instance, Indian p-notes business is often handled by the Singaporean or the Mauritian entities of the broker, thereby leveraging the tax treaties between the countries and mitigating the need to pay the Indian Capital Gain Tax.

Why the sell-side is drawn to equities swaps

For sell-side firms, shrinking commission revenue from standard equity flows makes swaps business more attractive. Overall equity-linked products are offered to buy-side clients at much higher margins, in the range of 20 to 50 bps. In contrast, flow business commissions are now in the range of 5 to 10 bps for High Touch to 1 to 5 bps for Low Touch (an increasing proportion of the flow being Low Touch).

Regulatory considerations are also a factor for sell-sides. In the US, the Volker Rule introduced very strict restrictions around proprietary trading. Desks such as ETF market making, and Index Arbitrage are under close scrutiny. One reason to maintain such activities is to link them with inventory management in support of client flow activities.

Internationally, the Basel III framework introduced capital requirements for each type of business. Synthetic trades reduce some of the regulatory costs as the swap transactions are off the balance sheet. Basel III stipulates that firms can only net off physical securities finance trades such as repos and stock loans on a single counterparty basis from a balance sheet perspective. The rules for equity swaps, on the other hand, allow firms to net hedges between different clients, offering greater balance sheet efficiencies. This balance sheet netting means synthetic trades also provide efficiencies when calculating the firm’s leverage ratio.

Equity-linked products have become the favored solution for banks to not only protect and grow their margins but also to offer their clients an easier access to emerging equity markets.

Challenges for the sell-side in equities swaps trading

The growth of the swaps business presents major technological and operational challenges for the sell-side. The inherent complexity of swaps workflows can cause delays to execution and client communications. Complex trades across different asset classes means that multiple different trading and back-office systems may be involved, and manual steps may be required, raising the potential for errors.

The structure of swaps workflows also creates issues around balance sheet utilization, as swaps desks will hedge their exposure by trading on the house book. Many different desks across asset classes may become involved in swaps workflows, and effective inventory management is needed to optimize the impact of this business on the balance sheet.

A robust technology platform for swaps trading needs to excel in several key areas. Order and position management must be capable of handling client swap orders and their corresponding hedges. Additionally, integrated risk management is essential for tracking complex positions covering multi-asset workflows. Compatibility is critical. A swaps trading system needs to integrate seamlessly with inbound client orders, and middle and back-office systems, to reduce the need for manual data entry, streamlining the process. It’s also vital to incorporate audit streams and transaction reporting functionality, to help fulfil the stringent regulatory requirements around swaps.

Ensuring seamless execution and compliance

Equities swaps trading is an attractive solution to some of the key business challenges of both buy-side and sell-side firms. However, the inherent complexity of swaps workflows necessitates robust technological solutions to ensure seamless execution and compliance.